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CAPITAL BUDGETING AND DECISION MAKING 5DM APPROACH 753. Capital Budgeting and Decision Making,5DM Approach. Capital budgeting is the process of making long run planning decisions for investments LO 1. in projects In much of accounting income is calculated on a period by period basis Apply the concept of the time. However in choosing investments managers often must make a selection from among a value of money to capital. group of multiple projects each of which may span several periods Exhibit 20 1 illustrates budgeting decisions. these two different yet intersecting dimensions of cost analysis 1 horizontally across as. the project dimension which depicts the lifespan of the project and 2 vertically upward. as the accounting period dimension which depicts the accounting period in this case a. year Each project is represented as a horizontal rectangle starting and ending at different. times and stretching over time spans longer than one year The vertical rectangle for the. 2012 accounting period for example represents the dimensions of income determination. and routine annual planning and control that were ongoing that year. Capital budgeting analyzes each project by considering all of the cash flows in the. life of the investment from the initial expenditures through the termination of the pro. ject In this fashion it is analogous to life cycle budgeting and costing For example. when Samsung considers a new line of smartphones it begins by estimating all potential. revenues from the new line as well as any costs that will be incurred along its life cycle. Only after examining the potential costs and benefits across all of the business functions. in the value chain from research and development R D to customer service across the. entire lifespan of the new project does Samsung decide whether the new model is a wise. investment, The 5DM model demonstrates how capital budgeting is both a decision making and. a control tool, Step 1 Identify Projects For example when Samsung sought a strategy of product. Identify potential capital differentiation in the form of the phablet the Samsung. investments that agree with the Galaxy II it listed possible upgrades and changes from. organization s strategy its present offering Alternatively a strategy of cost lead. ership could be promoted by projects that improve pro. ductivity and efficiency in its low cost model offerings. Step 2 Obtain Information In this step marketing is queried for potential revenue. Gather information from all numbers plant managers are asked about assembly. parts of the value chain to times and suppliers are consulted about prices and the. evaluate alternative projects availability of key components Some projects may even. be rejected at this stage For example suppose Samsung. learns that the phablet simply cannot be built using. existing production lines It may opt to cancel the project. altogether,Exhibit 20 1 The,Project and Time,Project M Dimensions of Capital. 2010 2011 2012 2013 2014 2015,Accounting Period,M20 HORN8443 07 SE C20 indd 753 9 18 14 4 00 PM.
754 CHAPTER 20 CAPITAL BUDGETING METHODS OF INVESTMENT ANALYSIS. Step 3 Make Predictions Capital investment projects generally involve substantial. Forecast all potential cash initial outlays which are recouped over time through. flows attributable to the alter annual cash inflows and the disposal values at the ter. native projects mination of the project As a result they require the firm. to make forecasts of cash flows several years into the. future to estimate if the investment will be worth the. Step 4 Make Decisions by Using the quantitative information obtained in step 3. Choosing Among Alternatives which is typically limited to financial information. Determine which investment managers use their judgment and intuition to factor in. yields the greatest benefit and qualitative information and strategic considerations as. the least cost to the organiza well For example even if a proposed new line of low. tion cost phones meets its financial targets on a standalone. basis Samsung might decide not to pursue it further if. it feels that the new model will lessen the value of the. firm s brand,Step 5 Implement the,Decision Evaluate. Performance and Learn,Given the complexities of,capital investment decisions. and the long time horizons,they span this stage can be. separated into two phases, Phase 1 Obtain funding and Sources of funding include internally generated cash. make the investments selected flow as well as equity and debt securities sold in capital. in step 4 markets Managers must examine the most cost effective. strategy to generate capital within the firm s capabilities. and consistent with its overall strategy, Phase 2 Track realized cash As the cash outflows and inflows begin to accumulate.
flows compare against managers can verify whether the predictions made in. estimated numbers and revise step 3 agree with the actual flows of cash from the pro. plans if necessary ject When Microsoft initially released the new Surface. tablet its realized sales were substantially lower than. the original demand estimates Microsoft responded by. adjusting supplies and raw materials and manufacturing. fewer devices reflective of demand, To illustrate capital budgeting consider Top Spin tennis racquets Top Spin was one. of the first major tennis racquet producers to introduce graphite in its racquets This. allowed Top Spin to produce some of the lightest and stiffest racquets in the market. However new carbon fibre impregnated racquets are even lighter and stiffer than their. graphite counterparts Top Spin has always been an innovator in the tennis racquet indus. try and wants to stay that way so in step 1 it identifies the carbon fibre racquet project. During information gathering step 2 the company learns that it could feasibly begin. using carbon fibre in its racquets as early as 2016 if it replaces one of its graphite forming. machines with a carbon fibre weaving machine After collecting additional data Top Spin. begins to forecast future cash flows if it invests in the new machine step 3 Top Spin esti. mates that it can purchase a carbon fibre weaving machine with a useful life of five years. for a net after tax initial investment of 379 100 which is calculated as follows. Cost of new machine 390 000,Investment in working capital 9 000. Cash flow from disposing of existing machine after tax 19 900. Net initial investment for new machine 379 100,M20 HORN8443 07 SE C20 indd 754 9 18 14 4 00 PM. DISCOUNTED CASH FLOWS AND THE TIME VALUE OF MONEY 755. New projects often necessitate additional investments Note. Working capital refers to the difference between current. in current assets such as inventories and receivables In assets and current liabilities and represents the capital used in. the case of Top Spin the purchase of the new machine is the firm s day to day operations. accompanied by an outlay of 9 000 for supplies and spare. parts inventory At the end of the project the 9 000 in. supplies and spare parts inventory is liquidated resulting in a cash inflow However the. machine itself is believed to have no terminal disposal value after five years. Managers estimate that by introducing carbon fibre impregnated racquets operating. cash inflows cash revenues minus cash operating costs will increase by 100 000 after. tax in the first four years and 91 000 in year 5 To simplify the analysis suppose that all. cash flows occur at the end of each year Note that cash flow at the end of the fifth year. also increases by 100 000 91 000 in operating cash inflows and 9 000 in working. Management next calculates the costs and benefits of the proposed project This. chapter discusses four capital budgeting methods to analyze financial information. 1 Net present value NPV,2 Internal rate of return IRR. 4 Accrual accounting rate of return AARR, Both the net NPV and IRR methods use discounted cash flows which we discuss in.
the following section, A Note on Sources of Capital and Timing of Investments. Financing is most often the treasury function of an organization Once the investment. decision is made then the financing must be acquired Again this is an information. gathering process and if financing is unavailable this will change the investment deci. sion In reality financing opportunities are often investigated simultaneously with the. formal analyses of the costs and benefits of various investments One reason is that inter. est expense is a cash cost of any investment financed by debt. When a company such as Top Spin finally makes a decision and moves forward with. an investment careful thought must be applied in choosing the source of capital to fund. the project step 5 These choices must be consistent with the company s overall strategy. and within any constraints e g an agreement with a debt holder that it will take on no. more debt Long term investments are appropriately financed by long term capital to. avoid the opportunity costs of spending too much cash immediately and jeopardizing. the liquidity of the corporation Good long term debt contracts match the timing of cash. outflows to pay obligations somewhat closely to the timing of predicted cash inflows For. example an investment with a useful life of 25 years would be financed by a 25 year long. term debt contract Sources of financing can also include internally generated cash flow. from operations However this must be adequate to cover any working capital outlays. in the first year of a long term investment because long term investments rarely generate. cash inflow in their early years,Discounted Cash Flows and the. Time Value of Money, Discounted cash flow DCF methods measure all expected future cash inflows and LO 2. outflows of a project discounted back to the present point in time DCF focuses on cash Evaluate discounted cash. inflows and outflows rather than on operating income as used in conventional accrual flow DCF and non DCF. accounting Cash is invested now with the expectation of receiving a greater amount of methods to calculate rate of. return ROR, cash in the future It is important to understand that accrual accounting estimates of. value are reported on the statement of comprehensive income and statement of financial. position according to generally accepted accounting principles IFRS or ASPE Cash. flow will not equal either operating or net income for the current period Companies. M20 HORN8443 07 SE C20 indd 755 9 18 14 4 00 PM, 756 CHAPTER 20 CAPITAL BUDGETING METHODS OF INVESTMENT ANALYSIS.
without cash to fulfill their contractual obligations are either insolvent or bankrupt. Therefore the management team must focus on predicted cash flow when creating a. capital budget The predicted timing and amount of cash inflow and outflow is espe. cially important, The key feature of DCF methods is the application of the time value of money This. method estimates how a dollar or any other monetary unit received today is worth. more than a dollar received at any future time The reason is that 1 received today can. be invested at for example 10 per year so that it grows to 1 10 at the end of one. year The time value of money is the opportunity cost the return of 0 10 forgone per. year from not having the money today In this example 1 received one year from now. is worth 1 1 10 0 9091 today Similarly 100 received one year from now will be. weighted by 0 9091 to yield a DCF of 90 91 which is the value today of the 100 to be. received next year, The longer the time horizon e g a project spanning 15 years as compared to a. project spanning 5 years results in a higher level of uncertainty In practical terms the. risk increases the longer it takes to collect the long term returns of a project and the. greater the potential that those returns may not be realized In this way DCF methods. explicitly weigh cash flows by the time value of money Note that DCF focuses exclu. sively on cash inflows and outflows rather than on operating income as determined by. accrual accounting The compound interest tables and formulas used in DCF analysis. are in Appendix A, The two DCF methods we describe are the NPV method and the IRR method Both. DCF methods use what is called the required rate of return RRR which is the minimum. acceptable annual ROR on an investment The RRR is internally set usually by upper. management and typically reflects the return that an organization could expect to receive. elsewhere for an investment of comparable risk The RRR is also called the discount rate. hurdle rate cost of capital or opportunity cost of capital. Suppose the CFO at Top Spin has set the RRR for the firm s investments at 8 per. Net Present Value Method, The net present value NPV method calculates the expected financial gain or loss from a. project by discounting all expected future cash inflows and outflows back to the present. point in time using the RRR Only projects with a positive NPV are acceptable because. the return from these projects exceeds the cost of capital the return available by invest. ing the capital elsewhere Managers prefer projects with higher NPVs to projects with. lower NPVs if all other things are equal, To use the NPV method apply the first three steps of the 5DM as follows.
Step 1 Identify the scope and form of the project including an estimate of the initial. 754 CHAPTER 20 CAPITAL BUDGETING METHODS OF INVESTMENT ANALYSIS Step 3 Make Predictions Forecast all potential cash flows attributable to the alter

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