CHAPTER 21

CAPITAL BUDGETING AND COST ANALYSIS

LEARNING OBJECTIVES
1. Recognize the multiyear focus of capital budgeting
2. Understand the six stages of capital budgeting for a project
3. Use and evaluate the two main discounted cash flow (DCF) methods: the net present value (NPV)
method and the internal rate-of-return (IRR) method
4. Use and evaluate the payback method
5. Use and evaluate the accrual accounting rate-of-return (AARR) method
6. Identify and reduce conflicts from using DCF for capital budgeting decisions and accrual accounting
for performance evaluation
7. Identify relevant cash inflows and outflows for capital budgeting decisions

CHAPTER OVERVIEW
Chapter 21 looks at long-run decisions, those spanning multiple years. The focus moves from operations
of a year-by-year approach to that of an entire life span of a project. The accounting for capital budgeting
on a project-by-project approach is similar to life-cycle costing introduced in Chapter 12. The role of the
management accountant is highlighted in the six stages of capital budgeting.
Four quantitative methods used in making capital budgeting decisions are described and illustrated. The
two methods that focus on cash flows and the time value of money are net present value and internal rateof-return, discounted-cash flow models. Typically, the discounted cash-flow methods are superior for
providing information in the decision-making process because they are the most comprehensive in scope.
The concept of money having time value is a main feature of these models. The other methods presented
are the payback method and the accrual accounting rate-of-return. The payback method does use cash
flow as a basis but does not incorporate time value of money nor profitability. The accrual accounting
rate-of-return does not focus on cash flow but uses measures from the income statement. The role of
income taxes is incorporated within the chapter and the role of inflation is in the appendix to the chapter.
Though the methods presented provide a basis on which to make a quantitative financial decision, the
chapter examines the importance of nonfinancial quantitative and qualitative aspects for each decision.
The tension of evaluating a decision using a different model than the one used to make the initial decision
is discussed.

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WRITING/DISCUSSION EXERCISES
1. Recognize the multiyear focus of capital budgeting

Compare the reasons for using life-cycle costing to the project-by-project orientation for
capital budgeting. In Chapter 12, life-cycle costing was noted as being particularly important when
(a) nonproduction costs were large, (b) a high percentage of total life-cycle costs were incurred before
production began and before any revenues received, and (c) many of the life-cycle costs were locked in at
the beginning stages of the process.
Project-by-project approach to capital budgeting decision has these same characteristics.
2. Understand the six stages of capital budgeting for a project
How do the six stages of capital budgeting support the concept that one can look at
resource allocation in a budget and note what top management considers most
important? Throughout the six stages, the emphasis is on the objectives and strategy of the
organization. The decisions about projects involve the entire organization as noted in each of the stages.
3. Use and evaluate the two main discounted cash flow (DCF) methods: the net present value
(NPV) method and the internal rate-of-return (IRR) method

What approaches might be used to recognize risk in capital budgeting?

The required rate of return (RRR) is a critical variable in discounted cash flow analysis. It is the rate of
return that the organization forgoes by investing in a particular project rather than in an alternative project
of comparable risk. Risk is used here to refer to the business risk of the project, not the specific manner
in which the project is financed. A safe generalization is that the higher the risk, the higher the required
rate of return and the faster management would want to recover the net initial investment. A higher risk
means a greater chance that the project may lose money, and what makes management willing to take
added risk is a higher expected rate of return.
Organizations can use one or more of the following in dealing with risk factors of projects:

Adjusting the required rate of return (higher rate when higher risk).
Adjusting the estimated future cash inflows (reduce the estimated cash inflows if higher risk).
Estimating the probability distribution of future cash inflows and outflows for each project.
Sensitivity analysis (discussed in chapter in text).
Varying the required payback time (discussed in chapter in text).

Can the emphasis on cash flows be reconciled with an accrual accounting approach?
A basic tenet of accrual accounting is realization. The accrual basis of accounting, though recognizing
revenue when earned and expense when incurred, is separated from the operating events in the cash flow
statement because of timing differences, not because of basic differences in amounts. The importance of
cash flow is noted by requiring the cash flow statement as one of the basic financial statements of a
company.

32 Chapter 21

1. Use and evaluate the payback method

The payback method of capital budgeting has been compared to a meat cleaver and the
discounted cash flow methods to a scalpel. Why might this be an appropriate analogy?
If an organization must select a few projects from a large pool of projects, an initial threshold could be
established by use of the payback method. Only projects that would pay back within a prescribed number
of years would be considered in more detail.
2. Use and evaluate the accrual accounting rate-of-return (AARR) method

Discuss the need to specifically define words used in describing the various methods. It
has been stated that the conceptual framework for financial accounting is primarily the
definition of terms. Because accounting serves as an information tool for organizations
(the language of business), the value of common meanings for terms is critical. For
example, the use of the term return elicits several definitions.
Return has several different meanings. Return can mean income. Income can mean operating income,
net income, income before interest and income taxes, and income from extraordinary items among other
uses. The text clearly illustrates the use of the term in this chapter. Do note that the accrual accounting
method has its own required rate of return that differs from the required rate of return used in net present
value or internal rate of return.
3. Identify and reduce conflicts from using DCF for capital budgeting decisions and accrual
accounting for performance evaluation

The tension between methods used to make the initial decision and then to evaluate the
decision is an ongoing problem. Recall some other situations in which this has been
noted. Some examples thus far have been from Chapter 6 LO 8 (related one in Chapter 15 LO2),
Chapter 9 LO4, Chapter 11 LO9, and Chapter 20 LO3. Similar situations are discussed in the last
two chapters22 and 23. One common point to be noted: If the purpose is clearly stated and understood
for original decision, the evaluation of the results of that decision should be in terms of the fulfilling of
that purposeand not other purposes.
4. Identify relevant cash inflows and outflows for capital budgeting decisions

What would be the effect of using a depreciation method other than straight-line when
considering the role of income taxes on the net present value method? Accelerated
depreciation methods such as double-declining balance and sum-of-years digits serve the purpose of
taking the deduction sooner rather than later. The cash flow in the earlier years is larger (tax savings),
creating more present value inflows, resulting in higher NPV.

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SUGGESTED READINGS
Arya, A., Fellingham, J. and Glover, J., Capital Budgeting: Some Exceptions to the Net Present Value
Rule, Issues in Accounting Education (August 1998) p.499 [10p].
Ashton, A., Ashton, R. and Maines, l., Instructional Case: General Medical CenterEvaluation of
Diagnostic Imaging Equipment, Issues in Accounting Education (November 1998) p.985 [19p].
Bailes, J., Nielsen, J. and Lawton, S., How Forest Product Companies Analyze Capital Budgets,
Management Accounting (October 1998) p.24 [7p].
Balakrishnan, R. and Bhattacharya, U., Ace Company (B): The Option Value of Waiting and Capital
Budgeting, Issues in Accounting Education (Fall 1997) p.399 [13p].
Coburn, S., Grove, H. and Cook, T. How ABC Was Used in Capital Budgeting, Management
Accounting (May 1997) p.38 [9p].
Copeland, T., The Real-Options Approach to Capital Allocation, Strategic Finance (October 2001) p.33
[6p].
Gordon, L. and Myers, M., Postauditing Capital Projects, Management Accounting (January 1991) p.39
[4p].
Hendricks, J., Bastian, R. and Sexton, T., Bundle Monitoring of Strategic Projects, Management
Accounting (February 1992) p.31 [6p].
Migliore, R. and McCracken, D., Tie Your Capital Budget to Your Strategic Plan, Strategic Finance
(June 2001) p.38 [5p].
Truitt, J. F., Capital Rationing: An Annualized Approach, Journal of Cost Analysis (Summer 1988) p.63
[13p].
Wolk, H. I., Porter, G. A. and Vetter, D. E., Net Working Capital Investment and Capital Budgeting
Analysis: Some Pedagogical Insights, Journal of Accounting Education (Fall 1989) p.253 [10p].

34 Chapter 21