CAPITAL BUDGETING AND COST ANALYSIS
21-1 No. Capital budgeting focuses on an individual investment project throughout its life,
recognizing the time value of money. The life of a project is often longer than a year. Accrual
accounting focuses on a particular accounting period, often a year, with an emphasis on income
21-2 The five stages in capital budgeting are the following:
1. An identification stage to determine which types of capital investments are available to
accomplish organization objectives and strategies.
2. An information-acquisition stage to gather data from all parts of the value chain in order to
evaluate alternative capital investments.
3. A forecasting stage to project the future cash flows attributable to the various capital
4. An evaluation stage where capital budgeting methods are used to choose the best
alternative for the firm.
5. A financing, implementation and control stage to fund projects, get them under way and
monitor their performance.
21-3 In essence, the discounted cash-flow method calculates the expected cash inflows and
outflows of a project as if they occurred at a single point in time so that they can be aggregated
(added, subtracted, etc.) in an appropriate way. This enables comparison with cash flows from
other projects that might occur over different time periods.
21-4 No. Only quantitative outcomes are formally analyzed in capital budgeting decisions.
Many effects of capital budgeting decisions, however, are difficult to quantify in financial terms.
These nonfinancial or qualitative factors (for example, the number of accidents in a
manufacturing plant or employee morale) are important to consider in making capital budgeting
21-5 Sensitivity analysis can be incorporated into DCF analysis by examining how the DCF of
each project changes with changes in the inputs used. These could include changes in revenue
assumptions, cost assumptions, tax rate assumptions, and discount rates.
21-6 The payback method measures the time it will take to recoup, in the form of expected
future net cash inflows, the net initial investment in a project. The payback method is simple and
easy to understand. It is a handy method when screening many proposals and particularly when
predicted cash flows in later years are highly uncertain. The main weaknesses of the payback
method are its neglect of the time value of money and of the cash flows after the payback period.
The first drawback, but not the second, can be addressed by using the discounted payback
21-7 The accrual accounting rate-of-return (AARR) method divides an accrual accounting
measure of average annual income of a project by an accrual accounting measure of investment.
The strengths of the accrual accounting rate of return method are that it is simple, easy to
understand, and considers profitability. Its weaknesses are that it ignores the time value of money
and does not consider the cash flows for a project.