# FIN2120 Lecture Notes - Lecture 21: Accrual, Payback Period, Earnings Before Interest And Taxes

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CHAPTER 21

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

determination.

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

projects.

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

decisions.

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

method.

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.

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21-8 No. The discounted cash-flow techniques implicitly consider depreciation in rate of

return computations; the compound interest tables automatically allow for recovery of

investment. The net initial investment of an asset is usually regarded as a lump-sum outflow at

time zero. Where taxes are included in the DCF analysis, depreciation costs are included in the

computation of the taxable income number that is used to compute the tax payment cash flow.

21-9 A point of agreement is that an exclusive attachment to the mechanisms of any single

method examining only quantitative data is likely to result in overlooking important aspects of a

decision.

Two points of disagreement are (1) DCF can incorporate those strategic considerations that

can be expressed in financial terms, and (2) “Practical considerations of strategy” not expressed

in financial terms can be incorporated into decisions after DCF analysis.

21-10 All overhead costs are not relevant in NPV analysis. Overhead costs are relevant only if

the capital investment results in a change in total overhead cash flows. Overhead costs are not

relevant if total overhead cash flows remain the same but the overhead allocated to the particular

capital investment changes.

21-11 The Division Y manager should consider why the Division X project was accepted and

the Division Y project rejected by the president. Possible explanations are:

a. The president considers qualitative factors not incorporated into the IRR computation

and this leads to the acceptance of the X project and rejection of the Y project.

b. The president believes that Division Y has a history of overstating cash inflows and

understating cash outflows.

c. The president has a preference for the manager of Division X over the manager of

Division Y—this is a corporate politics issue.

Factor a. means qualitative factors should be emphasized more in proposals. Factor b. means

Division Y needs to document whether its past projections have been relatively accurate. Factor

c. means the manager of Division Y has to play the corporate politics game better.

21-12 The categories of cash flow that should be considered in an equipment-replacement

decision are:

1a. Initial machine investment,

b. Initial working-capital investment,

c. After-tax cash flow from current disposal of old machine,

2a. Annual after-tax cash flow from operations (excluding the depreciation effect),

b. Income tax cash savings from annual depreciation deductions,

3a. After-tax cash flow from terminal disposal of machines, and

b. After-tax cash flow from terminal recovery of working-capital investment.

21-13 Income taxes can affect the cash inflows or outflows in a motor vehicle replacement

decision as follows:

a. Tax is payable on gain or loss on disposal of the existing motor vehicle,

b. Tax is payable on any change in the operating costs of the new vehicle vis-à-vis the

existing vehicle, and

c. Tax is payable on gain or loss on the sale of the new vehicle at the project termination

date.

d. Additional depreciation deductions for the new vehicle result in tax cash savings.

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21-14 A cellular telephone company manager responsible for retaining customers needs to

consider the expected future revenues and the expected future costs of “different investments” to

retain customers. One such investment could be a special price discount. An alternative

investment is offering loyalty club benefits to long-time customers.

21-15 These two rates of return differ in their elements:

Real-rate of return Nominal rate of return

1. Risk-free element 1. Risk-free element

2. Business-risk element 2. Business-risk element

3. Inflation element

The inflation element is the premium above the real rate of return that is demanded for the

anticipated decline in the general purchasing power of the monetary unit.

21-16 Exercises in compound interest, no income taxes.

The answers to these exercises are printed after the last problem, at the end of the chapter.

(Please alert students that in some printed versions of the book there is a typographical

error in the solution to part 5. The interest rate is 8%, not 6%.)

21-17 (20–25 min.) Capital budget methods, no income taxes.

1a. The table for the present value of annuities (Appendix A, Table 4) shows:

8 periods at 8% = 5.747

Net present value = $67,000 (5.747) – $250,000

= $385,049 – $250,000 = $135,049

1b. Payback period = $250,000 ÷ $67,000 = 3.73 years

1c. Discounted Payback Period

Period

Cash

Savings

Discount

Factor (8%)

Discounted

Cash

Savings

Cumulative

Discounted

Cash

Savings

Unrecovered

Investment

0 $250,000

1 $67,000 .926 $62,042 $ 62,042 $187,958

2 $67,000 .857 $57,419 $119,461 $130,539

3 $67,000 .794 $53,198 $172,659 $ 77,341

4 $67,000 .735 $49,245 $221,904 $ 28,096

5 $67,000 .681 $45,627 $267,531

$28,096 ÷ $45,627 = 0.6158

Discounted Payback period = 4.62 years

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