Capital Budget I

STUDY UNIT NINE
SHORT-TERM FINANCING
AND CAPITAL BUDGETING I
9.1 Types and Costs of Short-Term Financing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
9.2 Capital Budgeting -- Basics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
9.3 Capital Budgeting -- Net Present Value Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
9.4 Capital Budgeting -- Net Present Value Calculations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
9.5 Capital Budgeting -- Internal Rate of Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
9.6 Capital Budgeting -- Payback Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
All entities require financing from outside sources to carry on day-to-day operations. These usually
take the form of either spontaneous financing in the form of trade credit offered by vendors, or bank
loans. Organizations must continually decide whether to invest in new product lines or means of
production. The process involves identifying appropriate projects, determining the level of resources
they will require, predicting the expected amounts and timing of returns, and ranking the desirability of
alternative projects.
9.1 TYPES AND COSTS OF SHORT-TERM FINANCING
1. Spontaneous Financing -- Trade Credit
a. If a supplier offers an early payment discount (e.g., terms of 2/10, n/30, meaning a 2%
discount is given if the invoice is paid within 10 days or the entire balance is due in
30 days), it is usually to the entitys advantage to avail itself of the discount. The
annualized cost of not taking a discount can be calculated with the following formula:
Cost of Not Taking a Discount
Discount %
100% - Discount %

Days in year
Total payment period - Discount period
EXAMPLE
A vendor has delivered goods and invoiced the company on terms of 2/10, net 30. The company has chosen to pay on
day 30. The effective annual rate the company paid by forgoing the discount is calculated as follows (using a 360-day
year):
Cost of not taking discount = [2% (100% 2%)] [360 days (30 days 10 days)]
= (2% 98%) (360 days 20 days)
= 2.0408% 18
= 36.73%
Only entities in dire cash flow situations would incur a 36.73% cost of funds.
2. Formal Financing Arrangements
a. Commercial banks offer short-term financing in the form of term loans and lines of
credit.
1) A term loan, such as a note, must be repaid by a definite time.
2) A line of credit allows the company to continuously reborrow amounts up to a
certain ceiling, as long as certain minimum payments are made each month
(similar to a consumers credit card).
1
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3. Simple Interest Short-Term Loans
a. A simple interest loan is one in which the interest is paid at the end of the loan term.
The amount of interest to be paid is based on the nominal (stated) rate and the
principal of the loan (amount needed).
Interest expense = Principal of loan Stated rate
EXAMPLE
A company obtained a short-term bank loan of $15,000 at an annual interest rate of 8%. The interest expense on the loan
is $1,200 ($150,000 8%).
The stated rate of 8% is also the effective rate.
b. The effective rate on any financing arrangement is the ratio of the amount the
company must pay to the amount the company gets use of.
Effective interest rate
Interest expense (interest to be paid)
Usable funds (net proceeds)
EXAMPLE
A company obtained a short-term bank loan of $15,000 at an annual interest rate of 8%. The bank charges a loan
origination fee of $500.
Effective rate = Interest paid Net proceeds
= ($15,000 8%) ($15,000 $500)
= $1,200 $14,500
= 8.27%
The effective interest rate (8.27%) is higher than the stated interest rate (8%) because the net proceeds are lower than the
principal.
4. Discounted Loans
a. A discounted loan is one in which the interest and finance charges are paid at the
beginning of the loan term.
Total borrowings
Amount needed
(1.0 - Stated rate)
EXAMPLE
A company needs to pay a $90,000 invoice. Its bank has offered to extend this amount at an 8% nominal rate on a
discounted basis.
Total borrowings = Amount needed (1.0 Stated rate)
= $90,000 (100% 8%)
= $90,000 92%
= $97,826
b. Because the borrower gets the use of a smaller amount, the effective rate on a
discounted loan is higher than its nominal rate.
EXAMPLE
Effective rate = Net interest expense (annualized) Usable funds
= ($97,826 8%) $90,000
= $7,826 $90,000
= 8.696%
2 SU 9: Short-Term Financing and Capital Budgeting I
c. As with all financing arrangements, the effective rate can be calculated without
reference to dollar amounts.
Effective rate on discounted loan
Stated rate
(1.0 - Stated rate)
EXAMPLE
The entity calculates the effective rate on this loan without using dollar amounts.
Effective rate = Stated rate (1.0 Stated rate)
= 8% (100% 8%)
= 8% 92%
= 8.696%
5. Loans with Compensating Balances
a. To reduce risk, banks sometimes require borrowers to maintain a compensating
balance during the term of a financing arrangement.
Total borrowings
Amount needed
(1.0 - Compensating balance %)
EXAMPLE
A company has received an invoice for $120,000 with terms of 2/10, net 30. The entitys bank will lend it the necessary
amount for 20 days so the discount can be taken on the 10th day at a nominal annual rate of 6% with a compensating
balance of 10%.
Total borrowings = Amount needed (1.0 Compensated balance %)
= ($120,000 98%) (100% 10%)
= $117,600 90%
= $130,667
b. As with a discounted loan, the borrower has access to a smaller amount than the face
amount of the loan and so pays an effective rate higher than the nominal rate.
EXAMPLE
Effective rate = Net interest expense (annualized) Usable funds
= ($130,667 6%) $117,600
= $7,840 $117,600
= 6.667%
c. Once again, the dollar amounts involved are not needed to determine the effective
rate.
Effective rate with comp. balance =
Stated rate
(1.0 - Compensating balance %)
EXAMPLE
Effective rate = Stated rate (1.0 Compensating balance %)
= 6% (100% 10%)
= 6% 90%
= 6.667%
SU 9: Short-Term Financing and Capital Budgeting I 3
9.2 CAPITAL BUDGETING -- BASICS
1. Capital Budgeting
a. Capital budgeting is the process of planning and controlling investments for long-term
projects. It is the long-term aspect of capital budgeting that presents the accountant
with specific challenges.
1) Most financial and management accounting topics, such as calculating
allowance for doubtful accounts or accumulating product costs, concern
tracking and reporting activity for a single accounting or reporting cycle, such as
1 month or 1 year.
2) By their nature, capital projects affect multiple accounting periods and will
constrain the organizations financial planning well into the future. Once made,
capital budgeting decisions tend to be relatively inflexible.
b. A capital project usually involves substantial expenditures. Planning is crucial
because of uncertainties about capital markets, inflation, interest rates, and the
money supply.
c. Capital budgeting applications include
1) Buying equipment
2) Building facilities
3) Acquiring a business
4) Developing a product or product line
5) Expanding into new markets
6) Replacement of equipment
2. Relevant Cash Flows
a. The first step in assessing the desirability of a potential capital project is to identify the
relevant cash flows.
1) Relevant cash flows do not include sunk costs, i.e., those that have already been
paid or are irrevocably committed to be paid. No matter which alternative is
selected, sunk costs are already spent and are thus irrelevant to a decision.
b. The relevant cash flows for capital budgeting are
1) Cost of new equipment
2) Annual after-tax cash savings or inflows
3) Proceeds from disposal of old equipment/residual (salvage) value
4) Adjustment for depreciation expense on new equipment (called the depreciation
tax shield) since it reduces taxable income and thereby reduces cash outflow
for tax expense
EXAMPLE
A companys annual recurring operating cash income from a new machine is $100,000. The annual depreciation expense
on this machine is $20,000. The effective tax rate is 40%. To calculate the companys after-tax annual cash flows from the
new machine, the annual depreciation expense must be taken into account.
Operating cash inflow $100,000 Taxable income $80,000
Depreciation expense (20,000) Effective tax rate 40%
Annual taxable income $ 80,000 Income tax payment $32,000
Operating cash inflow $100,000
Income tax payment (32,000)
After-tax cash flow $ 68,000
After-tax cash flow can also be calculated as follows:
Operating cash flow net of taxes [$100,000 (1.0 .40)] $60,000
Depreciation tax shield [$20,000 40%] 8,000
Annual after-tax cash flow $68,000
Note: Depreciation expense affects cash inflow only through income tax considerations.
3. Accounting Rate of Return
a. The accounting rate of return is a technique for assessing potential capital projects
that ignores the time value of money.
Accounting rate of return =
Annual increase in GAAP net income
Required investment

Annual cash inflow - Depreciation
Initial investment
1) Shareholders and financial analysts prefer the accounting rate of return because
GAAP-based numbers are readily available.
EXAMPLE
A manufacturer is considering the purchase of a new piece of machinery that would cost $250,000 and would decrease
annual after-tax cash costs by $40,000. The machine is expected to have a 10-year useful life, no salvage value, and
would be depreciated on the straight-line basis. The firm calculates the accounting rate of return on this machine as
follows:
Annual cash savings $ 40,000
Less: annual depreciation expense ($250,000 10 years) (25,000)
Annual increase in accounting net income $ 15,000
Divided by: purchase price of new equipment 250,000
Accounting rate of return 6%
2) However, certain aspects of the accounting rate of return create definite
limitations on its usefulness as a guide to selecting capital projects.
b. Accounting rate of return is affected by the companys choices of accounting methods.
1) Accountants must choose which expenditures to capitalize versus which to
expense immediately. They also choose how quickly to depreciate capitalized
assets.
2) A projects true rate of return cannot be dependent on such bookkeeping
decisions.
c. Another distortion inherent in comparing a single projects book rate of return to the
current one for the company as a whole is that the latter is an average of all of an
entitys capital projects.
1) It reveals nothing about the performance of individual investment choices.
Embedded in that number may be a handful of good projects making up for a
large number of poor investments.
The AICPA has tested accounting (book) rate of return by asking for its calculation. Questions have also
asked for the components that make up the accounting rate of return.
9.3 CAPITAL BUDGETING -- NET PRESENT VALUE THEORY
1. Discounted Cash Flow Analysis
a. A far more sophisticated method for evaluating potential capital projects than
accounting rate of return is discounted cash flow analysis, which involves discounting
the relevant cash flows (listed in item 2.b. in Subunit 9.2) using the required rate of
return as the discount rate (this rate is also called the hurdle rate or opportunity cost
of capital).
2. Net Present Value
a. A capital projects net present value is the difference between the present value of the
net cash savings or inflows expected over the life of the project and the required
dollar investment.
1) If the difference is positive, the project should be undertaken. If the difference is
negative, it should be rejected.
EXAMPLE
The Juan Fangio Co. is planning to invest $100,000 in new equipment. The equipment is expected to create savings in
cash operating expenses of $80,000 in the first year and $60,000 in the second year. The equipments estimated useful life
is 2 years, and the firm expects to resell it at the end of its useful life (salvage value) for $15,000. For simplicity, assume
that the equipment will be fully depreciated for tax purposes 50% each year. Fangios internal rate of return is 12%, and its
effective tax rate is 40%. The present value of $1 for one period at 12% is 0.893, and the present value of $1 for two
periods at 12% is 0.8. Fangio calculates the net present value of this potential investment as follows:
Annual depreciation shield for Year 1 and Year 2:
Assets cost $100,000
Depreciation percent 50%
Annual depreciation charge $ 50,000
Tax rate 40%
Depreciation tax shield $ 20,000
Resale of the new equipment (salvage value):
Expected inflow from the proceeds $ 15,000
Tax basis of equipment -- (since it is fully depreciated)
Gain on expected disposal $ 15,000
Taxes ($15,000 40%) (6,000)
Expected cash inflow $ 9,000
Net annual cash savings: Year 1 Year 2
Net annual savings/cash inflow $ 80,000 $60,000
Tax expense 40% 40%
Net cash inflow/savings $ 48,000 $36,000
Net present value: Year 0 Year 1 Year 2
Initial investment in equipment $(100,000)
Net annual savings/cash inflow $ 48,000 $36,000
Depreciation tax shield 20,000 20,000
Inflow from resale (salvage value) 9,000
After-tax net expected cash flows $(100,000) $ 68,000 $65,000
Discount rate 1 0.893 0.8
Net present value $(100,000) + $ 60,724 + $52,000 = $12,724
The positive net present value indicates that the project should be undertaken.
EXAMPLE
The Juan Fangio Co. is considering the purchase of a machine for $250,000 that will have a useful life of 10 years with no
residual (salvage) value. The machine is expected to generate an annual operating cash savings of $60,000 over its useful
life and would be depreciated on the straight-line basis, resulting in annual depreciation expense of $25,000 ($250,000
10 years). Fangios internal rate of return is 12%, and its effective tax rate is 40%.
The present value of $1 for 10 periods at 12% is 0.322, and the present value of an ordinary annuity of $1 for 10 periods at
12% is 5.650. Fangio calculates the net present value of this potential investment as follows:
Present value of cash savings
Annual operating cash savings/inflows $ 60,000
Annual tax expense:
Tax expense on annual cash savings
(60,000 40%) $(24,000)
Depreciation tax shield (25,000 40%) 10,000 (14,000)
After-tax net annual cash savings $ 46,000
Times: PV factor for an ordinary annuity 5.650
Present value of net cash savings $259,900
Required investment
Cost of new equipment $250,000
Net present value of investment
Present value of net cash savings $259,900
Less: required investment (250,000)
Net present value of investment $ 9,900
The positive net present value indicates that the project should be undertaken.
b. Use of the net present value method involves the implicit assumption that cash flows
are reinvested at the entitys minimum required rate of return.
3. Selecting the Appropriate Hurdle Rate
a. Adjusting for Inflation
1) In an inflationary environment, future cash inflows will consist of inflated dollars.
To compensate for this decline in purchasing power, hurdle rates must be
adjusted upward.
b. Adjusting for Risk
1) Particularly risky projects may be assigned higher hurdle rates to ensure that
only those whose potential returns are commensurate with their risks are
considered acceptable.
c. Division-Specific Rates of Return
1) When the divisions of a large, complex firm have their own specific risk attributes
and capital costs, using a single company-wide hurdle rate may lead to
suboptimal decisions.
a) The managers of a high-risk division will be tempted to over-invest in new
projects and those of low-risk divisions will tend to under-invest.
2) Thus, potential investments in inherently risky divisions should be required to
clear somewhat higher hurdle rates, and those being considered by divisions
with risks lower than the company average can be assigned slightly lower
hurdle rates.
9.4 CAPITAL BUDGETING -- NET PRESENT VALUE CALCULATIONS
This subunit consists entirely of questions that require the student to execute the detailed calculations
involved in applying the net present value technique. Please review Subunit 9.3 thoroughly before
attempting to answer the questions in this subunit.
9.5 CAPITAL BUDGETING -- INTERNAL RATE OF RETURN
1. Internal Rate of Return (IRR)
a. The internal rate of return of a project is the discount rate at which the investments net
present value equals zero. In other words, it is the rate that equates the present
value of the expected cash inflows with the present value of the expected cash
outflows.
1) If the internal rate of return is higher than the companys hurdle rate, the
investment is desirable. If the internal rate of return is lower, the project should
be rejected.
IRR > Hurdle rate: Accept project
IRR < Hurdle rate: Reject project
EXAMPLE
Niki Lauda, Inc., has a hurdle rate of 12% for all capital projects. The firm is considering a project that calls for a cash
outlay of $200,000 that will create savings in after-tax cash costs of $52,000 for each of the next 5 years. The applicable
present value factor is 3.846 ($200,000 $52,000). Consulting a table of present value factors for an ordinary annuity for
five periods places this factor somewhere between 9% and 10%. Since this is less than Laudas hurdle rate, the project will
be rejected.
2. Comparing Cash Flow Patterns
a. Often a decision maker must choose between two mutually exclusive projects: one
whose inflows are higher in the early years but fall off drastically later and one whose
inflows are steady throughout the projects life.
1) The higher an entitys hurdle rate, the more quickly a project must pay off.
2) Entities with low hurdle rates prefer a slow and steady payback.
EXAMPLE
Consider the net cash flows of these two projects with identical initial investments.
Initial
Investment Year 1 Year 2 Year 3 Year 4
Project K $(200,000) $140,000 $100,000
Project L (200,000) 65,000 65,000 $65,000 $65,000
A graphical representation of the two projects at various discount rates helps to illustrate the factors a decision maker must
consider in such a situation.
-- Continued on next page --
-- EXAMPLE continued --
Figure 9-1
Project Ks internal rate of return is 13.899%. Project Ls is 11.388%.
The NPV profile can be of great practical use to managers trying to make investment decisions. It gives the manager a
clear insight into the question, how sensitive is a projects profitability to changes in the discount rate?
G At a hurdle rate of exactly 7.9625%, a decision maker is indifferent between the two projects. The net present
value of both is $15,468 at that discount rate.
G At hurdle rates below 7.9625%, the project whose inflows last longer into the future is the better investment
(L).
G At hurdle rates above 7.9625%, the project whose inflows are front-loaded is the better choice (K).
3. Comparing Net Present Value (NPV) and Internal Rate of Return (IRR)
a. The reinvestment rate becomes critical when choosing between the NPV and IRR
methods. NPV assumes the cash flows from the investment can be reinvested at the
particular projects discount rate, that is, the desired rate of return.
b. The NPV and IRR methods give the same accept/reject decision if projects are
independent. Independent projects have unrelated cash flows. Hence, all
acceptable independent projects can be undertaken.
1) However, if projects are mutually exclusive, the NPV and IRR methods may rank
them differently if
a) The cost of one project is greater than the cost of another.
b) The timing, amounts, and directions of cash flows differ among projects.
c) The projects have different useful lives.
d) The cost of capital or desired rate of return varies over the life of a project.
The NPV can easily be determined using different desired rates of return
for different periods. The IRR determines one rate for the project.
e) Multiple investments are involved in a project. NPV amounts are addable,
but IRR rates are not. The IRR for the whole is not the sum of the IRRs
for the parts.
2) The IRR method assumes that the cash flows will be reinvested at the internal
rate of return.
a) If the projects funds are not reinvested at the IRR, the ranking calculations
obtained may be in error.
b) The NPV method gives a better grasp of the problem in many decision
situations because the reinvestment is assumed to be in the desired rate
of return.
For both net present value and internal rate of return, expect to see questions asking you to calculate these
values as well as understand the theory behind each method.
9.6 CAPITAL BUDGETING -- PAYBACK METHODS
1. Payback Period
a. The payback period is the number of years required for the net cash savings or inflows
to equal the original investment, i.e., the time necessary for an investment to pay for
itself.
1) Companies using the payback method set a maximum length of time within
which projects must pay for themselves to be considered acceptable.
b. If the cash flows are constant, the formula is
Payback period
Initial investment
Annual after-tax cash savings/inflows
1) Note that no consideration is made for the time value of money under this
method.
EXAMPLE with Constant Cash Flows
Niki Lauda also applies a 4-year payback period test on all capital projects.
Payback period = $200,000 $52,000 = 3.846 years
Judged by this criterion, the project is acceptable because its payback period is less than the companys maximum.
c. If the cash flows are not constant, the calculation must be in cumulative form.
EXAMPLE with Varying Cash Flows
Assume that Niki Laudas initial investment is $160,000 and that, instead of the smooth inflows predicted on page 8, the
projects cash stream is expected to vary. The payback period is calculated as follows:
End of Year Cash Savings
Remaining Initial
Investment
Initial investment $ -- $160,000
Year 1 48,000 112,000
Year 2 54,000 58,000
Year 3 54,000 4,000
Year 4 60,000 --
The project is acceptable because its payback period is over 3 years and under 4 years and is less than the companys
maximum.
d. The strength of the payback method is its simplicity.
1) To some extent, the payback period measures risk. The longer the period, the
more risky the investment.
e. The payback method has the following two significant weaknesses:
1) It disregards the time value of money. Weighting all cash inflows equally ignores
the fact that funds have a time cost.
2) It disregards all cash inflows after the payback cutoff date. Applying a single
cutoff date to every project results in accepting many marginal projects and
rejecting good ones.
2. Discounted Payback
a. The discounted payback method is sometimes used to overcome the major drawback
inherent in the basic payback method.
1) The net cash flows in the denominator are discounted to calculate the period
required to recover the initial investment.
EXAMPLE
Lauda has a 12% cost of capital.
Discounted Remaining
Cash 12% PV Cash Initial
Period Savings Factor Savings Investment
Initial investment $ -- -- $ -- $160,000
Year 1 48,000 0.89286 = 42,857 117,143
Year 2 54,000 0.79719 = 43,048 74,095
Year 3 54,000 0.71178 = 38,436 35,659
Year 4 60,000 0.63552 = 38,132 --
The project is acceptable because its discounted payback period is over 3 years and under 4 years and is less than the
companys maximum.
EXAMPLE
Lauda wants to determine the discounted payback periods in years and assumes that the cash flows are earned evenly
throughout each year. The discounted payback period in years is calculated as follows:
1) The full payback occurs sometime in Year 4. The remaining investment at the beginning of Year 4 is $35,659.
2) The following is the percentage of Year 4 until the amount of $35,659 is attained:
$35,659
$38,132
= 0.935%
3) The discounted payback period in years is 3.935 years (3 + 0.935).
b. The breakeven time is the amount of time required for the discounted cash flows of an
investment to equal the initial cost of an investment.
c. The discounted payback methods advantage is that it acknowledges the time value of
money.
1) Its drawbacks are that it loses the simplicity of the basic payback method and
still ignores cash flows after the arbitrary cutoff date.

Capital Budget I

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STUDY UNIT NINE

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