The following question-and-answer format summarizes the chapter’s learning objectives. Each decision presents a key question related to a learning objective. The guidelines are the answer to that question.
| Decision | Guidelines |
|---|---|
| Capital budgeting is long-run planning for proposed investment projects. The five stages of capital budgeting are: (1) Identify projects: Identify potential capital investments aligned with the organization’s strategy; (2) Obtain information: Gather information from all parts of the value chain to evaluate alternative projects; (3) Make predictions: Forecast all potential cash flows attributable to the alternative projects; (4) Choose among alternatives: Determine which investment yields the greatest benefit and the least cost to the organization; and (5) Implement the decision, evaluate performance, and learn: Obtain funding and make the investments selected in Stage 4; track the realized cash flows, compare them against estimated numbers, and revise plans if necessary. |
| The two main DCF methods are the net present value (NPV) method and the internal rate-of-return (IRR) method. The NPV method calculates the expected net monetary gain or loss from a project by discounting to the present all expected future cash inflows and outflows, using the required rate of return. A project is acceptable in financial terms if it has a positive NPV. The IRR method computes the rate of return (also called the discount rate) at which a project’s present value of expected cash inflows equals the present value of its expected cash outflows. A project is acceptable in financial terms if its IRR exceeds the required rate of return. The DCF method is the best approach to capital budgeting because it explicitly includes all project cash flows and recognizes the time value of money. The NPV method is the preferred DCF method. |
| The payback method measures the time it will take to recoup, in the form of cash inflows, the total cash amount invested in a project. The payback method neglects the time value of money and ignores cash flows beyond the payback period. The discounted payback method measures the time it takes for the present value of cash inflows to equal the present value of cash outflows. It adjusts for the time value of money but overlooks cash flows after the discounted payback period. |
| The accrual accounting rate-of-return (AARR) method divides an accrual accounting measure of average annual income from a project by an accrual accounting measure of its investment. The AARR gives managers an idea of how accepting a project will affect a firm’s future reported accounting profitability. However, the AARR uses accrual accounting income numbers, does not track cash flows, and ignores the time value of money. |
| Relevant cash inflows and outflows in a DCF analysis are the differences in expected future cash flows as a result of making the investment. Only cash inflows and outflows matter; accrual accounting concepts are irrelevant for DCF methods. For example, the income taxes saved as a result of depreciation deductions are relevant because they decrease cash outflows, but the depreciation itself is a noncash item. |
| Using accrual accounting to evaluate the performance of a manager may create conflicts with the use of DCF methods for capital budgeting. Frequently, the decision made using a DCF method will not report good “operating income” results in the project’s early years under accrual accounting. For this reason, managers are tempted to not use DCF methods even though the decisions based on them would be in the best interests of the company as a whole over the long run. This conflict can be reduced by evaluating managers on a project-by-project basis and by looking at their ability to achieve the amounts and timing of forecasted cash flows. |
| A company’s strategy is the source of its strategic capital budgeting decisions. Such decisions require managers to consider a broad range of factors that may be difficult to estimate. Managers must develop judgment and intuition to make these decisions. R&D projects, for example, are important strategic investments, with distant and usually highly uncertain payoffs. |