Chapter 12 - Strategy and the Analysis of Capital Investments
Chapter 12
Strategy and the Analysis of Capital Investments
Learning Objectives
New in this Edition
• All new beginning-of-chapter real-world examples of capital expenditure decisions undertaken by
a variety of organizations
• Shorter, more parsimonious discussion of material throughout the chapter
Teaching Suggestions
Depending on the depth required, this chapter can be taught in two or three 75-minute classes. (If the topic
of “real options” is covered, then a fourth class meeting might be required.) To pique the interest of students
in the subject matter, we begin chapter 12 is a variety of long-term investment examples, as taken from the
business press (WSJ, etc.). The introductory sections of the chapter provide a discussion of the linkage
Chapter 12 - Strategy and the Analysis of Capital Investments
discussion at this point is meant to both emphasize the strategic role of capital budgeting and the role that
management accounting plays in the capital budgeting process.
We then present students with information regarding a proposed long-term investment project that a
hypothetical firm (Mendoza Company) is considering. This information is presented in Exhibit 12.1. Next,
we provide a structure that can be used to identify relevant cash flows data at each of three primary stages
of a capital budgeting project: project initiation (Stage I), project operation (Stage II), and project disposal
(Stage III). Using this framework, we cast the data from Exhibit 12.1 into a form (Exhibit 12.2) that can be
used for properly analyzing proposed investment projects. Of particular importance to the discussion is the
tax savings associated with the depreciation deductions associated with an investment. Background
information for discussing this issue is provided in Exhibit 12.3 (Recovery Periods under MACRS) and
Exhibit 12.4 (MACRS depreciation rates for various asset lives). The discussion of generating relevant cash
flow data for evaluating a proposed long-term investment concludes with a discussion regarding the income
tax effects associated with an asset disposal (i.e., gain or loss on sale); Exhibit 12.5 is meant to provide
guidance in this regard.
After setting the stage by gathering pertinent cash flow data, we then transition to the topic of how such data
can be properly analyzed in a manner that informs the investment decision. We begin this topic by asking
students how prices in the market for common stocks are set. This leads to a discussion of DCF-based (NPV,
IRR, etc.) versus non-DCF-based capital budgeting decision models (e.g., ARR, Payback). We point out to
students that appropriate financial formulas in Excel can (and should) be used to calculate NPV and IRR.
Chapter 12 - Strategy and the Analysis of Capital Investments
Time permitting, the instructor can cover one or both of the following topics: (1) behavioral considerations
in the capital budgeting process (viz., cost escalation, incrementalism, and uncertainty intolerance, and goal-
congruency issue), and (2) selected complexities associated with the use of DCF models. Of particular
interest in terms of the former is the “goal congruency” problem that arises when one type of model is used
for decision-making (DCF-based) and another model (accrual accounting income) is used to evaluate
subsequent financial performance. We offer some insight as to ways to minimize this goal-congruency issue.
The latter material, found in Appendix B, comprises three topics: the problem of multiple IRRs (depending
on the pattern of project net cash flows), the question of mutually exclusive projects, and the issue of capital
rationing. Except for the capital rationing issue, where some measure of relative profitability is appropriate
(e.g., use of the profitability index [PI]), the general conclusion is to rely on the use of the NPV decision
criterion for capital budgeting purposes.
Appendix C contains present value tables. Notes appended to these tables provide the student with formulas
that can be used to generate the figures presented in Tables 1 and 2 of Appendix C.
New References—7th Edition
V. Martinez, “Time Value of Money Made Simple: A Graphic Teaching Method,” Journal of Financial
Education 39, Numbers 1/2 (Spring/Summer 2013), pp. 96-113. This article presents a visual aid for
structuring a variety of time-value-of-money problems, including: future value of a lump sum; present
value of a lump sum; future value of an annuity; present value of an annuity; and present value of a
perpetuity. As such, the article may be helpful in responding to some of the end-of-chapter
assignments in this chapter.
S. G. Berry, C. E. Betterton, and I. Karagiannidis, “Understanding Weighted-Average Cost of Capital: A
Pedagogical Application,” Journal of Financial Education 40, Numbers 1/2 (Spring/Summer, 2014),
pp. 115-136. This article includes an interactive spreadsheet model for estimating a company’s
WACC. The model allows students to explore alternative mixes of debt and equity in terms of a
company’s WACC. In addition, the model uses Crystal Ball (registered trademark of Oracle
Corporation) to perform Monte Carlo simulation analysis on several input variables to the WACC
calculation.
S. P. Rich and J. T. Rose, “Re-Examining an Old Question: Does the IRR Method Implicitly Assume a
Reinvestment Rate?” Journal of Financial Education 40, Numbers 1/2 (Spring/Summer 2014), pp.
152–166. This paper demonstrates that IRR can be interpreted as a constant rate of return on the
Chapter 12 - Strategy and the Analysis of Capital Investments
Assignment Matrix
End-of-Chapter Exercises & Problems
Chapter Learning Objectives (LOs)
Text Features
6th ed.
Transition
Chapter 12 - Strategy and the Analysis of Capital Investments
Lecture Notes
Introductory Definitions
A capital investment requires committing a large sum of funds to a project with expenditures and benefits
expected to stretch well into future. There are, in general, three types of capital investments: investments to
Chapter 12 - Strategy and the Analysis of Capital Investments
(NPV), internal rate of return (IRR), modified internal rate of return (MIRR), present value payback period,
and present value index (PI).
Non-discounted cash flow (non-DCF) capital budgeting decision models are those that do not explicitly
incorporate the time-value of money into the analysis. Chapter 12 discusses two such models: (unadjusted)
payback period, and accounting (book) rate of return (ARR).
Discount rate equals the interest rate (“hurdle rate” or “minimum rate of return”) used in DCF models to
convert estimated future after-tax cash flows (inflows and outflows) back to a present-value basis. For
projects of average risk, financial theory specifies that the discount rate be defined as the weighted-average
cost of capital (WACC) for the company. For projects of greater-than--average risk, the hurdle rate >
WACC (and vice versa).
Strategic Cost Management and Capital Investments
A capital investment analysis needs to take into consideration the firm’s strategic positioning and
competitive advantage, effect of the investment on both upstream and downstream activities in the firm’s
value chain, and impact of strategic structural and executional cost drivers.
Important factors considered or methods used in evaluating capital investments are likely to be different for
projects that fulfill different strategic missions. Volume is not the only cost driver in activities considered in
a capital investment project. Effects of structural or executional cost drivers are important considerations in
investment decisions.
How Can Accountants Add Value to the Capital Budgeting Process?
Chapter 12 - Strategy and the Analysis of Capital Investments
Effects of cash flows include direct and indirect (tax) effects. Direct effects include cash receipts, cash
payments, or cash commitments. Indirect or tax effects are changes in income-tax payments precipitated
by the investment decision. The sum of direct and indirect effects is net effect of a given item.
As noted in Exhibit 12.2, cash flows for investment projects occur at three stages: project initiation, project
operation, and project disposal (i.e., final disinvestment). Direct effects of cash outflows at initial
acquisition include cash disbursements for the purchase, installation, and testing of equipment and facilities,
commitment of net working capital needed for the proposed project, cash expenditures to hire and train
personnel, and cash disbursements for disposing of the replaced assets and/or facilities. Tax (i.e., indirect)
effects of cash flows at time of project initiation relate primarily to recognized gain or loss (if any) on the
disposal of an existing asset.
Cash flows during operations are increases in cash revenues or decreases in cash expenses during the
operation of the investment. Cash flows during project operation typically have both direct and indirect
effects. Items that have cash flow effects during the operating phase of an investment include cash receipts,
cash expenditures, and depreciation deductions on the investment asset.
Cash inflows at the final disinvestment stage include net-of-tax cash proceeds from the sale (disposal) of
the investment and from the release of previously committed net working capital. Cash outflows can also
include expenditures related to the restoration of facilities and the relocation and/or retraining of company
Chapter 12 - Strategy and the Analysis of Capital Investments
return (MIRR) does. The underlying mathematics of the MIRR are complicated. Thus, the text provides the
Excel financial function for MIRR.
The present value payback period for a project is defined as the length of time needed for discounted
future net cash flows to equal the original investment outlay of a project. One unique characteristic is that if
the discounted payback period is less than the life of the project (in years), then it must be true that the
project has a positive NPV.
As explained in Appendix B to this chapter, there are situations where the organization is working under a
capital constraint, that is, a situation where capital is “rationed.” In this situation, we employ a logic for
capital budgeting purposes similar to the logic used in Chapter 11 when we explored the short-term product-
mix problem: allocate available funds on the basis of profitability (e.g., NPV) per dollar of invested capital.
This relative measure of profitability is referred to as the present value index (PI). Note, however, that this
decision model is recommended for use only in the situation where the company faces capital rationing.
Dealing with Uncertainty: Sensitivity Analysis and the Use of Real Options
New to this edition is an expanded discussion of sensitivity analysis. Students should understand that the
capital budgeting decision models used in practice all require as inputs forecasted data. Because of the
inherent nature of capital investment projects, these data can stretch many years in the future. As well,
companies must estimate the discount rate (WACC for use in DCF decision models. In short, the inputs to
the decision models used in capital budgeting are subject to uncertainty.
Chapter 12 - Strategy and the Analysis of Capital Investments
As indicated in the chapter, the use of DCF models can be justified by sound financial theory. However, as
indicated by survey evidence reported in the chapter, DCF models are not generally used by small business.
Thus, students should be exposed to non-DCF capital budgeting decision models, as follows:
The payback period of an investment is the length of time required for its cumulative after-tax cash inflows
to equal its initial cash outlay. When future cash inflows are expected to be equal, the following formula is
used to calculate the payback period of a proposed investment:
InflowCashNetTaxAfterExpectedAnnual InvestmentCapitalInitialTotal
PeriodPayback −
=
The payback period method is easy to compute and to comprehend. The payback period can also serve as a
rough measurement of the investment’s risk and an indication of the liquidity of the proposed investment.
For projects that require quick payoffs, the payback period method often is the technique used in evaluating
capital investments.
Among the limitations of the payback period method are its failure to consider an investment’s total
profitability and its failure to explicitly incorporate the time value of money into the analysis.
Because of the latter limitation, some companies use what is called the present value payback period,
Chapter 12 - Strategy and the Analysis of Capital Investments
Firms or organizations need to recognize several common behavioral issues associated with the capital
budgeting process in practice: cost escalation, incrementalism, and uncertainty avoidance. As such, care
must be taken to not allow aggressive managers to overestimate revenues or underestimate expenses in
attempts to earn approval of capital investment for their units. Further, research has found that sunk costs
can play an important role influencing the framing of decisions, such as those related to capital investments.
A rational decision maker should ignore sunk costs. Intolerance of uncertainty often leads managers to
require short payback periods for capital investment. Many critically important capital investments,
however, require a lengthy time to install, test, adjust, train personnel, and gain market acceptance.
Chapter 12 includes an expanded discussion of the goal-congruency issues associated with the capital
budgeting process. These issues result from using one model for decision making (e.g., DCF) and another
model for financial performance evaluation (e.g., accounting ROI). This issue is one of the most critical
issues related to the design of comprehensive management accounting and control systems, and is addressed
at greater length in Chapter 19 of the text. However, in this chapter we offer at least three possible ways to
deal with the aforementioned goal-congruency problem:
Chapter 12 - Strategy and the Analysis of Capital Investments