Managerial Accounting-VII

ACC 3301, Managerial Accounting 1

Course Learning Outcomes for Unit VII

Upon completion of this unit, students should be able to:

6. Explore capital projects using a variety of capital budgeting tools.
6.1 Determine methods used to help companies make effective capital budgeting decisions.
6.2 Identify challenges involved in capital budgeting.
6.3 Determine how the statement of cash flows relates to capital budgeting decisions.

Required Unit Resources

Chapter 12: Planning for Capital Investments—Read the following sections:

• Capital Budgeting and Cash Payback
• Net Present Value Method
• Capital Budgeting Challenges and Refinements
• Internal Rate of Return
• Annual Rate of Return

Chapter 13: Statement of Cash Flows—Read the following sections:

• Usefulness and Format of the Statement of Cash Flows
• Preparing the Statement of Cash Flows—Indirect Method
• Analyze the Statement of Cash Flows

In order to access the following resources, click the links below.

Chapter 12 PowerPoint Presentation
PDF of Chapter 12 Presentation

Chapter 13 PowerPoint Presentation
PDF of Chapter 13 PowerPoint Presentation

Unit Lesson

Introduction

In Unit VI, we focused on performance evaluation methods and how they can impact the decision-making and
direction of a company. In this unit, we shift our focus to capital investing and the tools used to evaluate
multiple projects.

Capital Investments

One of the most significant challenges managers deal with is making capital investment decisions. Capital
investments refer to large expenditures made to purchase plant assets or develop new products. These
decisions commit financial resources for long periods of time and are difficult to reverse once the funds are
invested. Overall, companies stand to benefit from good capital investments for many years into the future.
The overall process of evaluating and prioritizing capital investment opportunities is referred to as capital
budgeting.

UNIT VII STUDY GUIDE
Capital Investments and
Statement of Cash Flows

ACC 3301, Managerial Accounting 2

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View the following video by accessing the Unit VII Additional Unit Resources folder in the unit.

To learn more about capital budgeting, check out the Real World Video: Capital Budgeting (Holland America
Line) video. Once you click on the link, closed-captioning can be accessed by clicking the “CC” button on the
bottom right of the video window, and a transcript can be accessed by clicking the “T” button next to the “CC”
button.

The capital budgeting authorization process includes the following steps:

• Various entities within an organization submit project proposals.
• Proposals are reviewed by a capital budget committee.
• Organization management determines which project they will fund.
• The board of directors then approves the capital budget (Weygandt et al., 2020).

Any decision that involves an immediate outlay of cash in order to obtain a future return falls within this realm
of capital budgeting.

A few examples of this type of decision would include the following:

• Cost reduction decisions: Should we purchase new equipment to reduce manufacturing costs?
• Expansion decisions: Should we build a new plant to increase sales and capacity?
• Equipment selection decisions: Which machine would be the best for our operations?
• Lease or buy decisions: Should new equipment be leased or purchased?
• Equipment replacement decisions: Should old and outdated equipment be leased or purchased?

Capital budgeting relies on estimates of future operating results. In turn, these estimates usually involve a
high degree of uncertainty and should be evaluated accordingly. Nonfinancial factors should also be
considered in such instances.

Capital budgeting decisions rely mainly on cash flows. Accounting net income is based on accruals that
ignore when cash flows occur. However, in capital budgeting, the timing of cash flows is crucial. The present
value of a cash flow depends on when it occurs. For this reason, cash flows rather than accounting net
income are the focus in capital budgeting.

Cash Flows

Most projects have at least three types of cash outflows. First, they often require an immediate cash outflow in
the form of an initial investment in equipment, installation costs, and so on. Any salvage value from the sale of
old equipment can be recognized as a reduction in the initial investment or as a cash inflow. Some projects
require a company to expand its working capital. When a company takes on a new project, the balances in
the current asset accounts often increase. For instance, opening a new Burger King fast food restaurant
requires additional cash in sales registers and more inventory. These additional working capital needs are
treated as part of the initial investment in a project. Additionally, many projects require periodic outlays for
repairs and maintenance and additional operating costs.

What about cash inflows? Most projects involve cash inflows, such as increasing revenues or reducing costs.
Either way, the amount involved should be treated as a cash inflow for capital budgeting purposes. From a
cash flow standpoint, a reduction in costs is equal to an increase in revenues. Further, cash inflows are
frequently realized from selling equipment for its salvage value when a project ends, even though the firm
may still have to pay to dispose of hazardous items. Finally, any working capital that was tied up on the
project can be released for use elsewhere at the end of the project and should be treated as a cash inflow at
that time. For instance, working capital is realized when a company sells off its inventory or collects its
accounts receivable.

Cash flows are a vital part of the capital budgeting process. Along with the discount rate and initial investment
amount, a capital budgeting tool can reveal whether to pursue or reject a particular project. While there are
several methods to choose from, the net present value method and the internal rate of return method tend to
be the most accurate in terms of relevant results. The net present value method determines whether a project
is acceptable by comparing the initial investment to the discounted sum of cash flows from the investment.

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Projects with a positive net present value are accepted, while those with negative net present values are
rejected. When the net present value method is utilized, the cost of capital is the discount rate used to
compute the net present value of a proposed project.

The internal rate of return method is also used to determine the best decision when it comes to project
selection. However, instead of looking at discounted sums, it focuses on the rate of return. In a nutshell, it is
computed by finding the discount rate that equates the present value of a project’s cash outflows with the
present value of its cash inflows. It is the discount rate that results in a net present value of zero. To evaluate
a project, the internal rate of return is compared to the company’s minimum required rate of return, which is
usually the company’s cost of capital. If the internal rate of return is equal to or greater than the required rate
of return, then the project is considered to be acceptable. However, if the internal rate of return is less than
the required rate of return, then the project is rejected.

When the internal rate of return method is used, the cost of capital is used as the hurdle rate that a project
must clear for acceptance. If the internal rate of return of a project is not high enough to clear the cost of
capital hurdle, then the project is ordinarily rejected.

Statement of Cash Flows

View the following videos by accessing the Unit VII Additional Unit Resources folder in the unit.

Since learning more about the different types of cash flows and their relevance to decision-making, check out
the Applied Skills Video: How to Identify the Contents of the Statement of Cash Flows and Applied Skills
Video: How to Prepare Statement of Cash Flows-Indirect Method videos about the statement of cash flows.
Once you click on each link, closed-captioning can be accessed by clicking the “CC” button on the bottom
right of the video window, and a transcript can be accessed by clicking the “T” button next to the “CC” button.