BUSN7031 · Management Accounting and Cost Analysis
Capital Expenditure Decisions
Capital expenditure decisions are the final and highest-stakes topic of BUSN7031 Management Accounting and Cost Analysis at the Australian National University. This is capital budgeting — the long-run planning of investments (a new machine, a replacement, an expansion) where you commit cash now for a stream of net cash receipts later. Because the decision spans several years it introduces the time value of money: future cash flows are discounted at a Required Rate of Return before they can be compared with cash spent today. The chapter appraises a project four ways — NPV and IRR (discounted-cash-flow methods) versus payback and the accrual accounting rate of return (non-DCF methods) — and drills which cash flows are relevant, why depreciation is not a cash flow but its tax shield is, and why sunk costs must be ignored.
What this chapter covers
- 011. Capital budgeting & its five stages — identify, gather information, forecast, select, implement (with post-investment audit)
- 022. Time value of money & the Required Rate of Return (RRR) — the discount / hurdle / cost-of-capital rate
- 033. Net Present Value (NPV) — discount every flow to today, sum, subtract the outlay; accept if NPV ≥ 0
- 044. Internal Rate of Return (IRR) — the rate that makes NPV = 0; accept if IRR ≥ RRR; find it by interpolation
- 055. Non-DCF methods — payback period and the accrual accounting rate of return, and their weaknesses
- 066. Relevant cash flows — the three tests (future, required, differential) and the three categories
- 077. Depreciation tax shield & sunk costs — depreciation is not a cash flow, but its tax saving is; ignore sunk costs
- 088. NPV vs IRR, escalation of commitment & the goal-congruence tension in manager evaluation
Worked example: NPV and payback of a level-cash-flow project
- +1PV of the inflows. The savings are a level 5-year stream, so use the annuity factor at the RRR: $34,000 × 3.791 = $128,894.
- +1NPV. Present value of inflows − net initial investment = $128,894 − $120,000 = +$8,894.
- +1Decision. NPV is positive (≥ 0), so the project earns more than the 10% required return — accept it.
- +1Payback. Cash flows are uniform, so use the shortcut: $120,000 ÷ $34,000 = 3.53 years — the outlay is recouped partway through year 4.
- +1Watch the relevant flows. Only future, differential cash flows are used; depreciation is not a cash flow, so it is excluded (in a with-tax question you would add back only the depreciation tax shield = depreciation × tax rate).
Key terms
- Capital budgeting
- The long-run planning of investment projects — committing cash now (a machine, replacement, expansion, new product) to obtain future net cash receipts that exceed the investment. The decision spans several years, so timing matters.
- Required Rate of Return (RRR)
- The minimum acceptable annual return on a project, based on returns available elsewhere at comparable risk. Also called the discount rate, hurdle rate, cost of capital or opportunity cost of capital; it is the rate used to discount future cash flows.
- Net Present Value (NPV)
- The sum of all a project's cash flows discounted to today at the RRR, less the net initial investment. Accept the project if NPV ≥ 0, meaning it earns at least the required return.
- Internal Rate of Return (IRR)
- The discount rate at which a project's NPV equals zero (present value of inflows = present value of outflows). Accept if IRR ≥ RRR. It is found by trial and interpolation between two table rates.
- Payback period
- The time taken to recoup the net initial investment from the project's cash flows; shorter is preferred as it flags liquidity and risk. It ignores the time value of money and any cash flows after the cut-off.
- Accrual Accounting Rate of Return (AARR)
- The increase in average annual operating profit divided by the net initial investment. It uses accrual profit (after depreciation) rather than cash and ignores the time value of money.
- Depreciation tax shield
- The cash saved because depreciation is tax-deductible, equal to depreciation × the tax rate. Depreciation itself is not a cash flow and is excluded, but this tax saving is a relevant operating inflow.
- Escalation of commitment
- Continuing to invest in a project that is no longer viable, driven by pride, optimism or guilt — fundamentally a failure to ignore sunk costs. It is reduced by regular review from people not involved in the original decision.
Capital Expenditure Decisions FAQ
What is capital budgeting and why does the time value of money matter?
Capital budgeting is the long-run planning of investments where you spend cash now to earn a larger stream of cash later. Because the payoffs arrive over several years, timing matters: a dollar today is worth more than a dollar next year, so discounted-cash-flow methods restate every future flow to its present value at the Required Rate of Return before comparing it with the money spent today.
What is the difference between NPV and IRR, and which is preferred?
NPV discounts every cash flow to today at the RRR and sums them, accepting the project if NPV ≥ 0. IRR is the discount rate that makes NPV equal zero, accepting the project if IRR ≥ RRR. NPV is theoretically preferred: it copes with a required return that varies over a project's life, NPVs are additive across projects, and it avoids the multiple-IRR problem and IRR's ranking error on mutually exclusive projects. When the two disagree, follow NPV.
Why is depreciation excluded from cash flows but its tax shield included?
Depreciation is a bookkeeping allocation, not a movement of cash, so it is excluded from the operating cash inflows in a DCF appraisal. However, because depreciation is tax-deductible it lowers the tax the firm pays, and that reduction is a genuine cash inflow — the depreciation tax shield, equal to depreciation × the tax rate. Forgetting the shield in a with-tax question, or double-counting depreciation as an outflow, are the two commonest errors.
How do I handle sunk costs in a replacement decision?
Ignore them. The original cost, book value and accumulated depreciation of an existing asset are sunk — historical and unchangeable — so they are irrelevant to the forecast. Only the asset's current disposal (salvage) value is relevant, because it is a future, differential cash flow. The examiner's favourite trap is dangling the old machine's original cost to see whether you correctly exclude it.
Can AI help me with Capital Expenditure Decisions?
Yes — ask Sia to walk through any Capital Expenditure Decisions problem or concept step by step, the way Australian National University tests it. Sia is an AI tutor that explains how to classify the three cash-flow categories, spot the sunk cost, read the annuity versus single-sum tables and interpolate an IRR, so you build the understanding yourself rather than doing your assessment for you.
How is capital budgeting examined in BUSN7031?
It is the Week 12 topic (Horngren Ch 18) and a reliable exam earner. It sits outside the online quizzes (the third online quiz covers only the first eleven weeks) and is examined in the 65% closed-book final only, where it is a strong candidate for one of the four worked problems — usually an NPV / payback / IRR computation or a replacement-decision relevant-cash-flow analysis. With no formula sheet, you must rebuild the DCF mechanics from memory, though PV tables are supplied, so practise reading the annuity and single-sum tables under time pressure.
Studying with AI? Sia — free AI accounting tutor works through BUSN7031 step by step.
Exam move
Treat a capex question as a fixed procedure. First, filter every figure through the three relevance tests — future, required by the proposal, and differential — which strips out sunk costs before you start. Sort the survivors into the three categories: net initial investment (year 0), after-tax operating flows each year (exclude depreciation, add its tax shield), and the terminal flow (salvage plus working-capital recovery). Match each flow to the right PV factor: a level stream uses the annuity factor once, a one-off future amount uses the single-sum factor. State the accept rule explicitly — NPV ≥ 0, or IRR ≥ RRR — then decide, and when NPV and IRR disagree follow NPV. Finally, remember the two behavioural traps the exam loves: escalation of commitment (ignoring sunk costs) and the goal-congruence tension between deciding on NPV but evaluating managers on an accrual metric.
