ACCT2019 Chap.10 Capital Budgeting and Long Term Decisions
Capital Budgeting and Long Term Decisions
Capital budgeting compares long-term project cash flows on a common date. Net present value discounts relevant after-tax inflows and outflows at the required return and subtracts the initial investment. Internal rate of return, payback and accrual accounting rate of return provide different lenses but carry different limitations.
Forecast design is central: working capital, disposal value, taxes, opportunity cost, timing and implementation must be identified before a precise calculation can support a decision. NPV measures expected value added at the required return, while IRR expresses the break-even discount rate. Simple payback highlights recovery speed but ignores time value and later flows; AARR uses accounting income rather than project cash.
A timeline keeps the initial outlay, operating flows and terminal effects in the correct periods. Sensitivity analysis should focus on the uncertain driver most capable of changing the sign, and post-audit should support forecast learning as well as accountability. Mutually exclusive projects require attention to scale and timing when NPV and IRR rankings conflict.
The final recommendation should name the required return, the key forecast assumption and the downside case that would reverse acceptance. Implementation review should compare realised timing and cash flows with the approved forecast, separating learning about the model from changes outside managerial control.
What this chapter covers
- 01
Capital-budgeting process
- 02
Net present value
- 03
Internal rate of return
- 04
Payback method
- 05
Accrual accounting return
- 06
Relevant project cash flows and post-audit
Worked example · free
Discounting uneven project cash flows
- +1AskSia practice weighting for these fresh figures. Year 1 present value is $42,000 x 0.9174 = $38,530.80.
- +1Year 2 present value is $39,000 x 0.8417 = $32,826.30.
- +1Year 3 present value is $36,000 x 0.7722 = $27,799.20.
- +1Total present value is $99,156.30 and NPV is -$843.70.
- +1Reject on the stated cash flows and required return, subject to checking omitted terminal or working-capital effects.
Key terms
- Net Present Value
- Present value of relevant project cash flows after the initial investment.
- Required Return
- The rate used to discount project cash flows for risk and time value.
- Internal Rate
- The discount rate at which a project has zero net present value.
- Payback Period
- Time required for undiscounted project inflows to recover the initial investment.
- Post-audit
- Comparison of project forecasts with realised results to support accountability and learning.
Capital Budgeting and Long Term Decisions FAQ
Why is NPV usually preferred?
NPV recognises time value, incorporates relevant project cash flows and measures expected value added at the required return. It also handles project scale directly, which helps when mutually exclusive choices produce conflicting percentage returns.
What does payback leave out?
Simple payback ignores time value and cash flows after the recovery cutoff. It can highlight liquidity or exposure, but it should not replace NPV when later benefits, project life and value creation matter.
Which project cash flows are easy to miss?
Working-capital investment and later recovery, disposal proceeds, tax effects, opportunity cost, incremental support cost and implementation expenditure are common omissions. Sunk research and unchanged allocated overhead should not enter simply because they appear in accounting records.
Exam move
Draw a timeline for every project and label time zero, operating periods and the terminal date. List relevant cash flows before selecting a method, including working capital, tax and disposal effects. Calculate NPV with each flow discounted separately; then use IRR, payback or AARR only when the question asks for the additional perspective.
Compare methods in words: NPV measures value at a required return, IRR expresses a break-even rate, payback emphasises recovery speed and AARR uses accounting income. For mutually exclusive projects, check scale and timing when rankings conflict.
End with a sensitivity question about the forecast variable most capable of changing the decision, and explain how a post-audit could improve later estimates without punishing managers for uncontrollable events. Build three timelines: an annuity, uneven operating flows and a project with working-capital recovery plus disposal proceeds. Discount every line separately and reconcile the present values to NPV.
Then calculate simple payback and explain which later flows it ignores. Use two mutually exclusive projects of different scale to show why the larger IRR need not produce the larger value. Change the required return and predict which distant cash flows will be most sensitive.
Before recommending approval, write a cash-flow audit that excludes sunk research, includes opportunity cost and checks whether financing has already been reflected in the discount rate. The final decision should state the result, its assumptions and the forecast variable most likely to reverse it.
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