Cost Accounting (14th Edition)

750 CHAPTER 21 CAPITAL BUDGETING AND COST ANALYSIS
Decision
Point
What are the
strengths and
weaknesses of the
accrual accounting
rate-of-return (AARR)
method for evaluating
long-term projects?
Learning
Objective 5
Identify relevant cash
inflows and outflows for
capital budgeting
decisions
. . . the differences in
expected future cash
flows resulting from the
investment
which ignores cash flows after the payback period, the AARR method considers income
earned throughout a project’s expected useful life. Unlike the NPV method, the AARR
method uses accrual accounting income numbers, it does not track cash flows, and it ignores
the time value of money. Critics cite these arguments as drawbacks of the AARR method.
Overall, keep in mind that companies frequently use multiple methods for evaluating
capital investment decisions. When different methods lead to different rankings of projects,
finance theory suggests that more weight be given to the NPV method because the
assumptions made by the NPV method are most consistent with making decisions that
maximize company value.
Relevant Cash Flows in Discounted Cash Flow
Analysis
So far, we have examined methods for evaluating long-term projects in settings where the
expected future cash flows of interest were assumed to be known. One of the biggest
challenges in capital budgeting, particularly DCF analysis, however, is determining
which cash flows are relevant in making an investment selection. Relevant cash flows are
the differences in expected future cash flows as a result of making the investment. In the
Top-Spin example, the relevant cash flows are the differences in expected future cash
flows between continuing to use the old technology and updating its technology with the
purchase of a new machine. When reading this section, focus on identifying expected
future cash flows and the differences in expected future cash flows.
To illustrate relevant cash flow analysis, consider a more complex version of the
Top-Spin example with these additional assumptions:
Top-Spin is a profitable company. The income tax rate is 40% of operating income
each year.
The before-tax additional operating cash inflows from the carbon-fiber machine are
$120,000 in years 1 through 4 and $105,000 in year 5.
For tax purposes, Top-Spin uses the straight-line depreciation method and assumes
no terminal disposal value.
Gains or losses on the sale of depreciable assets are taxed at the same rate as ordinary
income.
The tax effects of cash inflows and outflows occur at the same time that the cash
inflows and outflows occur.
Top-Spin uses an 8% required rate of return for discounting after-tax cash flows.
Summary data for the machines follow:
Old Graphite Machine New Carbon-Fiber Machine
Purchase price — $390,000
Current book value $40,000 —
Current disposal value 6,500 Not applicable
Terminal disposal value five years from now 0 0
Annual depreciation 8,000 a 78,000 b
Working capital required 6,000 15,000
a $40,000 , 5 years = $8,000 annual depreciation.
, 5 years = $78,000 annual depreciation.
Relevant After-Tax Flows
We use the concepts of differential cost and differential revenue introduced in Chapter 11.
We compare (1) the after-tax cash outflows as a result of replacing the old machine with
(2) the additional after-tax cash inflows generated from using the new machine rather
than the old machine.
As Benjamin Franklin said, “Two things in life are certain: death and taxes.” Income
taxes are a fact of life for most corporations and individuals. It is important first to