Strategy and the Analysis of Capital Investments

Introductory Definitions
Capital budgeting:
Procedures used to identify, select, monitor, and control

capital (i.e., long-term) investments

Capital investments:
Long-term projects involving substantial initial cash

outlays followed by a series of future cash returns

Capital budget:
Part of the organizations master budget (Chap. 10) that

deals with the current periods planned capital investment outlays

Blocher,Stout,Cokins Cost Management 5e The McGraw-Hill Companies 2010

Strategic Nature of CapitalBudgeting Decisions

Capital investment decisions:
Involve large amounts of capital outlays Provide anticipated returns (cash flows) over an

extended period of time

Linkage of capital investment decisions to the

organizations chosen strategy:

Build strategy Hold strategy
Blocher,Stout,Cokins Cost Management Harvest strategy 5e The McGraw-Hill Companies 2010

How Accounting Can Add Value to the Capital Budgeting Process

Linking capital budgeting to the master budgeting process (planning) Linking capital budgeting decisions to the

organizations Balanced Scorecard (control)

Generation of relevant data for investment analysis purposes (decision-making) Conducting post-audits of capital investment projects (control)
Blocher,Stout,Cokins Cost Management 5e The McGraw-Hill Companies 2010

Identifying Relevant Cash Flows for Capital- Expenditure Analysis

Project initiation:
Required investment outlays, including installation costs Incremental net working capital commitments After-tax cash flows associated with disposal of asset being

replaced

Project operation:
Cash operating expenses, net of tax Additional net working capital requirements Operating cash inflows (or cash savings), net of tax

Project disposal:
Net of tax investment disposal Recapture of investment in net working capital
Blocher,Stout,Cokins Cost Management 5e The McGraw-Hill Companies 2010

Additional Methods for Handling Uncertainty in the Analysis of Capital-Investment Projects

Scenario Analysis:
Disaster Scenario

Disappointing Scenario
Optimistic Scenario Monte Carlo Simulation Analysis:

Decision inputs subjected to probability distribution

Use of simulation (e.g., @ RISK Excel add-on)
Blocher,Stout,Cokins Cost Management 5e The McGraw-Hill Companies 2010

Chapter Summary (continued)

In Appendix A we presented alternative ways to structure a capital-budgeting analysis of an equipmentreplacement decision Finally, in Appendix B we dealt with the following complexities associated with the use of DCF capital budgeting decision models:
The case of multiple IRRs The case of mutually exclusive projects The case of capital rationing

Except for the capital rationing situation, the indicated solution is to base capital budgeting decisions on project NPVs
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