Learning Goal: I'm working on a business question and need guidance to help me learn.
The Budget Case
This case is designed to evaluate the budget process at a
large manufacturing company.
The learning objectives of this case study are as follows:
Use the budget to make decisions.
Identify how budgeting is used by leadership for planning and control.
1. Discuss ethical considerations in the budget process.
2. You have just been hired at ABC Manufacturing, and your supervisor has invited you to sit in
on today's budget meeting. You are given a copy of the following proposed budget for next
year to review. The budget is being used by ABC to plan for next year. Your supervisor tells
you right before the meeting, "We always overestimate because the president always makes
us cut the budget by 20%, and besides, I really want to go to that conference in Las Vegas next
year.” He continued,” I have really worked hard this year and put in a lot of overtime so I
deserve it."
3. Prepare a one- to two-page written report by addressing the following tasks:
Discuss if you think ABC Manufacturing is properly using the budget process to plan for next year's
expenses.
Discuss the comment about the president cutting the budget each year in terms of proper leadership
and control?
Discuss the ethical issues related to inflating the budget.
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Link to Practice
Address Cash Flow Uncertainty with a Revolving Loan
Many companies know they are going to need to borrow money when they must stock
up on inventory in anticipation of peak demand. This follows because the cash
collected from related sales may be weeks or months after the necessary payment for
purchases of inventory.
A problem is that companies are often uncertain as to the exact amount they will need
to borrow and when the loan will be needed. In such cases, companies often set up a
revolving loan (also known as a revolver) with a bank. With a revolving loan, the bank
sets up a credit limit and a company can borrow up to that limit at a specified rate of
interest. If the credit limit isn’t reached, a company can borrow additional funds
without reapplying for a new loan.
Use of Computers in the Budget Planning Process
The budget committee may review a budget and decide that it is inconsistent with
company goals. This conclusion may lead managers to explore a variety of actions that
affect future costs and revenues. If the managers decide to make changes, then they
must also revise the budget. Since budgets are highly interdependent, a change in one
can affect several others.
Computers are very useful in this situation. Most companies that use budgets define
the budget relationships in a computer model using a spreadsheet program such as
Excel or a custom program specifically designed for them. With computerized budget
information, an item in a budget can be changed, and the computer can recalculate
that budget and any other budget affected by the change. Obviously, this results in
substantial savings in time and managerial effort.
“What if” analysis, discussed in Chapter 4, is also facilitated when budgets are prepared
using a spreadsheet program. Suppose the management of Preston Joystick wants to
know what the cash balance will be in the fourth quarter if sales in the first quarter are
22,000 instead of the 21,000 units budgeted. If all of the budgetary relationships have
been properly specified in a spreadsheet, the answer can be found simply by changing
the sales figure in the first-quarter sales budget from 21,000 to 22,000 and letting the
computer recalculate the cash balance in the fourth quarter cash receipts and
disbursements budget.
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Link to Practice
Using Microsoft Excel for Budgeting
Most large companies use sophisticated software packages for budgeting, such as
those by SAP or Oracle. However, in a survey of CFOs, Centage, a company that
provides software for budgeting, forecasting, and analytics, found that 90 percent still
use Excel for budgeting. A benefit of Excel is that it’s widely available and users are
familiar with its interface. A problem is that errors are easy to make when importing
data or when the spreadsheets are complex.
Source: Dave Winterhalter, “The Pros and Cons of Excel for Business Budgeting,”
Centage (June 19, 2018). https://www.centage.com/pros-cons-of-excel-for-business-
budgeting
LEARNING OBJECTIVE 3
Explain why flexible budgets are needed for performance evaluation, and discuss the
conflict between the planning and control uses of budgets.
Budgetary Control
Our discussion of the master budget and its components gave you some indication of
how budgets are used in the planning process to communicate company goals and
coordinate diverse activities. Budgets, as noted earlier, also facilitate control of
operations. Next, we discuss that function in more detail.
Budgets as a Standard for Evaluation
Budgets facilitate control by providing a standard for evaluation. The standard is the
budgeted amount, against which actual results are compared. Differences between
budgeted and actual amounts are referred to as budget variances, and reports that
indicate budget variances are referred to as performance reports. If budgeted and actual
costs are approximately equal, no action needs to be taken because results are
consistent with management’s expectations. However, if actual costs differ from
budgeted costs by a material amount, management should launch an investigation to
determine the cause of the difference.
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How would performance be evaluated if budgets were not prepared? Most likely,
actual performance in the current period would be compared with actual performance
in the prior period. This is obviously an inferior approach because conditions may
change significantly from one period to the next, making a comparison of the two
periods meaningless. For example, suppose Preston Joystick evaluates the
performance of the marketing department by comparing sales in the current year with
sales in the past year. Further, suppose sales in the prior year are 75,833 units and
actual sales in the current year are 85,000 units. An evaluation of performance based
on a comparison with the prior year would lead to a favorable evaluation of the
marketing department, because sales are up by approximately 12 percent. However,
senior managers at Preston anticipated that, given an expanded advertising campaign,
the company should have sales of 91,000 units, a 20 percent increase that is reflected
in the budget. A comparison of actual sales to budgeted sales indicates that rather
than receiving a favorable evaluation, the marketing department should be asked to
explain why actual sales are only 85,000 units instead of the 91,000 units forecasted.
Static and Flexible Budgets
In evaluating performance by using budgets, care must be taken to make sure that the
level of activity used in the budget is equal to the actual level of activity. Let’s consider
an example to see why this is the case. Suppose the manager responsible for
manufacturing overhead at Preston Joystick is evaluated at the end of the first quarter
by comparing the actual level of overhead cost to the overhead costs budgeted at the
start of the year. This comparison is presented in Illustration 10.13.
ILLUSTRATION 10.13 Performance evaluation with a static budget
Preston Joystick
Performance Report, Manufacturing Overhead Static Budget Comparison
First Quarter, 2020
Static
Budget Actual Variance
Units produced 21,400 25,000 3,600
Variable costs:
Indirect materials (budgeted at $2 per
unit) $ 42,800 $ 49,000 ($ 6,200)
Indirect labor (budgeted at $1.50 per
unit) 32,100 38,000 (5,900)
Power and light (budgeted at $1 per
unit) 21,400 24,600 (3,200)
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Preston Joystick
Performance Report, Manufacturing Overhead Static Budget Comparison
First Quarter, 2020
Total variable costs 96,300
111,600
(15,300)
Fixed costs:
Supervisory salaries 90,000 90,200 (200)
Depreciation on plant and equipment 20,000 20,300 (300)
Other 5,000 5,000 –0–
Total fixed cost 115,000
115,500 (500)
Total overhead $211,300 $227,100 ($15,800)
( ) denotes unfavorable variance.
The analysis implies that the manager responsible for overhead costs has not done a
good job of cost control. After all, total variable overhead costs are $15,300 higher
than planned, and total fixed overhead costs are $500 higher than planned. However,
note that actual production was 25,000 units, whereas planned production was only
21,400 units. The extra production may be due to an unexpected increase in sales
necessitating increased production. With the increase in production, an increase in
variable costs is expected. Fixed costs, however, would be expected to remain the
same. Since changes in cost are expected when actual production is different from
planned production, the analysis presented is not very useful for evaluating
performance.
The budget presented in Illustration 10.13 is referred to as a static budget because it is
not adjusted for the actual level of production. A more appropriate analysis of
performance would make use of a flexible budget, which is a set of budget
relationships that can be adjusted to various activity levels. Thus, flexible budgets take
into account the fact that when production increases or decreases, variable costs
change. Fixed costs, however, stay the same. Consider a company that anticipates
variable production costs of $10 per unit and fixed production costs of $500,000. With
this cost structure, flexible budgets for production levels of 20,000 units, 30,000 units,
and 40,000 units can be prepared as in Illustration 10.14.
ILLUSTRATION 10.14 Flexible budgets for various production levels
Preston Joystick
Flexible Budgets for Production Levels of 20,000, 30,000, and 40,000 Units
Units produced 20,000 30,000 40,000
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Preston Joystick
Flexible Budgets for Production Levels of 20,000, 30,000, and 40,000 Units
Variable costs ($10 per unit) $200,000 $300,000 $400,000
Fixed costs 500,000 500,000 500,000
Total $700,000 $800,000 $900,000
In Illustration 10.15, a flexible budget is used to evaluate the performance of the
manager responsible for manufacturing overhead at Preston Joystick. Note that the
variable costs are adjusted to the actual level of units produced. The fixed costs are at
the same level as in the static budget, because they are not expected to change when
production increases or decreases. Comparison of actual overhead costs with the
overhead costs in a flexible budget is potentially more revealing about the manager’s
ability to control costs. Actual variable costs are $900 less than the flexible budget
amount. This contrasts sharply with the $15,300 amount by which actual costs were
greater than the static budget amount for variable costs. The variance with respect to
fixed costs is still $500 more than budgeted—the same as in the static budget
comparison.
ILLUSTRATION 10.15 Performance evaluation with a flexible budget
Preston Joystick
Performance Report, Manufacturing Overhead Flexible Budget Comparison
First Quarter, 2020
Flexible
Budget Actual Variance
Units produced 25,000 25,000 –0–
Variable costs:
Indirect materials (budgeted at $2 per
unit) $ 50,000 $ 49,000 $1,000
Indirect labor (budgeted at $1.50 per
unit) 37,500 38,000 (500)
Power and light (budgeted at $1 per
unit) 25,000 224,600 400
Total variable costs 112,500
111,600 900
Fixed costs:
Supervisory salaries 90,000 90,200 (200)
Depreciation on plant and equipment 20,000 20,300 (300)
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Preston Joystick
Performance Report, Manufacturing Overhead Flexible Budget Comparison
First Quarter, 2020
Other 5,000 5,000 –0–
Total fixed cost 115,000 115,500 (500)
Total overhead $227,500 $227,100 $ 400
( ) denotes unfavorable variances.
Investigating Budget Variances
As noted at the beginning of the chapter, significant deviations from the budget (i.e.,
significant variances) may have three causes:
1. The budget may not have been well conceived.
2. Conditions may have changed.
3. Managers may have performed their jobs particularly well or poorly.
If the budget is not carefully developed with reasonable estimates of cost, it should not
be surprising if actual costs are not equal to the budgeted amounts. In this case,
budget variances should not be blamed on the manager responsible for meeting the
budget.
Even if the budget is carefully developed, the company may nonetheless experience
unforeseen and unavoidable price increases. As a result, the actual costs will be
different from budgeted costs.
Finally, budget variances are sometimes due to inefficiencies resulting from poor
management techniques or decisions. In this case, top management may adjust the
compensation of the manager responsible for meeting the budget (e.g., reduce or
eliminate his or her bonus compensation) and suggest ways the manager can improve
the performance of his or her operation. In some cases, it may be necessary to fire a
manager who is incapable of improving.
The cause of a variance cannot be determined without an investigation. However,
because of the cost of investigation, it is not practical to investigate all budget
variances. A management by exception approach is more economical. Under this
approach, only exceptional variances are investigated. Generally, variances that are
large in absolute dollars or relative to budgeted amounts are considered exceptional.
It is important to point out that both exceptional “unfavorable” and exceptional
“favorable” variances should be investigated. For example, in the performance report
in Illustration 10.15, there is a $1,000 “favorable” variance for indirect materials,
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indicating that actual costs are less than budgeted costs. This seems to indicate a
favorable state of affairs. However, it is possible that cheap, low-quality materials are
being used. This could result in substandard products that damage the reputation of
the company.
Link to Practice
Using Rolling Budgets to Deal with Changes in Economic Conditions
Many companies find that shortly after they prepare their annual budget, it’s out of
date. The problem is unanticipated changes in economic conditions. In fact, according
to a study by Adaptive Insights, 64 percent of annual forecast targets are obsolete
after four to six months. To deal with this situation, companies such as Electrolux and
General Electric have turned to so-called rolling budgets. At the start of their fiscal
year, the companies prepare an annual budget covering four quarters, based on best
estimates of what they expect to occur. At the end of the first quarter, a new annual
budget is prepared that covers the remaining three quarters and the first quarter of
the following year. This new budget takes into account information on changes in
economic conditions that come to light in the first quarter which may affect spending
for capital acquisitions as well as product mix and prices. The process is then repeated
each quarter. Rolling budgets also can be updated monthly if desired.
To implement rolling budgets, companies must have a good handle on fixed and
variable expenses so they can predict how unanticipated changes in sales will affect
costs in the revised budget.
Source: Emma Taylor, “The Benefits of Rolling Forecasts,” Innovation Enterprise (July 30,
2015). https://channels.theinnovationenterprise.com/articles/the-benefits-of-rolling-
forecasts
For more information, see Marc P. Lynn and Roland L. Madison, “A Closer Look at
Rolling Budgets,” Management Accounting Quarterly, Fall 2004; and Randy Myers,
“Budgets on a Roll,” Journal of Accountancy, December 2001.
Any Questions?
Q: The chapter provides an example of a “favorable” variance from the budget that is
actually unfavorable from the standpoint of increasing shareholder value. Can there
also be “unfavorable” variances that are associated with increasing shareholder value?
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A: It is quite possible that an “unfavorable” budget variance could be due to an action
that increased shareholder value. For example, suppose a manager decides to spend
much more on customer service than budgeted. But the outcome of the additional
expenditures is that the company makes great strides in customer satisfaction and
sales increase dramatically. In this case, there’s an unfavorable variance, but the action
that generated the variance increased shareholder value.
Conflict in Planning and Control Uses of Budgets
As previously discussed, budgets are used for both planning and control. With respect
to planning, they communicate company goals and help coordinate various activities.
With respect to control, they focus the attention of managers on meeting or beating
budget targets. This is because a manager’s total compensation, including his or her
bonus, may depend on meeting or beating budget targets.
Unfortunately, there is an inherent conflict when budgets are used for both planning
and control. The result of the conflict is that managers may: (1) pad their budgets and
(2) shift income between periods to increase their compensation.2 Both problems are
discussed in the next section.
Why Budget-Based Compensation Can Lead to Budget Padding and
Income Shifting
Illustration 10.16 helps understanding of the two related problems. The illustration
shows a common budget-based compensation scheme in which a manager receives a
“hurdle” bonus once he or she hits a target, which is commonly 80 percent of
budgeted performance. (Here the budget could be in sales dollars, units of output,
profit, or some other performance measure. For our purposes, we will assume the
performance measure is profit.) Performance better than 80 percent of budgeted
profit results in additional “variable” bonus compensation until a cap is reached. This is
commonly 120 percent of the budget. At this point, no additional compensation is
earned for the budget period under consideration.
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ILLUSTRATION 10.16 Common budget-based compensation scheme
Now let’s examine the two potential problems. Recall that managers who are evaluated
with respect to a budget are likely to provide information used in setting it. This follows
because they are likely to have better information about costs and revenues than their
superiors. This leads to the first problem, which is that managers have an incentive to
pad a budget and create budget slack—that is, a budget with targets that are easy to
achieve. That’s because the lower the budget target, the more likely it is that the
managers will receive the hurdle bonus and the maximum variable bonus. Managers
can create slack by lowering their forecasts of sales and increasing their forecasts of
costs.
The second problem relates to the fact that managers who are evaluated with respect
to the budget may have an incentive to shift income from one period to another.
Consider a manager who estimates that it is unlikely he or she will meet the hurdle
target. This manager has an incentive to shift income from a future period into the
current period so that the hurdle target (80 percent of the budget) is reached and the
hurdle bonus is received. This might be done by cutting back research and
development expenditures in the current year and delaying them until a future year.
Or a manager could recognize revenue in the current year on goods that are not going
to be shipped until the start of the next year. This latter option violates generally
accepted accounting principles (GAAP) and is, most likely, illegal. But the action has
been used over the years by a number of ethically challenged managers.
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Now consider a manager who estimates that the performance of his or her business
unit is likely to exceed 120 percent of the budget target. This manager has an incentive
to shift income from the current period to a future period. The excess performance
(performance in excess of 120 percent of the budget) won’t help the manager’s
compensation since the bonus is capped once 120 percent of the budget is reached.
The manager might delay shipments scheduled at year-end so that revenue won’t be
recognized in the current period but will be recognized at the start of the next year,
when goods are finally shipped. The extra revenue in the next year will make
achievement of the budget target in that year relatively easy.
A factor that deters both budget padding and income shifting is the chance of getting
caught. There is always a chance that senior managers will detect that a lower-level
manager has padded a budget and punish this behavior by, for example, firing him or
her. That certainly reduces the incentive to build in excessive budget slack. With
respect to income shifting, there is also a chance that it will be detected and punished
by higher-level managers. And if the income shifting is illegal, penalties may be stiff
indeed.
Perhaps the best that can be done to mitigate the conflict between the planning and
control uses of budgets is to assure managers that their performance in comparison
to the budget will be fairly evaluated and compensated. Managers should be confident
that they will be allowed to comment on the real causes of budget variances and tell
their side of the story.
Evaluation, Measurement, and Management Behavior
You Get What You Measure
Managers pay close attention to those aspects of their jobs that are measured and
evaluated. Thus, it is important to quantify in budgets key “success factors” for the
company. Historically, budgets primarily have included dollar amounts. However,
including some nonmonetary measures of performance in the budget is likely to be
advantageous. For example, if a key aspect of a company’s success is high-quality,
defect-free products, it may be useful to budget the number of defects and the
number of customer complaints at levels consistent with high quality. The actual
number of defects and complaints can be compared with the budgeted quantities to
evaluate performance. Or, if a company is experiencing problems with employee
absenteeism, it may be useful to budget an acceptable number of days missed and
compare actual days missed with the target. Remember, you get what you measure!
Link to Practice
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Ratcheting and the Ability to Achieve Budget Targets
Some managers worry that beating their budgeted earnings targets may lead
superiors to make their budgets harder to achieve in the next budget period. That
practice, know as ratcheting, is thought to create an incentive problem in that it
motivates managers to avoid striving to beat budgeted earnings by a significant
margin.
Recent research by Mahlendorf, Matejaka, and Schäffer documents that favorable
performance relative to the target is, indeed, associated with increases in the target.
However, it appears that this isn’t a major obstacle in that well-performing managers
are able to repeatedly meet these higher targets. Thus, while ratcheting exists, it
doesn’t appear to create negative incentives for the best managers.
Source: Matthias Mahlendorf, Michal Matejka, and Utz Schäffer, “Target Ratcheting,
Incentives, and Achievability of Earnings Targets.” Working Paper (August 2014).
The Preston Joystick Case Revisited
At the start of the chapter, Alan Renton, president of Preston Joystick, noted: “The
marketing, production, and financing people need to know what is anticipated so we
can operate effectively and efficiently.” How can Alan plan and coordinate the activities
of his company?
As you know from reading the preceding material, the answer lies in developing
budgets. Once a sales budget is produced, the production group can develop budgets
for labor, material, and overhead that are consistent with the production level needed
to meet expected sales. Once these budgets are produced, the finance group can
prepare budgets that take into account the cash inflows and outflows anticipated in
the sales and production budgets as well as the cash flows related to selling and
administrative activities and capital acquisitions.
Decision-Making Insight
Budget-based compensation schemes can encourage budget padding (e.g.,
overestimation of expense and underestimation of revenue). But can this hurt decision
making? Absolutely. Suppose a manager underestimates next year’s sales so that his
or her budgeted income target will be relatively easy to beat. Since the sales figures in
the budget are used to prepare the production budget, production managers may fail
to make optimal hiring and material acquisition decisions. The result could be
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needless overtime and more costly rush orders for materials when sales turn out to
be higher than anticipated by the people in production.
Chapter Review
Summary of Learning Objectives
LEARNING OBJECTIVE 1
Discuss the use of budgets in planning and control.
Budgets are useful in the planning process because they enhance communication and
coordination. Budgets are also useful in the control process because they provide a
standard for evaluating performance.
LEARNING OBJECTIVE 2
Prepare the budget schedules that make up a master budget.
The master budget is a comprehensive planning document and usually includes
budgets for sales, production, direct materials, direct labor, manufacturing overhead,
selling and administrative expenses, capital acquisitions, cash receipts and
disbursements, a budgeted income statement, and a budgeted balance sheet. These
budgets are highly interrelated in that the amounts presented in one budget may be
dependent on the amounts in one or more other budgets.
LEARNING OBJECTIVE 3
Explain why flexible budgets are needed for performance evaluation, and discuss
the conflict between the planning and control uses of budgets.
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CHAPTER 10
Budgetary Planning and Control
LEARNING OBJECTIVES
1. Discuss the use of budgets in planning and control.
2. Prepare the budget schedules that make up a master budget.
3. Explain why flexible budgets are needed for performance evaluation, and discuss the conflict between the
planning and control uses of budgets.
Preston Joystick produces a joystick that is the top choice for many serious gamers. At a meeting of key managers, Alan
Renton, president of Preston Joystick, reviewed the past successes and failures of his firm. “As you know,” he
concluded, “we’ve begun a new marketing campaign, and I am confident that next year sales will increase by at least 20
percent.” Jack North, the production manager, seemed caught off guard by this good news. “Look, Alan,” he said, “if you
really think sales are going to take off, we’ve got to plan for the increase. I’ll have to hire additional workers, and the
people in purchasing will need to buy more parts so we don’t run out.” Pam Smith, vice president of finance, chimed in.
“Also, more sales means more inventory, and more inventory means we’ll have to borrow additional funds to finance
the expansion. I’ll need some lead time to arrange the loan.”
The meeting ended with everyone agreeing that more attention should be devoted to planning company activities. Alan
went back to his office convinced that without a plan to guide and coordinate company activities, the coming year
would be a series of near disasters. “The marketing, production, and finance people need to know what is anticipated
so we can operate effectively and efficiently,” he concluded.
In business, budgets are the formal documents that quantify a company’s plans for achieving its goals. The entire
planning and control process of many companies is built around budgets. This chapter illustrates the preparation of
several budgets that are in common use. The chapter also describes the role of budgets in the performance evaluation
process and discusses a number of issues associated with budgets.
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LEARNING OBJECTIVE 1
Discuss the use of budgets in planning and control.
Use of Budgets in Planning and Control
At companies from Microsoft to Marriott, from Walmart to Wendy’s, budgets are a high priority. As mentioned, the
entire planning and control process of many companies is built around budgets. This section describes how budgets
are used in planning and control.
Planning
Budgets are useful in the planning process because they enhance communication and coordination. The process of
developing a formal plan—that is, a budget—forces managers to consider carefully their goals and objectives and to
specify means of achieving them. Budgets become the vehicle for communicating information about where the
company is heading, and they aid coordination of managers’ activities. For example, the marketing department may
prepare a budget that includes estimates of sales for each month of a future year. The production department may
use the information contained in this budget to schedule workers and material deliveries. Thus, the necessary
coordination of product sales and product production is achieved.
Control
Budgets are useful in the control process because they provide a basis for evaluating performance. To control a
company—to make sure it is heading in the proper direction and operating efficiently—it is essential to assess the
performance of managers and the operations for which they are responsible. Often performance evaluation is carried
out by comparing actual performance with planned or budgeted performance.
Significant deviations from planned performance are associated with three potential causes:
1. It is possible that the plan or budget was poorly conceived. If a budget is not carefully developed, it should not
be surprising that actual results are different from planned results.
2. It is possible that although the budget was carefully developed, conditions have changed. For example, if the
economy were to take a sudden downturn, actual sales might be less than budgeted sales.
3. It is possible that managers have done a particularly good or poor job managing operations. If this is the
case, the managers will be rewarded for good performance (e.g., given a bonus or a promotion) or punished for
poor performance (e.g., given reduced responsibility or even fired).
You Get What You Measure
A graphic presentation of the role of budgets in the planning and control process appears in Illustration 10.1. As you
study this illustration, remember that you get what you measure! This idea is central to an understanding of the
control process. If managers know that their performance will be evaluated with respect to the budget, they are likely
to work especially hard to achieve budgeted goals. Thus, it is critical that the budgeted goals be well thought out and
clearly communicated to managers
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ILLUSTRATION 10.1 Role of budgets in the planning and control process
Developing the Budget
Budgets are prepared for departments, for divisions of a company, and for the company as a whole. Often the group
within a company that is responsible for approval of the various budgets is the budget committee. This committee
consists of senior managers, including the president, the chief financial officer, the vice president for operations, and
the controller. Typically, the budget committee works with departments to develop realistic plans that are consistent
with overall company goals. In some cases, however, the budget committee may impose a budget without soliciting
input from department managers.
The extent to which departments are consulted relates to the distinction between top-down and bottom-up
approaches to the development of a budget. In a top-down approach, budgets are developed at higher organizational
levels without substantial input from lower-level managers. In a bottom-up approach, lower-level managers are the
primary source of information used in setting the budget. Most managers believe a successful budgeting process
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requires a bottom-up approach. After all, lower-level managers often have the best information regarding business
conditions affecting their departments. If this is the case, their input is critical in developing realistic financial plans.
Budget Time Period
Before a budget can be prepared, managers must decide on an appropriate budget period. A company may prepare
budgets for a variety of time periods, depending on its needs. In some cases, long-run budgets are prepared for a
three-year or even a five-year period. Short-run budgets may cover a month, a quarter, or a year. Generally, the longer
the time period, the less detailed the budget.
Zero-Based Budgeting
A common starting point in developing a budget is a consideration of the costs and revenues of the previous period.
These amounts are adjusted up or down based on current information and assumptions or estimates of what will
happen in the future. However, this approach may not lead to a fresh consideration of activities.
So-called zero-based budgeting is a method of budget preparation that requires budgeted amounts to be justified by
each department at the start of each budget period, even if the amounts were supported in prior budget periods. That
is, managers must start from zero in developing their budgets. This results in a fresh consideration of the validity of
budget amounts, but the technique is time-consuming and expensive. Although zero-based budgeting has gained
some support in governmental budgeting, it is not widely practiced by business enterprises.
Link to Practice
People Problems in Budgeting
Centage and the Institute of Management and Administration conducted a survey of chief financial officers (CFOs) from
more than 20 industries regarding their budgeting practices. According to the respondents, the number one budgeting
pain point was dealing with managers. In particular, the CFOs faulted managers for:
Not taking ownership or being accountable.
Lack of cooperation and/or participation.
Lack of understanding of the process or what’s required.
Not meeting deadlines.
Padding their budgets/providing unrealistic numbers.
Source: Centage/IOMA, Budgeting Survey: Benchmarks & Issues, 2008.
LEARNING OBJECTIVE 2
Prepare the budget schedules that make up a master budget.
The Master Budget
The master budget is a comprehensive planning document that incorporates a number of individual budgets. Typically,
it includes budgets for sales, production, direct materials, direct labor, manufacturing overhead, selling and
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administrative expenses, capital acquisitions, and cash receipts and disbursements, as well as a budgeted income
statement and a budgeted balance sheet.
In this section, we present examples of each of these components of a master budget. For purposes of the example,
budgetary information is prepared by quarter for Preston Joystick. As you will see, the various budgets are interrelated.
In particular, the sales budget influences the production budget. The production budget, in turn, influences the
material purchases budget, the direct labor budget, and the manufacturing overhead budget. The relationships among
the various budgets are presented in Illustration 10.2.
ILLUSTRATION 10.2 Relationships among various budgets that comprise the master budget
Sales Budget
The first step in the budget process involves preparation of sales forecasts and development of a sales budget. This
budget comes first because other budgets cannot be prepared without an estimate of sales. For example, managers
preparing the production budget must have an estimate of future sales before they can determine what level of
production will be necessary to meet demand.
Companies use numerous methods to estimate sales. Very large companies may hire economists to prepare sales
forecasts using sophisticated mathematical models that take into consideration the rate of inflation, national capital
expenditures, and other economic data. Smaller companies may develop forecasts based on an analysis of the trend in
their own sales data. Trade journals or magazines exist for almost every industry, and they may provide useful
information for developing sales forecasts. Typically, these journals contain information on past industry sales. They
may also make predictions about the growth of the industry. Sales personnel may be another good source of
information for forecasting sales. Some companies periodically ask all of their salespersons to estimate sales in their
territories for the coming year. These estimates may be highly accurate if the salespersons make their estimates based
on thorough knowledge of their customers’ needs. In general, forecasts of sales are part science and part art. The
forecasts of even the most sophisticated mathematical models are often adjusted based on the professional judgment
of experienced managers.
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Link to Practice
Soft Benefits Related to Investing in Information Technology
Techno-PM, a firm that sells project management templates, notes that there are many soft benefits related to
investing in information technology. For example, investing in a sophisticated user interface could lead to faster
checkout times from a company’s website and, in turn, increase customer satisfaction. The increase in customer
satisfaction is likely to be quite valuable but assigning a dollar value to it would be difficult if not impossible. Or
consider an investment in technology that automates a manual process and reduces human errors. Reducing errors
seems quite valuable but what, specifically, is the value. That is very hard to quantify and so error reduction may be
considered a soft benefit.
Source: Swapnil Wale, “10 Tangible Benefits Examples and Intangible Benefits Examples,” Techno-PM, July 9, 2015.
http://www.techno-pm.com/2015/07/project-benefits-examples-list.html
The present value of the soft benefits must be at least $80,000 before the project is acceptable. Using the present
value of an annuity table, we find that the discount factor for 10 periods at 15 percent is 5.019. This implies that as
long as the soft benefits are worth at least $15,939 per year, the project should be funded. Managers at Dynamic
Medical Equipment will likely find this analysis very useful. For example, while they may be unable to specify the exact
value of the soft benefits, there may be general agreement that the value will certainly exceed $16,000 each year. If
this is the case, then the wheelchair appears to be a good investment. However, there may be general agreement
that while there certainly will be some soft benefit, the value is unlikely to exceed even $10,000 per year. If this is the
case, then the wheelchair is not a good investment.
Estimating the Required Rate of Return
In the problems presented earlier, we simply stated a required rate of return that could be used to calculate an
investment’s net present value or that could be compared with an investment’s internal rate of return. In practice,
the required rate of return must be estimated by management. Under certain conditions, the required rate of return
should be equal to the cost of capital for the firm. The cost of capital is the weighted average of the costs of debt and
equity financing used to generate capital for investments. The cost of debt arises because interest must be paid to
individuals, banks, and other companies that lend money to the firm. Essentially, the cost of equity is the return
demanded by shareholders for the risk they bear in supplying capital to the firm. Estimating the cost of capital,
especially the cost due to equity capital, is a challenge even to sophisticated financial managers.4 Because of this
difficulty, many managers use their judgment to determine the required rate of return, following the general
principle that the more risky the investment, the higher the required rate of return.
Link to Practice
Cost of Capital for Various Business Sectors
The Stern School of New York University has a website
(people.stern.nyu.edu/adamodar/New_Home_Page/datafile/wacc.htm) that lists the cost of capital by business
sector. The values provide you with a good feel for differences in the cost of capital across companies.
Some examples as of July 2019 are:
Aerospace/defense 8.72%
Apparel 6.98%
Auto parts 7.86%
Drugs (Biotechnology) 10.49%
Entertainment 9.42%
Food processing 6.12%
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Semiconductor 9.75%
Telecoms Equipment 8.30%
LEARNING OBJECTIVE 2
Calculate the depreciation tax shield and evaluate long-run decisions, other than investment decisions, using time
value of money techniques.
Additional Cash Flow Considerations
To be useful in investment analysis, both the net present value and the internal rate of return methods require a
proper specification of cash flows. It is particularly important to remember that only cash inflows and outflows, not
revenues and expenses, are discounted back to present value. Thus, if a sale is expected to occur in period 1 but the
collection of the sale is not anticipated until period 2, the cash flow that is discounted back to present value is a
period 2 cash flow, even though the related revenue will be recorded in period 1. Similarly, if a cash payment is
anticipated at the start of period 1 to purchase an asset, and related depreciation is to be recorded in periods 1
through 5, only the start of period 1 cash outflow is used in the net present value analysis. Depreciation is a
legitimate business cost, but it does not require a cash outflow in the period in which it is recorded. Present value
analysis is concerned only with cash flows.
In this section, we consider two special topics related to cash flows. The first deals with depreciation. Although
depreciation does not have a direct effect on cash flows, it does have an indirect effect because of taxes. The second
topic deals with the effect of inflation on cash flows.
Cash Flows, Taxes, and the Depreciation Tax Shield
In all of the previous examples, we ignored the effect of income taxes on cash flows. However, tax considerations play
a major role in capital budgeting decisions, and we discuss them here. If an investment project generates taxable
revenue, cash inflows from the project will be reduced by the taxes that must be paid on the revenue. Similarly, if an
investment project generates tax-deductible expenses, cash inflows from the project will be increased by the tax
savings resulting from the decrease in income taxes payable.
Earlier we stated that depreciation is not relevant in a present value analysis of an investment opportunity because it
is not a cash flow. But although depreciation does not directly affect cash flow, it indirectly affects cash flow because it
reduces the amount of tax a company must pay. That is, it acts to shield income from taxes. The term depreciation
tax shield is used to refer to the tax savings resulting from depreciation.
As an example, suppose the Mando Party Supply Company is considering a new product, custom-imprinted T-shirts.
Imprinting will require an investment in equipment costing $100,000. Each year, the company expects sales to
amount to $70,000 and expenses (other than depreciation on the equipment) to amount to $40,000. Depreciation
calculated on a straight-line basis for the expected 10-year life of the equipment is $10,000 per year. The company has
a 20 percent tax rate.5 Assume that revenue is collected in the period earned and expenses other than depreciation
are paid in the period incurred. Thus, net income and cash flows related to the investment are as follows:
Net Income
Revenue $70,000
Less:
Operating expense other than depreciation $40,000
Depreciation 10,000 50,000
Income before taxes 20,000
Income taxes (20% tax rate) 4,000
Net income $16,000
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Cash Flows
Cash Flows
Revenue $70,000
Less taxes on revenue (14,000)
Less expenses other than depreciation (40,000)
Plus tax savings related to expenses other than depreciation 8,000
Plus tax savings related to depreciation ($10,000 × .20) 2,000
Cash flow $26,000
Note that revenue increases cash inflows by $70,000 but taxes on the revenue decrease cash flows by $14,000.
Expenses other than depreciation reduce cash flows by $40,000 but, since they reduce taxable income by $40,000,
they also save taxes of $8,000. Now note that depreciation expense does not reduce cash flows—that’s because
depreciation is a noncash expense. However, it does reduce taxable income and thus results in a cash inflow equal to
the amount of depreciation times the tax rate ($10,000 × .20 = $2,000). Thus, there is a depreciation tax shield of
$2,000.
In the example, we calculated cash flows in a rather circuitous way because we wanted to show the depreciation tax
shield. A much more direct way would be to simply add depreciation back to net income as follows:
Net income $16,000
Plus depreciation 10,000
Cash flow $26,000
We add depreciation back because it is the only item in the calculation of Mando Party Supply’s net income that is not
a cash flow.
Because the project is fairly risky, top management of Mando Party Supply has set a required rate of return of 16
percent. The net present value calculation for the investment under consideration is presented in Illustration 9.9.
Note that because the amounts of revenue, expense, and tax are the same each year, we can work with the net
amount and treat it as a 10-year annuity with a required rate of return of 16 percent. Because the net present value is
a positive $25,663, the investment in the equipment should be undertaken.
ILLUSTRATION 9.9 NPV analysis taking taxes into account
Link to Practice
Depreciation Tax Shield at Delta Air Lines
Federal tax laws (with certain restrictions that we won’t go into) allow companies to carry losses backward to reduce
previous taxes paid and receive a refund. If the losses cannot be carried back, they can be carried forward to offset
future income in the determination of federal income taxes.
The use of tax loss carry forwards appears to be particularly useful to Delta Air Lines. In 2013, the company had
income of $2.7 billion excluding special items. However, it was not required to pay federal income taxes. The reason—
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it had more than $15 billion in tax loss carry forwards related to previous years when the company had significant
losses.
How would this affect the value of the depreciation tax shield for an investment in equipment in January 2014 that
results in depreciation expense in 2014 and 2015? Since the company isn’t going to pay taxes in 2014 or 2015, it is
clear that the incremental depreciation related to the investment will not save taxes in these years, and there is no
depreciation tax shield in 2014 or 2015.
The fact that depreciation reduced taxes had a significant effect on the value of the investment project. With
depreciation of $10,000 and a 20 percent tax rate, we saw that there is a $2,000 tax saving each year due to
depreciation. The present value of this “tax shield” over 10 years at 16 percent is $9,666 ($2,000 × present value factor
of 4.8332).
Adjusting Cash Flows for Inflation
An additional topic that must be addressed in estimating the cash flows of investments is how to handle inflation.
During the 1970s and early 1980s, the United States experienced double-digit inflation. Because high rates of inflation
are still common in many foreign countries, it may be quite important to consider inflation when estimating the cash
flows associated with investment opportunities.
Inflation can be taken into account by multiplying the current level of cash flow by the expected rate of inflation. For
example, if an investment is expected to yield a cash flow in period 1 of $100 and the rate of inflation is expected to be
five percent per year in the foreseeable future, then a reasonable estimate of the cash flow would be $105 ($100 ×
1.05) in period 2, $110.25 ($105 × 1.05) in period 3, $115.76 in period 4, and so forth. Estimates of inflation can be
obtained from financial journals or can be purchased for a fee from firms that specialize in economic forecasts.
If inflation is ignored in net present value analysis, many worthwhile investment opportunities may be rejected. Why?
Because current rates of return for debt and equity financing already include estimates of future inflation. For
example, banks charge higher rates of interest on loans to companies when they estimate that inflation will be high.
Suppose a company uses its current costs of debt and equity financing (which are high because a high rate of
inflation is expected) to determine its required rate of return. Now, if the company does not take inflation into
account in estimating future cash inflows, the cash inflows will be relatively low, whereas the required rate of return
will be relatively high. The result may be that suitable projects will appear to have a negative net present value.
Other Long-Run Decisions
So far we have discussed capital budgeting decisions that involve investments in long-lived assets, and we have
shown how to analyze them using time value of money techniques: specifically, the net present value method and the
internal rate of return method. In addition to being used to analyze capital budgeting decisions, time value of money
techniques are also applicable to the analysis of other long-run decisions. Long-run decisions are those that affect
the cash flows of a number of future periods. Since cash flows occur in the future and a dollar today is worth more
than a dollar tomorrow, the NPV and IRR methods are applicable to these types of decisions. Examples of long-run
decisions that are not investment decisions but should be analyzed using NPV or IRR are listed in Illustration 9.10.
ILLUSTRATION 9.10 Other long-run decisions
1. Decision to outsource grounds maintenance
2. Decision to drop a product line
3. Decision to buy rather than make a subcomponent of a product
4. Decision to conduct a multiyear advertising campaign
5. Decision involving customers paying for goods with alternative payment plans (e.g., large upfront
payment and smaller annual payments versus small upfront payment and larger annual payments)
Let’s consider an example that shows how time value of money techniques can be used to analyze a decision other
than a capital budgeting decision. Suppose that Accelerator Consulting is considering signing a contract to sponsor a
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golf tournament in Phoenix. The contract specifies that Accelerator will pay $1,000,000 at the start of each of five
years. In return, the tournament will be called the Accelerator Open when it is broadcast on television and there will
be highly visible signage around the clubhouse and course. Additionally, Accelerator will receive free catering and
seats on the 18th hole so the company can entertain customers and other VIPs.
Accelerator estimates that over the five years, exposure from the tournament will increase revenue by $2,000,000,
$3,000,000, $4,000,000, $5,000,000, and $6,000,000. The company’s normal pretax profit margin (pretax profit divided
by revenue) is 30 percent, and the company’s tax rate is 20 percent. The company would like to earn a 10 percent
return related to the event. Should the company agree to sponsor the tournament? Analysis of the decision using
NPV and IRR is presented in Illustration 9.11. Note that the NPV is a positive $54,660. Thus, Accelerator should
sponsor the tournament. The illustration also shows that the IRR on the project is 11.01 percent. This was calculated
using the IRR function in Excel as demonstrated in Appendix A.
ILLUSTRATION 9.11 Evaluation of decision to sponsor a golf tournament
Cash Flows Present Year 1 Year 2 Year 3 Year 4 Year 5
Payments ($1,000,000) ($1,000,000) ($1,000,000) ($1,000,000) ($1,000,000) —
Tax savings
from payments — 200,000a200,000 200,000 200,000 200,000
Additional
pretax profit
exluding
payments — 600,000b900,000 1,200,000 1,500,000 1,800,000
Additional
taxes related to
additional
pretax profit — (120,000)c (180,000) (240,000) (300,000) (360,000)
Cash flows ($ 600,000) ($ 320,000) ($ 80,000) $ 160,000 $ 400,000 $1,640,000
PV factor
(Table B9.1,
Appendix B)
× 1.0000 × 0.9091 × 0.8264 × 0.7513 × 0.6830 × 0.6209
Total ($1,000,000) ($ 290,912) ($ 66,112) $ 120,208 $ 273,200 $1,018,276 =$54,660(NPV)
11.01% (IRR)d
aEquals ($1,000,000) × .2
bEquals $2,000,000 × .3
cEquals $600,000 × .2
dCalculated using Excel, as described in Appendix A.
Any Questions?
Q: In Chapter 7, we analyzed decisions much like those described in Illustration 9.10 and in the example related to
Accelerator Consulting, but we focused on incremental revenues and incremental costs rather than cash inflows and
outflows, and we didn’t use NPV. Why could we ignore the time value of money in Chapter 7 but we have to use it in
this chapter?
A: In Chapter 7, we analyzed incremental revenues and incremental costs. An underlying assumption, which was not
spelled out because it would have been confusing then, is that the incremental revenues were also incremental cash
inflows, and the incremental costs were also incremental cash outflows. Also, we assumed that the time value of
money wasn’t important to analyzing the decision. This could be because the decision affected only one or two
periods, so ignoring the time value of money wouldn’t result in a significant error. Or, it may have been that the
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decision alternatives did not require significant investments and one alternative clearly dominated the others
because its incremental profit was the highest in all years.
LEARNING OBJECTIVE 3
Use the payback period and the accounting rate of return methods to evaluate investment opportunities, and explain
why managers may concentrate erroneously on the short-run profitability of investments rather than their net
present values.
Simplified Approaches to Capital Budgeting
The net present value and the internal rate of return methods are widely used in industry to evaluate capital projects.
However, many companies continue to use other, simpler, approaches to evaluating capital projects. Two of these
approaches, the payback period method and the accounting rate of return method, are discussed in this section. As
you will see, both of these methods have significant limitations in comparison to net present value and internal rate
of return.
Payback Period Method
The payback period is the length of time it takes to recover the initial cost of an investment. Thus, if an investment
opportunity costs $1,000 and yields cash flows of $500 per year, it has a payback period of two years. If an investment
costs $1,000 and yields cash flows of $300 per year, it has a payback period of three and one-third years. All else being
equal, a company would like to have projects with short payback periods.
One approach to using the payback method is to accept investment projects that have a payback period less than
some specified requirement. However, this can lead to extremely poor decisions. For example, suppose a company
has two investment opportunities, both costing $1,000. The first investment yields cash flows of $500 per year for
three years and has a payback period of two years. The second investment yields no cash flows in the first two years
but has cash flows of $1,000 in the third year and $4,000 in the fourth year. Thus, it has a payback period of three
years. Obviously, the second investment is preferable. However, if the company has a 2-year payback requirement, it
will select the first investment and reject the second. The problem is that the payback method does not take into
account the total stream of cash flows related to an investment. It only considers the stream of cash flows up to the time
the investment is paid back. Thus, in this example, the payback period method ignores the $4,000 cash inflow in the
fourth year of the second investment.
Link to Practice
Payback on Home Solar Power
What’s the payback on an investment in a home solar panel project? That depends on the number of panels, local
cost of electricity, and other factors. But, here’s an example from a homeowner in southeastern Pennsylvania. Kevin
Tofel added solar panels to his four-bedroom house at a cost of $51,865. After a federal tax credit and a state rebate,
the net cost was only $29,205. His typical electric bill had been around $2,500 per year. Thus, he estimated that his
payback period would be around 11.7 years ($29,205 ÷ $2,500).After he made the investment, Tofel sold his gas
powered car and bought an electric vehicle. He saved on gas and had no incremental electricity costs as his system
had plenty of capacity. This made his actual payback period even lower.
Source: Kevin C. Tofel, “Adding an Electric Car Cut the Payback Point of our Solar Panel Investment in Half,” GIGAOM,
May 12, 2013.
A further limitation of the payback method is that it does not consider the time value of money. Consider two
investments, each with a cost of $1,000. The first yields cash flows of $700 in the first year, $300 in the second year,
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and $300 in the third year. Thus, it has a payback of two years. The second investment yields cash flows of $300 in the
first year, $700 in the second year, and $300 in the third year. Thus, it also has a payback period of two years. But
although both investments have the same payback period (implying they are equally valuable), the first investment is
actually more favorable, because the $700 cash inflow is received in the first year rather than the second year. In fact,
the first investment has an internal rate of return of 17 percent, whereas the second investment has an internal rate
of return of only 14 percent.
Although the payback method has significant limitations, some companies may find it useful, particularly if they have
cash flow problems. Companies with cash flow problems may need to focus on investments that quickly return cash
in order to avoid bankruptcy.
Accounting Rate of Return
The accounting rate of return is equal to the average after-tax income from a project divided by the average
investment in the project:
Here the average investment is simply the initial investment divided by two.6 The accounting rate of return can be
used to evaluate investment opportunities by comparing their accounting rates of return with a required accounting
rate of return. The primary limitation of this approach is that, like the payback period method, it ignores the time
value of money.
Consider two investment alternatives facing a firm with a cost of capital of 15 percent and a 40 percent tax rate. Both
require investments in equipment costing $100,000, and both generate cash flows for two years. The investments are
identical except that, while both have total revenue over two years of $180,000, project 1 has $90,000 of revenue in
the first year, while project 2 has $70,000. In the second year, project 1 again has $90,000 of revenue, while project 2
has $110,000. Illustration 9.12 presents the net incomes and cash flows of the two alternatives for the two years. We
assume that all revenue items are collected in the period earned and all expense items (other than depreciation) are
paid in the period incurred. Thus, the difference between net income and cash flow is simply the amount of
depreciation.
ILLUSTRATION 9.12 Net income and cash flow data for alternative projects
Project 1 Project 2
Year 1
Revenue $90,000 $ 70,000
Less:
Operating expenses other than depreciation 20,000 20,000
Depreciation 50,000 50,000
Income before taxes 20,000 0
Taxes 8,000 0
Net income 12,000 0
Plus depreciation 50,000 50,000
Cash flow $62,000 $ 50,000
Year 2
Revenue $90,000 $110,000
Less:
Operating expenses other than depreciation 20,000 20,000
Depreciation 50,000 50,000
Income before taxes 20,000 40,000
Taxes 8,000 16,000
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Project 1 Project 2
Net income 12,000 24,000
Plus depreciation 50,000 50,000
Cash flow $62,000 $ 74,000
Based on the information, it is easy to calculate the accounting rate of return for each project, as indicated in
Illustration 9.13. Both have identical accounting rates of return of 24 percent, indicating that the two projects are
equally desirable. When we take into account the time value of money, however, it is clear that project 1 is more
desirable than project 2. As indicated in Illustration 9.14, using a cost of capital of 15 percent, the net present value
of project 1 is $793.40, whereas project 2 has a negative net present value of $568.60. Thus, taking into account the
time value of money, project 1 is an acceptable investment while project 2 is not acceptable.
ILLUSTRATION 9.13 Comparison of ARRs for alternative projects
ILLUSTRATION 9.14 NPV comparison of alternative projects
Project 1
Time Period Cash Flow Present Value Factor Present Value
–0– ($100,000) 1.0000 ($100,000.00)
1 $ 62,000 .8696 53,915.20
2 $ 62,000 .7561 46,878.20
Net Present Value $ 793.40
Project 2
Time Period Cash Flow Present Value Factor Present Value
–0– ($100,000) 1.0000 ($100,000.00)
1 $ 50,000 .8696 43,480.00
2 $ 74,000 .7561 55,951.40
Net Present Value ($ 568.60)
Test Your Knowledge
Compared to NPV, both the accounting rate of return and the payback method suffer from a failure to consider:
1. a. Soft benefits.
2. b. Unexpected consequences.
3. c. The time value of money.
Correct or Incorrect?
Clear Check Answer
The Accounting Rate of Return Is Not a Reliable Estimate of the Internal Rate of Return
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Some people think that while the accounting rate of return ignores the time value of money, it still provides a
reasonably accurate estimate of a project’s internal rate of return. This is not the case. Using Excel (see Apprendix A),
we can easily calculate the IRR of project 1 in Illustration 9.14 to be 15.62 percent. Recall that this is the rate that
makes the NPV of the project equal to zero. The accounting rate of return provided a return of 24 percent, which is
more than 50 percent greater than the internal rate of return. This clearly demonstrates that the accounting rate of
return need not be a reasonable estimate of a project’s real economic return, which is measured by IRR.
Conflict between Performance Evaluation and Capital Budgeting
You Get What You Measure
An NPV greater than zero or an IRR greater than the required rate of return informs managers that an investment
opportunity will increase their firm’s value. Thus, managers who wish to maximize shareholder wealth should use
these present value techniques to evaluate investments. However, in some companies, managers may be
discouraged from using present value techniques for evaluating investments because of the way in which their own
performance is evaluated.
For example, an investment may result in high amounts of depreciation in the early years of its life. At the same time,
in these early start-up years, revenues may be quite low, resulting in low profits or even losses. However, revenues in
later years may be large enough to ensure that the project has a positive net present value. If a manager knows that
job performance is evaluated in terms of reported accounting income, he or she may fear being fired because of the
low initial profits of this investment. If this is the case, the manager will likely ignore the fact that a project has a
positive net present value and concentrate instead on reported income.
To illustrate this, suppose a manager is considering producing a new product that requires an investment of
$1,000,000 in equipment. Depreciation on the equipment will be recorded using the straight-line method. Based on a
10-year life, depreciation will be $100,000 per year. The product is not expected to sell well in the early years. Expected
first-year revenue is only $40,000. However, by the end of the seventh year, expected revenue is up to $400,000 per
year. In addition to depreciation, there are $40,000 of other expenses each year. The company has a 10 percent
required rate of return.
Illustration 9.15 is a net present value analysis of the investment. The net present value is $26,998, indicating that
the project should be undertaken. However, will the manager be motivated to undertake this project, which is in the
best interest of the company? Note that the project shows a substantial loss in each of the first three years. The
manager may fear that this will reflect badly on his or her performance, perhaps leading to dismissal from the firm. If
this is the case, the manager may opt to pass up this valuable investment opportunity.
ILLUSTRATION 9.15 Net present value analysis of new producta
Year 1 Year 2 Year 3 Year 4 Year 5
Revenue $ 40,000 $ 60,000 $100,000 $150,000 $200,000
Less:
Operating expenses other than depreciation 40,000 40,000 40,000 40,000 40,000
Depreciation 100,000 100,000 100,000 100,000 100,000
Net income (100,000) (80,000) (40,000) 10,000 60,000
Plus depreciation 100,000 100,000 100,000 100,000 100,000
Cash flow $ 0 $ 20,000 $ 60,000 $110,000 $160,000
Year 6 Year 7 Year 8 Year 9 Year 10
Revenue $300,000 $400,000 $400,000 $400,000 $400,000
Less:
Operating expenses other than depreciation 40,000 40,000 40,000 40,000 40,000
Depreciation 100,000 100,000 100,000 100,000 100,000
Net income 160,000 260,000 260,000 260,000 260,000
Plus depreciation 100,000 100,000 100,000 100,000 100,000
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Year 1 Year 2 Year 3 Year 4 Year 5
Cash flow $260,000 $360,000 $360,000 $360,000 $360,000
Time Period Cash Flows Factor for 10% Present Value
0 ($1,000,000) 1.0000 ($1,000,000)
1 0 0.9091 0
2 20,000 0.8264 16,528
3 60,000 0.7513 45,078
4 110,000 0.6830 75,130
5 160,000 0.6209 99,344
6 260,000 0.5645 146,770
7 360,000 0.5132 184,752
8 360,000 0.4665 167,940
9 360,000 0.4241 152,676
10 360,000 0.3855 138,780
Net present value $ 26,998
aNote that the example is simplified and ignores taxes. Therefore, there is no depreciation tax shield. Also,
the example assumes that revenue is collected in the period earned and other expenses are paid in the
period incurred.
At least a partial solution to this problem is to make sure managers realize that, if they approve projects with positive
net present values that lower reported income in the short run, evaluations of their performance and their
compensation will take the expected future benefits into account. Managers must be confident that their
performance will be evaluated with respect to the long-run profitability of the firm, or they will not take a long-run
perspective in evaluating capital projects.
At some firms, top managers are required to hold stock in the company they work for. The idea behind the
requirement is that it aligns the interests of managers with the interests of shareholders. These managers will tend
to take actions that maximize the value of the firm, because increasing firm value increases their own wealth. It is
hoped that these managers will tend to focus on present value techniques in evaluating investments because these
techniques identify investments that increase the firm’s value.
Wilson Air Example Revisited
At the beginning of the chapter, Steve Wilson, president of Wilson Air, was trying to decide whether he should
purchase another plane. At this point, we have developed the tools needed to analyze problems like the one facing
Steve.
Recall that a new plane costs $1,000,000. The residual value of the plane after five years will be $500,000, and annual
depreciation using the straight-line method is $100,000. Revenue will increase by $700,000 per year, and operating
costs (ignoring depreciation and taxes) will be $400,000. Revenue will be collected in the period earned, and operating
costs other than depreciation will be paid in the period incurred. Assume the income tax rate is 20 percent. What is
the net present value of the investment in the plane if the required rate of return is 10 percent? The answer is
$296,058, as shown in Illustration 9.16. Because the NPV is positive, the investment should be undertaken.
ILLUSTRATION 9.16 Present value of investment in plane
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Decision-Making Insight
Capital budgeting decisions involve estimation of incremental cash inflows and outflows. Since the cash flows don’t
occur in the same periods and because a dollar today is worth more than a dollar tomorrow, we need to take into
account the time value of money by using the net present value (NPV) approach or the internal rate of return (IRR)
approach.
However, managers may not make investments in projects with substantial NPVs (or projects with IRRs greater than
the required rate of return) because they are evaluated in terms of short-run accounting profit, which may decrease
when the projects are undertaken.
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CHAPTER 9
Capital Budgeting and Other Long-Run Decisions
LEARNING OBJECTIVES
1. Define capital expenditure decisions and capital budgets and evaluate investment opportunities using the net
present value approach and the internal rate of return approach.
2. Calculate the depreciation tax shield and evaluate long-run decisions, other than investment decisions, using
time value of money techniques.
3. Use the payback period and the accounting rate of return methods to evaluate investment opportunities, and
explain why managers may concentrate erroneously on the short-run profitability of investments rather than
their net present values.
For several years, Steve Wilson, president of Wilson Air, has operated a successful business flying passengers
between Seattle and resorts in Idaho and around Washington State. Now Steve thinks it’s time to consider adding to
his fleet of three seven-passenger aircraft. “Look,” he explains to his chief accountant, Ellen Ortega, “with another
plane, we can service 3,500 additional round-trip passengers a year. At an average fare of $200, that’s $700,000!” “But
don’t forget,” Ellen points out, “a relatively new but pre-owned plane will cost around $1,000,000, operating cost will
be nearly $400,000 per year, and, after five years, that $1,000,000 plane will only be worth $500,000. It’s not clear that
buying another plane is a good business decision.”
This chapter extends the discussion of decision making in Chapter 7 to include problems like the one facing Steve
Wilson. Steve is considering investing cash today in order to receive cash in the future. Obviously, Steve will require a
total cash inflow that is larger than his initial outflow, since he wants to earn a return on his investment in the plane.
Here we discuss how to determine whether future cash inflows are sufficient to earn a satisfactory return.
We begin our discussion by focusing on capital budgeting decisions. Essentially, these are decisions related to
investments in property, plant, and equipment. As you will see, the approach to the proper analysis of these decisions
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requires that we take into account the fact that a dollar today is worth more than a dollar tomorrow. In other words,
we must consider the time value of money. After we learn about capital budgeting decisions and time value of money
approaches to decision making, we will use the same techniques to evaluate other long-run decisions. Since these
decisions also affect cash flows across multiple years, we will need to take the time value of money into account in
analyzing them.
LEARNING OBJECTIVE 1
Define capital expenditure decisions and capital budgets and evaluate investment opportunities using the net
present value approach and the internal rate of return approach.
Capital Budgeting Decisions
Individuals make investments in their homes, automobiles, major appliances, furniture, and other long-lived assets.
Companies also make investments in long-lived assets. Examples of investment decisions are presented in
Illustration 9.1. In each example, a firm is considering investing in one or more assets that will affect its operations
for several years.
ILLUSTRATION 9.1 Examples of investment decisions
1. Amazon invests in a 2.4 million square foot warehouse in Orlando. The estimated cost of the facility is
$14 million.
2. Nordstrom invests in a new department store in Toronto. The store was Nordstrom’s sixth full-line
store in Canada.
3. Tesla invests in a factory in Nevada to produce lithium-ion batteries and electric vehicle
subassemblies. The factory is one of the largest in the world and is estimated to cost $5 billion. As of
December 2018, the factory was 5.4 million square feet but that is less than half of its potential size.
4. Starbucks invests in a 23,000 square foot “Reserve Roastery” in Manhattan.
5. Kroger invests $200 million in Home Chef, a company that offers online meal kits.
Investment decisions are extremely important because they have a major, long-term effect on a firm’s operations. In
2017, BMW announced a $600 million expansion of its factory in South Carolina. This investment in additional
productive capacity will affect its labor and transportation costs for many years to come. Labor to build the cars is
supplied by American rather than German workers, so labor costs are largely determined by business conditions in
the United States rather than in Germany. Transportation costs are greatly reduced for cars sold in the United States
because cars can be shipped from South Carolina rather than continental Europe.
The investment decisions of small companies are also extremely important. Consider a small print shop that decides
to make an investment in a computerized printing machine. The cost of the machine may represent 50 percent or
more of the company’s total assets. But the cost savings from the investment in new technology may make the
difference between being a solid competitor in its market or being on the verge of financial failure.
Investment decisions involving the acquisition of long-lived assets are often referred to as capital expenditure
decisions because they require that capital (company funds) be expended to acquire additional resources.
Investment decisions are also called capital budgeting decisions. Most firms carefully analyze the potential projects in
which they may invest. The process of evaluating the investment opportunities is referred to as capital budgeting, and
the final list of approved projects is referred to as the capital budget.
Evaluating Investment Opportunities: Time Value of Money Approaches
Crucial to an understanding of capital budgeting decisions is an understanding of the time value of money. In
evaluating an investment opportunity, a company must know not only how much cash it receives from or pays for an
investment but also when the cash is received or paid. The time value of money concept recognizes that it is better to
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receive a dollar today than it is to receive a dollar next year or any other time in the future. This is because the dollar
received today can be invested so that at the end of the year, it amounts to more than a dollar.
In an investment decision, a company invests money today in the hopes of receiving more money in the future.
Obviously, the company would not invest money in a project unless it expected the total amount of funds received in
the future to exceed the amount of the original investment. But by how much must the future cash flows exceed the
original investment? Because money in the future is not equivalent to money today, we need to develop a way of
converting future dollars into their equivalent current, or present, value. The techniques developed to equate future
dollars to current dollars are referred to as present value techniques or time value of money methods.
Some readers of this book will have been introduced to present value techniques in their study of financial
accounting and the valuation of long-term debt. We review the basics in the next section, “Basic Time Value of Money
Calculations.” After that, we discuss two approaches for evaluating investments that take into account the time value
of money: the net present value method and the internal rate of return method.
Link to Practice
MSC Cruises Launches $1 Billion Ship
In 2017, Switzerland-based MSC Cruises launched the MSC Meraviglia, a 171,598 ton cruise ship costing $1 billion. The
ship can hold 5,714 passengers. In making this investment, MSC decided that the net future cash inflows generated by
the ship would earn a satisfactory return on the cost of building it.
Source: Gene Sloan, “Yet Another Giant New Cruise Ship Takes to the Sea,” USA Today, May 31,2017.
https://www.usatoday.com/story/travel/cruises/2017/05/31/msc-takes-delivery-of-giant-new-cruise-ship/102339646/
Basic Time Value of Money Calculations
Suppose you invest $100 at an interest rate of 10 percent. At the end of one year, you will have $110.
Now let’s turn this problem around. Suppose you require a return of 10 percent on your investments. How much is a
payment of $110, one year from now, worth today? A little algebra (dividing both sides by 1 + .10) indicates that it is
worth $100. In other words, if your required return is 10 percent, the present value of $110 received one year from
now is $100. Put another way, $100 is the amount you would have to invest today, at an interest rate of 10 percent, to
have $110 at the end of one year:
Now suppose you invest $100 at 10 percent for two years. At the end of the first year, you will have $100 times (1 +
.10). At the end of the second year, you will have this new amount times (1 + .10), which equals $121:
Turning this problem around, if you require a return of 10 percent on your investments, then how much is a payment
of $121, two years from now, worth today? The answer is $100:
You may note that a pattern is emerging. In general, if your required rate of return is r, the present value (P) of any
amount (F) received n years in the future is:
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That is, to calculate the present value (P) of an amount (F) received n years in the future, we divide F by 1 plus the
required rate of return (r) raised to the nth power.
Let’s try out the formula. What is the present value of $1,000 received five years from now if your required rate of
return is 12 percent? To answer the question, we divide $1,000 (the amount received in the future) by 1 plus the
required return raised to the fifth power, since the cash is received at the end of year 5. The answer is $567.43:
To simplify calculations, managers can use present value tables to look up present value factors (also called discount
factors).1 Present value factors are simply calculations of . Thus, to calculate the present value of a future
amount, you can multiply the future amount by the present value factor.
For example, let’s consider again the present value of $1,000 received five years from now if the required rate of
return is 12 percent. The present value factor, or discount factor, is . Substituting values into this equation
and rounding the result to four places, we find that the factor is:
Rather than working through the calculation of present value factors, we can turn to the present value of $1 table,
Table B9.1 in Appendix B of this chapter. Going across the top of the table to a discount rate of 12 percent and down
five rows (since the amount is to be received five years in the future), we come to a present value factor of .5674, the
same as the value we calculated. Now we can find the present value itself by multiplying the factor times $1,000 (the
amount to be received at the end of five years):
Test Your Knowledge
Using the previous formula, what is the present value of $500 received two years in the future if you desire a return of
10 percent?
1. $413.20.
2. $468.58.
3. $471.60.
4. $480.30.
a. ($500 × [1 ÷ (1 + .10)2]).
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The Net Present Value Method
The time value of money forms the basis of the net present value method for evaluating capital investments.
Steps in the NPV Method
Decision Making/Incremental Analysis
The first step in using the net present value method is to identify the amount and time period of each cash flow
associated with a potential investment. Investment projects have both cash inflows (which are positive) and cash
outflows (which are negative). Consistent with our discussion in Chapter 8, the only relevant cash flows are those that
are incremental—the cash flows that will be incurred if the project is undertaken. Cash flows that have already been
incurred are sunk and have no bearing on a current investment decision.
The second step is to equate or discount the cash flows to their present values using a required rate of return. The
required rate of return is discussed later. For now, simply assume that the required rate of return (also called the
hurdle rate) is the minimum return that top management wants to earn on investments.
The third and final step is to evaluate the net present value. The sum of the present values of all cash flows (inflows
and outflows) is the net present value (NPV) of the investment. If the NPV is zero, the investment is generating a rate
of return exactly equal to the required rate of return. Thus, the investment should be undertaken. If the NPV is
positive, it should also be undertaken because it is generating a rate of return that is even greater than the required
rate of return. Investment opportunities that have a negative NPV are not accepted because their rate of return is
less than the required rate of return. A graphical presentation of the NPV approach to evaluating investments is
presented in Illustration 9.2.
ILLUSTRATION 9.2 NPV approach to evaluating investments
An Example of the NPV Approach
An example will show how the NPV approach is used. Suppose an auto repair shop is considering purchasing
automated paint-spraying equipment. The company estimates that the equipment will last five years. Each year it will
save the company $2,000 in paint wasted in the current manual spraying operation. It will also reduce labor costs by
$20,000. It is estimated that the machine will require maintenance costs of $1,000 per year. The machine costs
$70,000, and it is expected to have a residual value (also called salvage value) of $5,000 at the end of five years. Top
management has determined that the required rate of return is 12 percent. Should the company invest in the new
equipment?
The cash flows related to the investment opportunity are presented on the timeline at the top of Illustration 9.3. In
analyzing the cash flows, we make the assumption that all cash inflows and outflows (other than the cash outflow of
$70,000 for purchasing the equipment) occur at the end of a year. To simplify analysis, managers commonly make this
assumption, and it is unlikely to introduce significant error, even though cash flows actually take place throughout the
year (not just at year-end).
ILLUSTRATION 9.3 Evaluation of automated paint-spraying equipment
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Illustration 9.3 also includes present value (PV) factors for each year’s cash-flow total. Consider first the $70,000 cash
outflow created by the purchase of the spraying equipment. Note that the present value factor associated with the
$70,000 purchase price is 1.0000. Because this amount is going to be spent immediately, it is already expressed in
terms of its present value. Now consider the cash flows in year 1. In this year, the net cash inflow is $21,000. The
present value factor for an amount received at the end of year 1 using a 12 percent rate of return is .8929 (see Table
B9.1 in Appendix B). Multiplying the present value factor by the cash inflow of $21,000 indicates that the present value
of the net cash inflow in year 1 is $18,751. The net present value of the investment in spraying equipment is found by
summing the present values of the cash flows in each year. This amounts to $8,538. Because the net present value is
positive, the company should go ahead with plans to purchase the equipment.
In the preceding problem, the $20,000 labor savings, the $2,000 paint savings, and the $1,000 maintenance expense
are identical in each of the five years. Thus, the net annual amount of $21,000 can be treated as a five-year annuity
(series of equal payments) in calculating the present value. This treatment is presented in Illustration 9.4. Present
value factors that apply to annuities are in Table B9.2 in Appendix B. The present value factor, using a 12 percent rate
of return, for an annuity lasting five years is 3.6048 (see Table B9.2 in Appendix B). Multiplying this factor by the
$21,000 annuity indicates a present value of $75,701. In other words, a five-year annuity of $21,000 is worth $75,701 if
you require a 12 percent rate of return. The present value of the $5,000 residual value in year 5 is calculated using a
factor from the Present Value of $1 table B9.1 (Appendix B). Note that the total net present value, $8,538, is equal to
the amount calculated in Illustration 9.3.
ILLUSTRATION 9.4 Evaluation of automated paint-spraying equipment using present value of an annuity
approach
Comparing Alternatives with NPV
It is relatively easy to evaluate decision alternatives with the NPV approach. Essentially, we calculate the NPV of each
alternative and select the one with the highest NPV. The difference between the NPVs of any two alternatives is the
incremental value of the highest NPV investment.
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Consider an alternative to the investment we have just considered. Let’s call the previous investment A and the
alternative B. The alternative piece of equipment will also last five years. Each year it will save the company $3,000 in
paint wasted in the current manual spraying operation, and it will reduce labor costs by $27,000 per year. It will
require $4,000 of annual maintenance. Thus, the net savings each year is $26,000:
Paint savings $ 3,000
Labor savings 27,000
Maintenance (4,000)
Net annual savings $26,000
The cost of the machine is $80,000, and it will have a residual value of $7,000. The alternative investments are
evaluated in Illustration 9.5. As indicated, alternative B has the highest NPV, $17,697, and, thus, it is the preferred
alternative. Its incremental value over alternative A is the difference in their NPVs, which is $9,159.
ILLUSTRATION 9.5 Evaluation of alternatives using NPV
Link to Practice
Gold Mine Has an NPV of Negative $552 Million
In 2017, International Tower Hill, the owner of the Livengood Gold Mine in Alaska commissioned a study that
calculated the NPV of the mine. Using a discount rate of five percent and a gold price of $1,250 per ounce, the NPV
was a loss of $552 million. The company also performed sensitivity analysis. A 30 percent increase in gold price to
$1,625 per ounce showed a positive NPV of $551 million. A 30 percent decrease in gold price showed a negative NPV
of $1.887 billion.
The study, not surprisingly, concluded that “the mine is not economic at the base case gold price of $1,250/oz.”
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Source: Report to the British Columbia Securities Commission Dated April 10, 2017 from International Tower Hill
Mines entitled “Prefeasibility Study of The Livengood Gold Project, Livengood, Alaska, USA.”
Another way to evaluate alternatives is to compute the present values of their incremental cash flows. This is
presented in the bottom panel of Illustration 9.5. As indicated, alternative B has an incremental outflow related to
the purchase price of $10,000. However, it has positive incremental cash flows related to labor, paint, and
maintenance each year of $5,000 ($26,000 of savings for B versus $21,000 for A). Also, it has an incremental salvage
value of $2,000. Applying present value factors to these incremental cash flows again shows us that the incremental
value of alternative B is $9,159 greater compared to alternative A. While the approach you take will yield the same
answer, students seem to make fewer errors when they calculate each alternative’s NPV and compare these values to
determine which alternative is best.
The Internal Rate of Return Method
The internal rate of return method is an alternative to net present value for evaluating investment possibilities. Like
net present value, it takes into account the time value of money. Specifically, the internal rate of return (IRR) is the
rate of return that equates the present value of future cash flows to the investment outlay. In other words, it is the
return that makes the NPV equal to zero. If the IRR of a potential investment is equal to or greater than the required
rate of return, the investment should be undertaken. In Illustration 9.6, the IRR approach to evaluating investments
is outlined.
ILLUSTRATION 9.6 IRR approach to evaluating investments
Consider a simple case where $100 is invested to yield $60 at the end of year 1 and $60 at the end of year 2. What rate
of return equates the two-year, $60 annuity to $100? Recall that when we performed present value analysis for
previous annuities, we multiplied a present value factor by the annuity to solve for a present value. That is:
In the current case, we set the present value equal to the initial outlay for the investment. Then, we can solve for the
present value factor and use it to look up the rate of return implicit in the investment:
With a $100 cost of the investment and a $60 annuity, the present value factor is 1.667:
Because the $60 is to be received in each of two years, we use the annuity table (Table B9.2 in Appendix B) to look up
the internal rate of return. In the row in Table B9.2 for two periods, we find a present value factor of 1.6681 (very close
to 1.6667) in the column for a 13 percent rate of return. Thus, the IRR on this investment is approximately 13 percent.
If the required rate of return is 13 percent or less, the investment should be undertaken.
Insight into the IRR can be gained by using it to calculate the net present value of the project. If we evaluated the
previous project using a 13 percent required rate of return, what would be the net present value? The answer is zero,
because the internal rate of return equates the present value of future cash flows to the investment outlay:
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Item Cash Flow Present Value Factor Present Value
Item Cash Flow Present Value Factor Present Value
Cash flow $ 60 1.6681 $100.09
Table B9.2, Appendix B
Initial investment ($100) 1.0000 (100.00)
Difference (due to rounding) $ .09
Test Your Knowledge
A potential investment should be undertaken if:
1. a. The NPV is zero or positive.
2. b. The IRR is equal to or greater than the required rate of return.
3. c. Both a and b are true.
Correct or Incorrect?
Clear Check Answer
The Internal Rate of Return with Unequal Cash Flows
For cases where cash flows are not equal each year, the approach previously presented cannot be used to calculate
the IRR, because we cannot divide the initial investment by a single cash flow annuity to yield a present value factor.
Instead, we must estimate the internal rate of return and use the estimate to calculate the net present value of the
project. If the net present value is greater than zero (implying an internal rate of return greater than the estimate),
the estimate of the internal rate of return should be increased. If the net present value is less than zero (implying an
internal rate of return less than the estimate), the estimate should be decreased. By estimating the internal rate of
return in this trial-and-error fashion, it is possible to eventually arrive at the actual internal rate of return.
Link to Practice
College Education Yields 15% Return
In this chapter, we focus on business investments and how to calculate their internal rates of return. The same
procedures can be applied to calculate the IRR on an investment in a college education. Indeed, the calculation was
performed by the Brookings Institution, a nonprofit public policy organization based in Washington, DC. According to
a paper it published in 2011, a four-year college degree had a return of 15.2 percent. Interestingly, this is more than
double the average return to investments in stocks since 1950 and more than five times the return to corporate
bonds. While the study didn’t specifically address the return on investments in an undergraduate business degree or
an MBA, it wouldn’t be surprising if they were quite a bit higher than 15 percent!
Source: Michael Greenstone and Adam Looney, “Where is the Best Place to Invest $102,000—In Stocks, Bonds, or a
College Degree?” Brookings, June 25, 2011.
Let’s consider an example to illustrate the method. Suppose a company is considering changes in its production
process that will involve purchasing several pieces of equipment costing a total of $120,000. The changes are
expected to yield cost savings of $49,500 in year 1; $45,000 in year 2; $35,000 in year 3; $22,000 in year 4; and $19,600
in year 5:
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The company wants to evaluate the potential project in terms of its internal rate of return. The first step is to estimate
what the internal rate of return is likely to be. Since the cash flow is fairly large in relation to the initial investment, a
reasonable guess as to the internal rate of return might be 14 percent. However, when we calculate the net present
value of the investment as in Illustration 9.7 using 14 percent, we see that the present value is a positive $4,880.
Thus, the true internal rate of return is greater than 14 percent. As a next approximation, we can try 20 percent.
However, with this rate of return, the present value is a negative $8,761. This indicates that our second estimate of
the internal rate of return was too high.
ILLUSTRATION 9.7 Calculating the IRR when there are unequal cash flows
14% 20% 16%
Time
Period
Cash
Flows
Factor for
14%
Present
Value
Factor for
20%
Present
Value
Factor for
16%
Present
Value
0 ($120,000) 1 ($120,000) 1 ($120,000) 1 ($120,000)
1 $ 49,500 0.8772 $ 43,421 0.8333 $ 41,248 0.8621 $ 42,674
2 $ 45,000 0.7695 $ 34,628 0.6944 $ 31,248 0.7432 $ 33,444
3 $ 35,000 0.6750 $ 23,625 0.5787 $ 20,255 0.6407 $ 22,425
4 $ 22,000 0.5921 $ 13,026 0.4823 $ 10,611 0.5523 $ 12,151
5 $ 19,600 0.5194 $ 10,180 0.4019 $ 7,877 0.4761 $ 9,332
Total $ 4,880 ($ 8,761) $ 26
Data Analytics in Action
Build Versus Buy—Which Is the Best Approach for Investing in Data Analytics?
Most large firms are convinced that they need to invest in data analytics. But should they make the investment by
building analytics capability in house or should they buy the capability from an outside vendor? Firms need to
calculate the NPV of each alternative and, when they do, they should consider the following:
1. Licensing software isn’t a one-time charge—you’ll have outlays each year.
2. Developing the software in house likely will result in more upfront cost, so taking the time value of money into
consideration is very important.
3. Software developed in house can be highly customized, thus giving a company a competitive advantage it won’t
have if it uses the same software that others in its industry use.
4. It may be much faster to license software from a vendor compared to the time it takes to develop in house.
Source: Landon Starr, “Build or Buy: Finding the Right Data Science Software for Your Organization,” ORACLE + DATA
SCIENCE.Com, (August 16, 2018). https://www.datascience.com/blog/build-or-buy-finding-the-right-data-science-
software-for-your-organization
At this point, we know that the internal rate of return is somewhere between 14 percent and 20 percent. Thus, as a
further attempt, we might try 16 percent. The present value using a rate of 16 percent is $26. This is sufficiently close
to zero to allow us to conclude that the internal rate of return is approximately 16 percent. If management of the
company believes that a return of 16 percent is sufficient, then the company should go ahead with the project.
It may appear that the need to estimate the internal rate of return using a trial- and-error approach presents a
significant obstacle to its use. Actually, this is not the case. A spreadsheet program such as Microsoft Excel and even
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some pocket calculators contain functions that easily estimate the internal rate of return of a project. The user simply
inputs the cash flow information, and the IRR is computed automatically.
Summary of Net Present Value and Internal Rate of Return Methods
Although both the net present value method and the internal rate of return method take into account the time value
of money, they differ in their approach to evaluating investment alternatives. With net present value, any investment
with a zero or positive net present value should be undertaken. With the internal rate of return method, any
investment with an internal rate of return equal to or greater than the required rate of return should be undertaken.2
Considering “Soft” Benefits in Investment Decisions
When managers make investment decisions, it is important that they consider so-called soft benefits in addition to a
project’s NPV or IRR. Soft benefits are benefits that are difficult to quantify.3 Consider a situation faced by Dynamic
Medical Equipment. The company is considering production of a high-tech wheelchair. The wheelchair would take
advantage of advances in lightweight graphite construction techniques pioneered in the manufacturing of tennis
racquets and design improvements suggested by athletes competing in wheelchair events. Suppose that in
evaluating the project, the finance department fails to consider the fact that production of the high-tech wheelchair
will improve the firm’s reputation as an industry leader committed to innovation. Such a reputation is clearly valuable,
since it has a positive effect on sales of the firm’s entire product line. However, the value is also very difficult to
quantify. Or consider the fact that producing the wheelchair will introduce new construction techniques that will help
the firm produce future products made from graphite. This may be a major benefit to the firm, but it is very difficult
to quantify.
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1
The Budget Case
Student's Name
Course Department: Institution Affiliation
Course Code: Course Name
Professor's Name
Date
2
The Budget Case
The report will evaluate the entire budget process of ABC Manufacturing Company. The
proposed budget for the following year is critical for the company in planning for the following
year. Even though the budgeting was accurate, several ethical issues were brought up, including
overspending and the president's role in reducing the budget by around 20% annually.
Question 1
Budgeting is vital for businesses to plan for their various financial activities (Pfiffner,
2019). As shown and spoken by the supervisor on the overestimation and inflation of the budget,
multiple concerns have been raised regarding the accuracy of the presented budget. First,
inflating the budget to get around the 20 percent reduction that the company would make would
misallocate various resources and could negatively affect the company's financial performance.
Thus, the company must ensure the budgeting process is entirely accurate and realistic.
Question 2
Ideally, the president must know the business's financial performance and spending
needs. Without considering the company's financial situation or budgetary needs, the president's
decision to reduce the budget by a set percentage could harm business operations (Pfiffner,
2019). As a result, the president must examine the budget case by case and base their choices on
the business's financial health.
Question 3
For ABC Manufacturing, inflating the budget is unethical because it could have several
unfavorable effects. First, inflating the budget may lead to improper resource allocation, harming
3
the business's financial performance (Ferrell & Ferrell, 2021). Also, inflating the budget can
result in a lack of trust between the company and its stakeholders, such as shareholders, staff
members, and clients, which might harm the business's credibility and reputation. Inflating the
budget could also be unethical because it falsely reflects the company's financial status and
performance, which could have negative legal and regulatory repercussions. In order to avoid
moral dilemmas connected to budget inflation, ABC Manufacturing must ensure that the
budgeting process is open, precise, and realistic.
Conclusion
In conclusion, budgeting is crucial for organizations to organize their financial
operations. ABC Manufacturing uses the budgeting technique to prepare for expenses the
following year. However, the budget's inflation and the president's influence in its reduction raise
questions about its accuracy and proper leadership and management. Inflating the budget could
also result in moral dilemmas, including improper resource allocation and a loss of confidence
between the business and its stakeholders. ABC Manufacturing must ensure the budgeting
process is precise, reasonable, and open.
4
References
Ferrell, O. C., & Ferrell, L. (2021). New directions for marketing ethics and social responsibility
research. Journal of Marketing Theory and Practice, 29(1), 13-22.
Pfiffner, J. P. (2019). Inflexible budgets, fiscal stress, and the tax revolt. In The Municipal Money
Chase (pp. 37-66). Routledge.
