ACC 7000 Module 2 Written Assignment: Cost of Capital, Capital Budgeting and the Budget Example

A Freezer Warehouse at 9.5 Percent: Cost of Capital, NPV and an Honest Budget for a Cold Storage Company

Student Name

MBA in Accounting, Thomas Edison State University

ACC-7000: Managerial Accounting for Decision Making

Mentor Name

Month Day, Year

A Freezer Warehouse at 9.5 Percent: Cost of Capital, NPV and an Honest Budget for a Cold Storage Company

Introduction

A capital investment is worth making when the present value of its cash flows exceeds its cost, discounted at the return investors require for its risk. That rate is the firm's weighted average cost of capital if the project's risk resembles the firm's. The cash flows themselves come from a budget, and budgets are prepared by managers who are often evaluated against them, which creates a conflict between forecasting accurately and setting targets that are easy to beat (Zimmerman, 2014).

Part A: Weighted Average Cost of Capital

Interest is deductible, so debt's cost is its after-tax rate. The cost of equity comes from the capital asset pricing model. Graham and Harvey (2001) found that most large U.S. companies estimate the cost of equity this way and use net present value or internal rate of return for major investments, though many also look at payback.

Part B: Evaluating the Warehouse

The warehouse costs $4,200,000, is expected to produce $680,000 of after-tax operating cash flow a year for ten years and to have a $500,000 salvage value.

Both tests approve the warehouse, since NPV is above zero and IRR clears the hurdle. The margin is thin, though. The IRR is only 1.4 points above the hurdle rate, and if occupancy fell enough to cut annual cash flow by about $43,000, roughly 6 percent, the NPV would fall to zero. Payback of 6.2 years ignores cash flows after that point and the time value of money, so it serves only as a rough indicator of risk.

The accounting rate of return tells a misleading story. Average net income of $310,440 on an average investment of $2,350,000, the cost plus salvage divided by two, gives about 13.2 percent, which looks comfortably above the hurdle rate, yet it ignores timing and is computed on income rather than cash. Managers judged on accounting returns would favor this project more than its NPV justifies.

Part C: The Operating Budget Behind the Cash Flows

Occupancy is the key assumption. At 84 percent, revenue falls by about $60,000 and cash flow by about $45,000, close to the break-even level found in Part B. The budget therefore tells the board which number to question.

Part D: Budgets, Bonuses and Honest Forecasts

Garden State's warehouse managers receive bonuses for beating their annual budgets, and they propose those budgets. That system rewards low forecasts. The manager who proposes the new warehouse's budget will be tempted to underestimate occupancy for its bonus, while the manager who proposes the investment may overestimate it to win approval. Jensen (2003) argued that linking pay to budget targets rewards dishonest forecasts, with costs that show up in bad decisions, not just padded numbers. Zimmerman (2014) adds the ratchet effect: managers who beat a budget find next year's target raised, so they hold back performance.

The company should separate forecasting from rewards. Forecasts should be judged on accuracy, with occupancy assumptions compared to market data, and bonuses should rest on performance measures such as actual occupancy and cost per pallet against peer warehouses, rather than on beating a self-proposed target. A post-audit after two years should compare actual cash flows with the forecast in the capital request, holding the sponsor accountable for overstated benefits.

Zimmerman also stresses that budgets coordinate as well as control. The sales team's occupancy forecast drives the energy and labor budgets, so a low forecast does not only pad a bonus; it leads to understaffing and lost business.

References

Graham, J. R., & Harvey, C. R. (2001). The theory and practice of corporate finance: Evidence from the field. Journal of Financial Economics, 60(2-3), 187-243. https://doi.org/10.1016/S0304-405X(01)00044-7

Jensen, M. C. (2003). Paying people to lie: The truth about the budgeting process. European Financial Management, 9(3), 379-406. https://doi.org/10.1111/1468-036X.00226

Zimmerman, J. L. (2014). Accounting for decision making and control (8th ed.). McGraw-Hill.