Royal Caribbean Cruises invested $1.4 billion to build the Oasis of the Seas, a cruise ship that carries 5,400 passengers and stands 20 stories above the sea. The vessel is a third larger than any other cruise ship and contains 21 pools, 24 restaurants, 13 retail shops, and 300-foot water slides.
When considering investment opportunities, managers must make two types of decisions—screening decisions and preference decisions. Screening decisions, which come first, pertain to whether or not a proposed investment is acceptable. Preference decisions come after screening decisions and attempt to answer the following question: “How do the remaining investment proposals, all of which have been screened and provide an acceptable rate of return, rank in terms of preference? That is, which one(s) would be best for the company to accept?”
Sometimes preference decisions are called rationing decisions, or ranking decisions. Limited investment funds must be rationed among many competing alternatives. Hence, the alternatives must be ranked. Either the internal rate of return method or the net present value method can be used in making preference decisions. However, as discussed earlier, if the two methods are in conflict, it is best to use the net present value method, which is more reliable. When using the internal rate of return (IRR) method to rank competing investment projects, the preference rule is: The higher the internal rate of return, the more desirable the project. The net present value (NPV) of one project cannot be directly compared to the NPV of another project unless the initial investments are equal.
After an investment project has been approved and implemented, a post-audit should be conducted. A post-auditinvolves checking whether or not expected results are actually realized. This is a key part of the capital budgeting process because it helps keep managers honest in their investment proposals. Any tendency to inflate the benefits or downplay the costs in a proposal should become evident after a few post-audits have been conducted. The post-audit also provides an opportunity to reinforce and possibly expand successful projects and to cut losses on floundering projects.
The same capital budgeting method should be used in the post-audit as was used in the original approval process. That is, if a project was approved on the basis of a NPV analysis, then the same procedure should be used in performing the post-audit. However, the data used in the post-audit analysis should be actual observed data rather than estimated data. This gives management an opportunity to make a side-by-side comparison to see how well the project has succeeded. It also helps assure that estimated data received on future proposals will be carefully prepared because the persons submitting the data knows that their estimates will be compared to actual results in the post-audit process. Actual results that are far out of line with original estimates should be carefully reviewed.
Source:
Garrison, R., Noreen, E., & Brewer, P. (2014). Managerial accounting (15th ed.). Columbus, OH: McGraw-Hill Education.
Unit Learning Outcomes
ULO 5. Use capital budgeting decision tools to track the success of a capital investment post implementation. (CLO 1, 2, 3, 4, 5, 6, and 7)