Managerial accounting tool for business decision making chapter 12

Chapter 12-4 Planning for Capital Investments Planning for Capital Investments Net Present Value Method Cash Payback Cash Payback Additional Consid- erations Additional Consid- erations

Chapter 12-1

Managerial Accounting, Fifth Edition

Chapter

12-3

1. Discuss the capital budgeting evaluation process, and

explain inputs used in capital budgeting.

2. Describe the cash payback technique Describe the cash payback technique.

3. Explain the net present value method.

4. Identify the challenges presented by intangible benefits

in capital budgeting.

5. Describe the profitability index.

6. Indicate the benefits of performing a post-audit.

7. Explain the internal rate of return method.

8. Describe the annual rate of return method.

Chapter

12-4

Planning for Capital Investments

Planning for Capital Investments

Net Present Value Method

Cash Payback

Cash Payback

Additional Consid- erations

Additional Consid- erations

Other Capital Budgeting Techniques

Other Capital Budgeting Techniques

Calculation Evaluation

Equal cash flows

Unequal cash flows Choosing a discount Rate Simplifying Assumption Comprehen- sive example

Intangible benefits Profitability index

Risk analysis Post-audit of projects

Intangible benefits Internal rate

of return method Comparing discounted cash flow methods Annual rate

of return method

Capital Budgeting Budgeting Evaluation Evaluation Process Process

Many companies follow a carefully prescribed

process in capital budgeting At least once a year:

1) Proposals for projects are requested from

each department.

2) The proposals are screened by a capital

budgeting committee, which submits its

finding to officers of the company.

3) Officers select projects and submit a list of projects to the board of directors.

SO 1 Discuss the capital budgeting evaluation process, and explain what inputs are used

in capital budgeting.

Capital Budgeting Authorization Process Budgeting Authorization Process

SO 1 Discuss the capital budgeting evaluation process, and explain what inputs are used

in capital budgeting.

Illustration 12-1

Chapter

12-7

Capital Budgeting Evaluation Process

 Most methods to evaluate capital budgeting

decisions employ cash flow numbers rather than accrual revenues and expenses.

 For capital budgeting, estimated cash

inflows and outflows are the preferred inputs.

 WHY?

 Ultimately the value of financial

investments is determined by the value of the cash flows received or paid.

SO 1 Discuss the capital budgeting evaluation process, and explain what inputs are used

in capital budgeting.

Chapter

12-9

Capital Budgeting Evaluation Process

The capital budgeting decision depends on a

variety of considerations:

1) The availability of funds.

2) Relationships among proposed projects.

3) The company’s basic decision-making

Chapter

12-10

Facts for Stewart Soups Example

SO 1 Discuss the capital budgeting evaluation

process, and explain what inputs are used in capital budgeting.

Illustration 12-3

Chapter

12-11

Cash Payback Formula

SO 2 Describe the cash payback technique.

The cash payback technique identifies the time period required to recover the cost of the capital investment from the net annual cash flow produced by the investment.

The formula for computing the cash payback period is:

Illustration 12-4

Chapter

12-12

Cash Payback Formula-Equal Cash Flows

SO 2 Describe the cash payback technique.

Illustration 12-4

$130,000 ÷ $24,000 = 5.42 years

The shorter the payback the more attractive the

investment.

Chapter

12-13

Cash Payback Formula-Unequal Cash Flows

SO 2 Describe the cash payback technique.

Illustration 12-5

Chapter

12-14

Cash Payback

SO 2 Describe the cash payback technique.

May be useful as an initial screening tool Easy to use and understand.

May be critical for company that wants quick cash turnaround with weak cash position.

Ignores profitability of the project!

Ignores the time value of money!

$100,000 = Cost of Capital ÷ 32,500 = Net annual cash flow = 3.08 Years cash payback period

Chapter

12-16

Net Present Present Value Value Method Method

 The discounted cash flow technique The discounted cash flow technique is

generally recognized as the best conceptual approach to making capital budgeting decisions

 This technique considers both the estimated

total cash inflows and the time value of money

 Two methods are used with the

discounted cash flow technique:

1) Net present value, and 2) Internal rate of return.

SO 3 Explain the net present value method.

Chapter

12-17

Net Present Value Method

Under the

Under the net present value method net present value method , cash inflows are

discounted to their present value and then compared with the capital outlay required by the investment The interest rate used in discounting the future cash inflows is the required

inflows is the required minimum rate of return minimum rate of return.

A proposal is acceptable when

A proposal is acceptable when NPV NPV is zero or positive .

The higher the positive NPV, the

The higher the positive NPV, the more attractive the more attractive the

investment.

SO 3 Explain the net present value method.

Chapter

Net Present Value Decision Criteria

Illustration 12-6

Chapter

12-19

Present Value of Equal Annual Cash

Flows

Stewart Soup Company’s annual cash inflows are $24,000 If we

assume this amount is uniform over the asset’s useful life, the present value of the annual cash inflows can be computed by using the present value of an annuity of 1 for 10 periods The computations at rates of return of 12% and 15%, respectively are:

SO 3 Explain the net present value method.

Illustration 12-7

Chapter

12-20

Computation of Net Present Values

The proposed capital expenditure is acceptable at a required rate of

return of 12% (not 15%) because the net present value is positive

The analysis of the proposal by the net present

value method is as follows:

SO 3 Explain the net present value method.

Illustration 12-8

Chapter

12-21

Present Value of Annual Cash Inflows-Unequal

Annual Cash Flows

SO 3 Explain the net present value method.

When annual cash inflows are unequal, we cannot use annuity tables to

calculate their present value Instead tables showing the present value of a

single future amount must be applied to each annual cash inflow

Illustration 12-9

Chapter

12-22

Analysis of Proposal Using Net Present

Value Method

SO 3 Explain the net present value method.

Therefore, the analysis of the proposal by the net present value method is as follows:

In this example, the present values of the cash inflows are greater than the $130,000 capital investment Thus, the project is acceptable at both a 12% and 15% required rate

of return

Illustration 12-10

Chapter

12-23

Choosing a Discount Rate

SO 2 Describe the cash payback technique.

In most cases the discount rate (required

rate of return) is equal to its cost of capital – the amount it must pay to obtain funds

from creditors or stockholders.

All cash flows are immediately

reinvested in another project that has a similar return.

All cash flows can be predicted with

certainty.

SO 3 Explain the net present value

SO 3 Explain the net present value method.

Present Value of Cash Flows:

$50,000 × 5.65022 = $282,511 Minus capital investment 260,000 Net present value $ 22,511

A few intangible benefits:

Increased quality, and Improved safety.

SO 4 Explain the net present value method.

Chapter

12-27

Additional Considerations - NPV

To avoid rejecting projects that actually should be

accepted, two possible approaches are suggested:

1 Calculate net present value ignoring intangible

benefits Then, if the NPV is negative, ask whether the intangible benefits are worth at least the amount of

the negative NPV.

2.Project rough, conservative estimates of the value of the intangible benefits, and incorporate these values

into the NPV calculation.

SO 4 Identify the challenges presented by intangible benefits in capital budgeting.

Chapter

12-28

Additional Considerations – Intangibles

SO 4 Identify the challenges presented by intangible benefits in capital budgeting.

Based on negative NPV the projected is unacceptable.

Illustration 12-14

Chapter

12-29

Additional Considerations – Intangibles

SO 4 Identify the challenges presented by intangible benefits in capital budgeting.

However, engineers believe buying the machine will

improve electrical connections (an intangible benefit ) that may reduce future warranty costs.

Illustration 12-15

Chapter

12-30

Additional Considerations - Intangibles

SO 4 Identify the challenges presented by intangible benefits in capital budgeting.

Illustration 12-16

Chapter

12-31

The Profitability Index

SO 5 Describe the profitability index.

Illustration 12-20

Chapter

12-32

The Profitability Index

SO 5 Describe the profitability index.

All projects with NPV should be accepted – in theory.

Why aren’t they?

Projects are mutually exclusive – only need one new packaging

machine.

Limited resources.

Chapter

12-33

The Profitability Index

SO 5 Describe the profitability index.

Illustration 12-17

Illustration 12-18

Chapter

12-34

The Profitability Index

SO 5 Describe the profitability index.

Illustration 12-20

Profitability index allows comparison of the relative

desirability of projects that require initial investments

Chapter

12-35

Assume Project A has a present value of net cash inflows of $79,600 and an initial investment of $60,000 Project B has a present value of net cash inflows of $82,500 and an initial investment of $75,000

Assuming the projects are mutually exclusive, which project should management select?

SO 5 Describe the profitability index.

Present Value of Net Cash Flows Initial Investment

PV of Net Cash Flows 79,600 82,500

Chapter

12-36

Post-Audit of Investment Projects

Performing a post-audit is important for a variety of

reasons.

compared to actual results they will be more likely to submit reasonable and accurate data when making investment proposals.

which the company can determine whether existing projects should be supported or terminated.

because by evaluating past successes and failures, managers improve their estimation techniques.

SO 6 Indicate the benefits of performing

a post-audit.

Chapter

12-37

The

The internal rate of return internal rate of return method finds the interest

yield of the potential investment

This is the interest rate that will cause the present value

of the proposed capital expenditure to equal the present value of the expected annual cash inflows

Determining the true interest rate involves two steps:

STEP 1 Compute the internal rate of return factor using this formula:

Internal Rate of Return Method

SO 7 Explain the internal rate of return method.

Illustration 12-22

Chapter

12-38

Internal Rate of Return Method

$244,371 ÷ $1000,000 = 2.44371

The computation for the Stewart Soup

Company, assuming equal annual cash inflows

is:

SO 7 Explain the internal rate of return method.

Chapter

12-39

Internal Rate of Return Method

annuity of 1 table to find

The

discount factor that is closest to the internal rate of return factor for the time period covered by the

annual cash flows.

For Stewart Soup, the annual cash flows are expected

to continue for 3 years In the table below, the discount factor of 2.44371 represents an interest rate of 11%.

SO 7 Explain the internal rate of return method.

Chapter

12-40

return is equal to or greater than the required rate of return Reject the project when the internal rate of return is less than the required rate

SO 7 Explain the internal rate of return method.

Internal Rate of Return Decision Criteria

Illustration 12-23

Chapter

12-41

Comparison of Discounted Cash Flow Methods

In practice, the

In practice, the internal rate of return internal rate of return and cash payback and cash payback

methods are most widely used.

A comparative summary of the two discounted cash flow methods-net present value and internal rate of return is presented below:

SO 7 Explain the internal rate of return method.

Illustration 12-24

Chapter

12-42

A $60,000 project has net cash inflows for 10 years of $9,349

Compute the internal rate of return from this investment.

Chapter

12-43

Annual Rate of Return Formula

The

The annual rate of return technique annual rate of return technique is based on

accounting data It indicates the profitability

of a capital expenditure The formula is:

which is the rate of return that management expects to pay on

all borrowed and equity funds

SO 8 Describe the annual rate of return method.

Chapter

12-44

Formula for Computing Average Investment

For Reno, average investment is

For Reno, average investment is $65,000: $65,000: [($130,000 + $0)/2]

Expected annual net income ($13,000) is obtained from

the projected income statement Average investment is

derived from the following formula:

SO 8 Describe the annual rate of return method.

Chapter

12-45

Solution to Annual Rate of Return Problem

$13,000 ÷ $65,000 = 20%

The expected annual rate of return for Reno Company’s

investment in new equipment is therefore 20%, computed

as follows:

The decision rule is:

A project is acceptable if its rate of return is greater than management’s minimum rate of return It is unacceptable when the reverse is true

When choosing among several acceptable projects, the higher the rate of

return for a given risk, the more attractive the investment.

SO 8 Describe the annual rate of return method.

Chapter

12-46

Bear Company computes an expected annual net income of $30,000 from

an investment The investment has an initial cost of $200,000 and a

terminal value of $20,000 Compute the annual rate of return

SO 8 Describe the annual rate of return method.

Expected Annual Net Income 30,000

Chapter

12-47

All About You: The Risks of Adjustable

Rates

Chapter

12-48

All About You: The Risks of Adjustable

Rates

Chapter

12-49

All About You: The Risks of Adjustable

Rates

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