Cost management accounting and control 6e by hansen mowen guan chapter 20

Explain the roles of the payback period and accounting rate of return in capital investment decisions.. Payback and Accounting Rate of Return: Nondiscounting Methods• Provides informatio

Study Objectives

1 Describe the difference between independent and mutually

exclusive capital investment decisions

2 Explain the roles of the payback period and accounting rate of

return in capital investment decisions

3 Calculate the net present value (NPV) for independent projects

4 Compute the internal rate of return (IRR) for independent projects

5 Tell why NPV is better than IRR for choosing among mutually

exclusive projects

6 Convert gross cash flows to after-tax cash flows

Capital Investment Decisions

• Capital investment decisions are

concerned with

– The planning process of planning

– Setting goals and priorities

– Arranging financing

– Using certain criteria to select long-term

assets

Capital Investment Decisions

Payback and Accounting Rate of Return: Nondiscounting Methods

• Provides information than can:

– Help control the risks associated with the uncertainty of future cash flows

– Help minimize the impact of an investment on a firm’s liquidity problems

– Help control the risk of obsolescence

– Help control the effect of the investment on performance

measures

• Deficiencies:

Payback Analysis

Accounting Rate Of Return (ARR)

Payback and Accounting Rate of Return: Nondiscounting Methods

Average income ARR =

Original investment or Average investment

Average annual net cash flows, less average depreciation

Average investment

(I + S) ÷ 2

I = original investment

S = salvage value

Major deficiency: ignores

the time value of money

NPV = P – I

where:

P = the present value of the project’s

future cash inflows

I = the present value of the project’s

Net present value is the difference between the

present value of the cash inflows and outflows

associated with a project.

The Net Present Value Method

Polson Company has developed a new cell

phone that is expected to generate an annual

revenue of $750,000.

Necessary production equipment would cost

$800,000 and can be sold in five years for

$100,000.

Working capital is expected to increase by

$100,000 and is expected to be recovered at the

end of five years.

Annual operating expenses are expected to be

$450,000.

The required rate of return is 12 percent.

The Net Present Value Method

The Net Present Value Method

The Net Present Value Method

c difference due to rounding

If NPV > 0:

1 The initial investment has been recovered

2 The required rate of return has been

recovered For the cell phone project, NPV = $294,600

Polson should manufacture the cell phones.

Decision Criteria for NPV

The Net Present Value Method

The internal rate of return (IRR) is the interest

rate that sets the project’s NPV at zero.

Thus, P = I for the IRR.

Internal Rate of Return

Example: A project requires a $240,000

investment and will return $99,900 at the end of each of the next three

years What is the IRR?

$240,000 = $99,900(df)

$240,000 ÷ $99,900 = 2.402

i = 12%

If the IRR > Cost of Capital, accept the project

If the IRR = Cost of Capital, accept or reject

If the IRR < Cost of Capital, reject the project

Decision Criteria:

Internal Rate of Return

NPV versus IRR:

Mutually Exclusive Projects

• Two major differences between net present value and the internal rate of return:

– Reinvestment of cash inflows

• NPV assumes reinvestment at the required rate of return

• IRR assumes reinvestment at the internal rate of return

– Measurement of profitability

• NPV measures profitability in absolute dollars

• IRR measures profitability as a percentage

NPV versus IRR:

Mutually Exclusive Projects

NPV versus IRR:

Mutually Exclusive Projects

a $1,440,000 + [(1.20 x $686,342) - (1.08 x $686,342)] This last term is what is needed to repay the capital and its

cost at the end of Year 2.

b $686,342 + (1.20 x $686,342).

Annual revenues $240,000 $300,000

Milagro Travel Agency Example

Standard T2

Custom Travel

The cost of capital is 12 percent

NPV versus IRR:

Mutually Exclusive Projects

NPV versus IRR:

Mutually Exclusive Projects

NPV versus IRR:

Mutually Exclusive Projects

NPV versus IRR:

Mutually Exclusive Projects

Computing After-Tax Cash Flows

• Steps in computing cash flows

– Forecast revenues, expenses, and capital

outlays

– Adjust cash flows for inflation and tax effects

• The cost of capital is composed of two

elements

– The real rate

600,000Additional working capital

540,000 Total

$8,700,000

Computing After-Tax Cash Flows

Computing After-Tax Cash Flows

The net investment is:

Total cost of flexible system

A company plans to make a new product that requires new

equipment costing $1,600,000 The new product is

expected to increase the firm’s annual revenue by

$1,200,000 Materials, labor, etc will be $500,000 per year

The income statement for the project is as follows:

Computing After-Tax Cash Flows

After-Tax Operating Cash Flows: Life of the

Project

After-Tax Operating Cash Flows: Life of the

Project

Computing After-Tax Cash Flows

* Non-cash expenses shield revenues from taxation, thus

generating cash flows (i.e., cash savings)

The tax laws classify most assets into three classes

(class = allowable years):

Class Types of Assets

Assets in any of the three classes can be depreciated using

either straight-line or MACRS (Modified Accelerated Cost

MACRS Depreciation

Computing After-Tax Cash Flows

Computing After-Tax Cash Flows

MACRS Depreciation

– Half the depreciation for the first year can be claimed regardless

of when the asset is actually placed in service

– The other half year of depreciation is claimed in the year

following the end of the asset’s class life

– If the asset is disposed of before the end of its class life, only half of the depreciation for that year can be claimed

Computing After-Tax Cash Flows

A company is evaluating a potential investment in a flexible

manufacturing system (FMS) The choice is to continue

producing with its traditional equipment, expected to last 10

years, or to switch to the new system, which is also expected

to have a useful life of 10 years The company’s discount rate

is 12 percent

Present value ($4,000,000 × 5.65) $22,600,000

How Estimates of Operating Cash Flows Differ

Capital Investment:

Advanced Technology and Environmental

Considerations

Capital Investment:

Advanced Technology and Environmental

Considerations

Capital Investment:

Advanced Technology and Environmental

Considerations

Future Value

Let:

F = future value

i = the interest rate

P = the present value or original

outlay

n = the number or periods

Present Value Concepts

Future value can be expressed by the formula:

Assume the investment is $1,000 The interest

rate is 8% What is the future value if the money

is invested for one year? Two? Three?

Present Value Concepts

Future Value

F = $1,000(1.08) = $1,080.00 (after one year)

F = $1,000(1.08)2 = $1,166.40 (after two years)

F = $1,000(1.08)3 = $1,259.71 (after three years)

P = F/(1 + i)n The discount factor df, 1/(1 + i), is

computed for various combinations of i and n

P = F(df)

Present Value Concepts

Present Value

Compute the present value of $300 to be received three years

from now The interest rate is 12%.

From Exhibit 20B-1, the discount factor is 0.712

The present value (P) is:

Present Value Concepts

COST MANAGEMENT

Accounting & Control

Hansen▪Mowen▪Guan

End Chapter 20