Test bank managerial accounting by kieso weygandt 5e ch012

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

CHAPTER 12 Planning for Capital Investments

ASSIGNMENT CLASSIFICATION TABLE

Study Objectives Questions

Brief Exercises Exercises

A Problems

B Problems

evaluation, and explain

inputs used in capital

rate of return method.

ASSIGNMENT CHARACTERISTICS TABLE

Problem

Number Description

Difficulty Level

Time Allotted (min.)

internal rate of return.

benefits.

with sensitivity analysis.

internal rate of return.

benefits.

with sensitivity analysis.

BLOOM’S TAXONOMY TABLE

E12-1 E12-2 P12-1A P12-2A P12-1B P12-2B

Q12-5 Q12-6 Q12-4 Q12-7 BE12-3 E12-8 BE12-4 P12-5A P12-5B

BE12-2 BE12-5 E12-1 E12-2 E12-3 P12-1A P12-2A P12-3A P12-4A P12-1B P12-2B P12-3B P12-4B

P12-1A P12-1B P12-2A P12-2B

STUDY OBJECTIVES

1 DISCUSS CAPITAL BUDGETING EVALUATION, AND EXPLAIN INPUTS USED IN CAPITAL BUDGETING.

2 DESCRIBE THE CASH PAYBACK TECHNIQUE.

3 EXPLAIN THE NET PRESENT VALUE METHOD.

4 IDENTIFY THE CHALLENGES PRESENTED BY GIBLE BENEFITS IN CAPITAL BUDGETING.

INTAN-5 DESCRIBE THE PROFITABILITY INDEX.

6 INDICATE THE BENEFITS OF PERFORMING A AUDIT.

POST-7 EXPLAIN THE INTERNAL RATE OF RETURN METHOD.

8 DESCRIBE THE ANNUAL RATE OF RETURN METHOD.

CHAPTER REVIEW

The Capital Budgeting Evaluation Process

1 (S.O 1) The capital budgeting evaluation process generally has the following steps:

a Project proposals are requested from departments, plants, and authorized personnel.

b Proposals are screened by a capital budget committee.

c Officers determine which projects are worthy of funding; and

d Board of directors approves capital budget.

Cash Flow Information

2 While accrual accounting has advantages over cash accounting in many contexts, for purposes of capital budgeting, estimated cash inflows and outflows are preferred for inputs into the capital budgeting decision tools.

3 Sometimes cash flow information is not available, in which case adjustments can be made to accrual accounting numbers to estimate cash flows.

4 The capital budgeting decision, under any technique, depends in part on a variety of considerations:

a The availability of funds;

b Relationships among proposed projects;

c The company’s basic decision-making approach; and

d The risk associated with a particular project.

Cash Payback

5 (S.O 2) The cash payback technique identifies the time period required to recover the cost of the capital investment from the net annual cash inflow produced by the investment The formula for computing the cash payback period is:

Cost of Capital Investment ÷ Net Annual Cash Flow = Cash Payback Period Net annual cash flow can be approximated by adding depreciation expense to net income.

6 The evaluation of the payback period is often related to the expected useful life of the asset.

a With this technique, the shorter the payback period, the more attractive the investment.

b This technique is useful as an initial screening tool.

c This technique ignores both the expected profitability of the investment and the time value of money.

Net Present Value Method

7 (S.O 3) Under the net present value (NPV) method, cash flows are discounted to their present value and then compared with the capital outlay required by the investment The difference between these two amounts is the net present value (NPV).

a The interest rate used in discounting the future net cash flows is the required minimum rate of return.

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

c The higher the positive NPV, the more attractive the investment.

8 When there are equal annual cash inflows, the table showing the present value of an annuity of

1 can be used in determining present value When there are unequal annual cash inflows, the table showing the present value of a single future amount must be used in determining present value.

9 The discount rate used by most companies is its cost of capital—that is, the rate that the company must pay to obtain funds from creditors and stockholders.

10 The net present value method demonstrated in the text requires the following assumptions:

a All cash flows come at the end of each year;

b All cash flows are immediately reinvested in another project that has a similar return; and

c All cash flows can be predicted with certainty.

Intangible Benefits

11 (S.O 4) By ignoring intangible benefits, such as increased quality or improved safety, capital budgeting techniques might incorrectly eliminate projects that could be financially beneficial to the company To avoid rejecting projects that actually should be accepted, two possible approaches are suggested;

a Calculate net present value ignoring intangible benefits, and then, if the NPV is negative, ask whether the intangible benefits are worth at least the amount of the negative NPV.

b Project rough, conservative estimates of the value of the intangible benefits, and incorporate these values into the NPV calculation.

Mutually Exclusive Projects

12 (S.O 5) In theory, all projects with positive NPVs should be accepted However, companies rarely are able to adopt all positive-NPV proposals because (1) the proposals are mutually exclusive (if the company adopts one proposal, it would be impossible to also adopt the other proposal), and (2) companies have limited resources.

13 In choosing between two projects, one method that takes into account both the size of the original investment and the discounted cash flows is the profitability index. The profitability index formula is as follows:

Present Value of Future Cash Flows ÷

I nitial Investment =

Profitability Index The project with the greater profitability index should be the one chosen.

14 Another consideration made by financial analysts is uncertainty or risk One approach for dealing with uncertainty is sensitivity analysis. Sensitivity analysis uses a number of outcome estimates to get a sense of the variability among potential returns In general, a higher risk project should be evaluated using a higher discount rate.

Post-Audit of Investment Projects

15 (S.O 6) A post-audit is a thorough evaluation of how well a project’s actual performance matches the projections made when the project was proposed Performing a post-audit is beneficial for the following reasons:

a Management will be encouraged to submit reasonable and accurate data when they make investment proposals;

b A formal mechanism is used for determining whether existing projects should be supported or terminated;

c Management improves their estimation techniques by evaluating their past successes and failures.

16 A post-audit involves the same evaluation techniques that were used in making the original capital budgeting decision—for example, use of the net present value method The difference is that, in the post-audit, actual figures are inserted where known, and estimation of future amounts is revised based on new information.

Internal Rate of Return Method

17 (S.O 7) The internal rate of return method results in finding 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 internal rate of return can be done with a financial (business) calculator, computerized spreadsheet, or by employing a trial-and-error procedure.

18 The decision rule is: Accept the project when the internal rate of return is equal to or greater than the required rate of return, and reject the project when the internal rate of return is less than the required rate.

Annual Rate of Return Method

19 (S.O 8) The annual rate of return method indicates the profitability of a capital expenditure and its formula is:

Expected Annual Net Income ÷ Average Investment = Annual Rate of Return Average investment is based on the following:

Original investment + Value at end of usefull life

2 = AverageInvestment

20 The annual rate of return is compared with management’s required minimum rate of return for investments of similar risk The minimum rate of return (the hurdle rate or cutoff rate) is generally based on the company’s cost of capital 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.

21 When the rate of return technique is used in deciding among several acceptable projects, the higher the rate of return for a given risk, the more attractive the investment.

LECTURE OUTLINE

A Capital Budgeting Evaluation Process

1 The process of making capital expenditure decisions in business isreferred to as capital budgeting

2 Capital budgeting involves choosing among various projects to find theone(s) that will maximize a company’s return on its financial investment

ILLUSTRATION 12-1 presents the steps involved in the capital budgetingevaluation process

3 Top management requests proposals for projects from each departmentand a capital budgeting committee screens the proposals and recom-mends worthy projects to company officers

4 Company officers decide which projects to fund and submit this list ofprojects to the board of directors for approval

5 For purposes of capital budgeting, estimated cash inflows and outflowsare the preferred inputs

1 The cash payback technique identifies the time period required torecover the cost of the capital investment from the net annual cash flowproduced by the investment

2 Net annual cash flow is computed by adding back depreciation expense

to net income Depreciation expense is added back because it is anexpense that does not require an outflow of cash

TEACHING TIP

ILLUSTRATION 12-2 provides an example of calculating the cash paybackperiod on an investment project Point out that cash payback is easy to computeand is often used to screen projects for risk, but it does not consider the profit-ability of the project

Also available as teaching transparency.

a The formula when net annual cash flows are equal is: Cost ofCapital Investment ÷ Net Annual Cash FIow = Cash PaybackPeriod

b The shorter the payback period, the more attractive the investment

c The cash payback technique recognizes that:

(1) The earlier the investment is recovered, the sooner the companycan use the cash funds for other purposes

(2) The risk of loss from obsolescence and changed economicconditions is less in a shorter payback period

d In the case of uneven net annual cash flows, the company determinesthe cash payback period when the cumulative net cash flows fromthe investment equal the cost of the investment

e The cash payback technique is relatively easy to compute andunderstand

f It should not ordinarily be the only basis for the capital budgetingdecision because it ignores the expected profitability of the project

C Net Present Value Method.

1 Discounted cash flow techniques are generally recognized as the mostinformative and best conceptual approaches to making capital budgetingdecisions

TEACHING TIP

2 These techniques consider both the time value of money and theestimated net cash flow from the investment.

3 The primary discounted cash flow technique is the net present valuemethod

4 The net present value method in values discounting net cash flows totheir present value and then comparing that present value with thecapital outlay required by the investment The difference between thesetwo amounts is referred to as net present value (NPV)

ILLUSTRATION 12-3 presents a diagram of the decision criteria for the netpresent value method

a Company management determines what interest rate to use indiscounting the future net cash flows This rate is often referred to

as the discount rate or required rate of return

b A proposal is acceptable when net present value is zero or positive,because this means the rate of return on the investment equals orexceeds the discount rate (required rate of return)

c The higher the positive net present value, the more attractive theinvestment

ILLUSTRATION 12-4 provides a short example of applying the net present valuemethod

Also available as teaching transparency.

TEACHING TIP

TEACHING TIP

D Intangible Benefits.

1 Intangible benefits, such as increased quality, improved safety, orenhanced employee loyalty, are difficult to quantify, and thus often areignored in capital budgeting decisions

2 To avoid rejecting projects that should actually be accepted, managerscan either

a Calculate the net present value (NPV) ignoring intangible benefits,and if the resulting NPV is negative, evaluate whether the intangiblebenefits are worth at least the amount of the negative NPV

b Incorporate intangible benefits into the NPV calculation by projectingrough, conservative estimates of their value If, after using conserva-tive estimates, the net present value is positive, the project should

be accepted

E Mutually Exclusive Projects.

1 Proposals are often mutually exclusive—if the company adopts oneproposal, it would be impossible to also adopt the other proposal

2 The profitability index is a method that compares the relative merits ofalternative capital investment projects

3 This method takes into account both the size of the original investmentand its discounted future cash flows

4 It is computed by dividing the present value of net cash flows by theinitial investment

ILLUSTRATION 12-5 provides an example of calculating the profitability index.Point out that any project with a positive NPV will have a profitability indexgreater than 1

Also available as teaching transparency.

5 The higher the profitability index, the more desirable the project

TEACHING TIP

F Post-Audit of Investment Projects.

1 A post-audit is a thorough evaluation of how well a project’s actualperformance matches the original projections

2 Performing a post-audit is important for several reasons

a Since managers know that their results will be evaluated, there is

an incentive for them to make accurate estimates rather thanpresenting overly optimistic estimates in an effort to get projectsapproved

b A post-audit provides a formal mechanism for determining whetherexisting projects should be continued, expanded, or terminated

c Post-audits improve future investment proposals because managersimprove their estimation techniques by evaluating past successesand failures

3 A post-audit involves the same evaluation techniques used in makingthe original capital budgeting decision In the post-audit, managers useactual figures where known, and they revise estimates of future amountsbased on new information

G Internal Rate of Return.

1 The internal rate of return method differs from the net present valuemethod in that it finds the interest yield of the potential investment

a The internal rate of return is the interest rate that will cause thepresent value of the proposed capital expenditure to equal thepresent value of the expected net annual cash flows

Use ILLUSTRATION 12-4 to calculate the internal rate of return on an investmentproject Compare the net present value method and the internal rate of returnmethod for the same investment proposal

Also available as teaching transparency.

TEACHING TIP

b The determination of the internal rate of return involves the use of afinancial calculator or computerized spreadsheet to solve for therate (if the cash flows are uneven)

c If the net annual cash flows are equal, an easier approach tosolving for the internal rate of return can be used This approachinvolves two steps:

(1) Compute the internal rate of return factor

(2) Use the factor and the present value of an annuity of 1 table tofind the internal rate of return

d The formula for determining the internal rate of return factor is:Capital Investment ÷ Net Annual Cash Flows = Internal Rate ofReturn Factor

e Once managers know the internal rate, of return, they compare it tothe company’s required rate of return (the discount rate)

f The decision rule is: Accept the project when the internal rate

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

ILLUSTRATION 12-6 provides a diagram of the decision criteria for the internal

rate of return method

2 The two discounted cash flow methods differ as follows:

a Objective:

(1) Net present value: compute net present value (a dollar amount)

(2) Internal rate of return: compute internal rate of return(a percentage)

TEACHING TIP