Managerial accounting by garrison noreen 13e chap002chap014

Discounted cash flow methods automatically provide for a return of the original investment.. Discounted cash flow methods automatically provide for a return of the original investm

Capital Budgeting Decisions

Chapter 14

Typical Capital Budgeting Decisions

Plant expansionEquipment selection

Lease or buy Cost reduction

Time Value of Money

A dollar today is

worth more than a

dollar a year from

now Therefore,

projects that promise

earlier returns are

preferable to those

that promise later

returns

The Net Present Value Method

To determine net present value we

Calculate the present value of cash inflows,

Calculate the present value of cash outflows,

Subtract the present value of the outflows

from the present value of the inflows.

The Net Present Value Method

Typical Cash Outflows

Repairs and maintenance

Incremental operating costs

Initial investment Working

capital

Typical Cash Inflows

Reduction

of costs

Salvage value

Incremental revenues

Release of

working

capital

Recovery of the Original Investment

Depreciation is not deducted in computing the present value of a

project because

It is not a current cash outflow.

Discounted cash flow methods

automatically provide for a return of the

original investment.

Depreciation is not deducted in computing the present value of a

project because

It is not a current cash outflow.

Discounted cash flow methods

automatically provide for a return of the

original investment.

Recovery of the Original Investment

Carver Hospital is considering the purchase of an

attachment for its X-ray machine

No investments are to be made unless they have an

annual return of at least 10%.

Will we be allowed to invest in the attachment?

Recovery of the Original Investment

This implies that the cash inflows are sufficient to recover the $3,170

provide exactly a 10% return on the investment.

Two Simplifying Assumptions

Two simplifying assumptions are usually made

in net present value analysis:

All cash flows other

than the initial

investment occur at

the end of periods.

All cash flows generated by an investment project are immediately reinvested at a rate of return equal to the discount rate.

Quick Check 

Denny Associates has been offered a four-year contract to

supply the computing requirements for a local bank.

• The working capital would be released at the end of the contract.

• Denny Associates requires a 14% return.

What is the net present value of the contract with the local bank?

Internal Rate of Return Method

 The internal rate of return is the rate of return

promised by an investment project over its useful

life It is computed by finding the discount rate that

will cause the net present value of a project to be

zero

 It works very well if a project’s cash flows are

identical every year If the annual cash flows are

not identical, a trial and error process must be used

to find the internal rate of return.

Internal Rate of Return Method

General decision rule

If the Internal Rate of Return is Then the Project is

Equal to or greater than the minimum

required rate of return Acceptable

Less than the minimum required rate

of return Rejected

When using the internal rate of return,

the cost of capital acts as a hurdle rate

that a project must clear for acceptance.

Quick Check 

The expected annual net cash inflow from a project

is $22,000 over the next 5 years The required

investment now in the project is $79,310 What is

the internal rate of return on the project?

a 10%

b 12%

c 14%

d Cannot be determined

The expected annual net cash inflow from a project

is $22,000 over the next 5 years The required

investment now in the project is $79,310 What is

the internal rate of return on the project?

a 10%

b 12%

c 14%

d Cannot be determined

The expected annual net cash inflow from a project

is $22,000 over the next 5 years The required

investment now in the project is $79,310 What is

the internal rate of return on the project?

a 10%

b 12%

c 14%

d Cannot be determined

The expected annual net cash inflow from a project

is $22,000 over the next 5 years The required

investment now in the project is $79,310 What is

the internal rate of return on the project?

$79,310/$22,000 = 3.605, which is the present value factor for an annuity over five years when the interest rate is 12%.

Least Cost Decisions

In decisions where revenues are not directly

involved, managers should choose the

alternative that has the least total cost from a

present value perspective.

Let’s look at the Home Furniture Company.

In decisions where revenues are not directly

involved, managers should choose the

alternative that has the least total cost from a

present value perspective.

Let’s look at the Home Furniture Company.

Least Cost Decisions

decide whether to overhaul an old

delivery truck now or purchase a new one.

decide whether to overhaul an old

delivery truck now or purchase a new one.

Least Cost Decisions

Old Truck

Overhaul cost now $ 4,500

Annual operating costs 10,000

Salvage value in 5 years 250

Salvage value now 9,000

Here is information about the trucks

Least Cost Decisions

Buy the New Truck

Year

Cash Flows

10%

Factor

Present Value Purchase price Now $ (21,000) 1.000 $ (21,000) Annual operating costs 1-5 (6,000) 3.791 (22,746) Salvage value of old truck Now 9,000 1.000 9,000 Salvage value of new truck 5 3,000 0.621 1,863

Keep the Old Truck

Year

Cash Flows

10%

Factor

Present Value

Annual operating costs 1-5 (10,000) 3.791 (37,910) Salvage value of old truck 5 250 0.621 155

Least Cost Decisions

Home Furniture should purchase the new truck.

Preference Decision – The Ranking of

most to least appealing.

Internal Rate of Return Method

The higher the internal

rate of return, the more desirable the

project.

When using the internal rate of return

method to rank competing investment

projects, the preference rule is:

Net Present Value Method

The net present value of one project cannot

be directly compared to the net present

value of another project unless the

investments are equal

Ranking Investment Projects

index

=

The higher the profitability index, the

more desirable the project.

The higher the profitability index, the

more desirable the project.

The Payback Method

The payback period is the length of time that it

takes for a project to recover its initial cost out

of the cash receipts that it generates.

When the annual net cash inflow is the same

each year, this formula can be used to compute

the payback period:

The payback period is the length of time that it

takes for a project to recover its initial cost out

of the cash receipts that it generates.

When the annual net cash inflow is the same

each year, this formula can be used to compute

the payback period:

Payback period = Investment required

Annual net cash inflow

Payback and Uneven Cash Flows

$1,000 $0 $2,000 $1,000 $500

When the cash flows associated with an

investment project change from year to year,

the payback formula introduced earlier cannot

be used

Instead, the un-recovered investment must be

Simple Rate of Return Method

 Does not focus on cash flows rather it focuses

on accounting net operating income

 The following formula is used to calculate the

simple rate of return:

*Should be reduced by any salvage from the sale of the old equipment

Present Value of a Series of Cash Flows

$100 $100 $100 $100 $100 $100

An investment that involves a series of

identical cash flows at the end of each year is called an annuity annuity.

Present Value of a Series of Cash Flows –

An Example

Lacey Inc purchased a tract of land on

which a $60,000 payment will be due each year for the next five years What is the present value of this stream of cash

payments when the discount rate is

12%?

Present Value of a Series of Cash Flows –

Simplifying Assumptions

Taxable income equals net income as

computed for financial reports.

The tax rate is a flat percentage of taxable income.

Concept of After-tax Cost

After-tax cost

An expenditure net of its tax effect is

known as after-tax cost.

Here is the equation for determining the

after-tax cost of any tax-deductible cash

expense:

Depreciation Tax Shield

While depreciation is not a cash flow, it does affect the taxes that must be paid and therefore has

an indirect effect on a company’s cash flows.

Tax savings from

the depreciation

tax shield

= Tax rateDepreciation deduction

End of Chapter 14