Managerial Accounting-VII

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Managerial Accounting Ninth Edition

Weygandt Kimmel Mitchell

Chapter 12

Planning for Capital Investments

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Chapter Outline

Learning Objectives LO 1 Describe capital budgeting inputs and apply the cash payback

technique. LO 2 Use the net present value method. LO 3 Identify capital budgeting challenges and refinements. LO 4 Use the internal rate of return method. LO 5 Use the annual rate of return method.

Capital Budgeting and Cash Payback LEARNING OBJECTIVE 1 Describe capital budgeting inputs and apply the cash payback technique.

For purposes of capital budgeting, estimated cash inflows and outflows are the preferred inputs. Why? Ultimately, the value of all financial investments is determined by the value of cash flows received and paid.

LO 1

Cost Flow Information Typical cash flows relating to capital budgeting

Cash Outflows

Initial investment Repairs and maintenance Increased operating costs Overhaul of equipment

Cash Inflows

Proceeds from sale of old equipment Increased cash received from customers Reduced cash outflows related to operating costs Salvage value of equipment

LO 1

Cost Flow Information Considerations for capital budgeting decisions

• Availability of funds • Relationships among proposed projects • Company’s basic decision-making approach • Risk associated with a particular project

LO 1

Illustrative Data Stewart Shipping Company is considering an investment of $130,000 in new equipment.

Illustration 12.3

Initial investment $130,000

Estimated useful life 10 years

Estimated salvage value ─0─

Estimated annual cash flows

Cash inflows from customers $200,000

Cash outflows for operating costs 176,000

Net annual cash flow $ 24,000

LO 1

Cash Payback Cash payback equation Cash payback technique identifies time period required to recover cost of capital investment from net annual cash inflow produced by investment. Cash payback period for Stewart is …

Illustration 12.4

Cost of Capital Investment ÷ Net Annual Cash

Flow = Cash Payback Period

$130,000 ÷ $24,000 = 5.42 years

LO 1

Cash Payback Evaluation of project

Shorter payback period = More attractive investment In case of uneven net annual cash flows, company determines cash payback period when:

= Cumulative net

Cost of cash flows from

investment investment

LO 1

Cash Payback Cash payback period-unequal cash flows Illustration: Chen Company proposes an investment in new equipment that is estimated to cost $300,000.

LO 1

Cash Payback Review Question

A $100,000 investment with a zero scrap value has an 8- year life. Compute the payback period if straight-line depreciation is used and net income is determined to be $20,000. a. 8.00 years. b. 3.08 years. c. 5.00 years. d. 13.33 years.

LO 1

Cash Payback Review Answer

LO 1

DO IT! 1 Cash Payback Period

Watertown Paper Corporation is considering adding another machine for the manufacture of corrugated cardboard. The machine would cost $900,000. It would have an estimated life of 6 years and no salvage value. The company estimates that annual cash inflows would increase by $400,000 and that annual cash outflows would increase by $190,000. Compute the cash payback period.

Estimated annual cash inflows $400,000

Estimated annual cash outflows 190,000

Net annual cash flow $210,000

Cash payback period = $900,000 = $210,000

4.3 years

LO 1

Net Present Value Method

LEARNING OBJECTIVE 2

Use the net present value method.

Discounted cash flow technique: • Generally recognized as best approach • Considers both estimated total cash inflows and time

value of money • Two methods:

o Net present value (NPV) o Internal rate of return (IRR)

LO 2

Net Present Value Method The primary capital budgeting technique

• Cash inflows are discounted to their present value and then compared with capital outlay required by investment

• Interest rate used in discounting is required minimum rate of return

• Proposal is acceptable when NPV is zero or positive • Higher positive NPV, more attractive investment

LO 2

Net Present Value Method Net present value decision criteria

Proposal is acceptable when net present value is zero or positive.

Illustration 12.6

LO 2

Equal Annual Cash Flows Present value of equal net annual cash flows

Illustration: In the Stewart Shipping Company example (Illustration 12.3), the company’s net annual cash flows are $24,000. If we assume this amount is uniform over the asset’s useful life, we can compute the present value of the net annual cash flows.

Illustration 12.7

Present Value at 12%

Discount factor for 10 periods 5.65022

Present value of net cash flows:

$24,000 × 5.65022 $135,605

LO 2

Equal Annual Cash Flows Net present value-equal net annual cash flows Illustration: Calculate the net present value.

Illustration 12.8

12%

Present value of net cash flows $135,605

Less: Capital investment 130,000

Net present value $ 5,605

Proposed capital expenditure is acceptable at a required rate of return of 12% because the net present value is positive.

LO 2

Unequal Annual Cash Flows Illustration

Stewart Shipping Company expects the same total net cash flows of $240,000 over the life of the investment. But, because of a declining market demand for the new product, the net annual cash flows are higher in the early years and lower in the later years. The present value of the net annual cash flows is calculated as follows.

LO 2

Unequal Annual Cash Flows Present value of unequal annual cash flows

Illustration 12.9

LO 2

Unequal Annual Cash Flows Net present value-unequal annual cash flows Illustration: Calculate the net present value.

Illustration 12.10

12%

Present value of net cash flows $144,367

Less: Capital investment 130,000

Net present value $ 14,367

Proposed capital expenditure is acceptable at a required rate of return of 12% because the net present value is positive.

LO 2

Choosing a Discount Rate Rate to obtain funds from creditors and stockholders In most instances a company uses a required rate of return equal to its cost of capital — that is, the rate that it must pay to obtain funds from creditors and stockholders. Discount rate has two components: • Cost of capital • Risk Rate also know as required rate of return, hurdle rate, and cutoff rate. LO 2

Choosing a Discount Rate Comparison of NPV at different discount rates Illustration: Stewart Shipping used a discount rate of 12%. Suppose this rate does not take into account the risk of the project. A more appropriate rate might be 15%.

Illustration 12.11

LO 2

Simplifying Assumptions

• All cash flows come at end of each year • All cash flows are immediately reinvested in another

project that has a similar return • All cash flows can be predicted with certainty

LO 2

Net Present Value (NPV) Method Review Question

Compute the net present value of a $260,000 investment with a 10-year life, annual cash inflows of $50,000 and a discount rate of 12%. a. $(9,062) b. $22,511 c. $9,062 d. $(22,511)

LO 2

Net Present Value (NPV) Method Review Answer

Compute the net present value of a $260,000 investment with a 10-year life, annual cash inflows of $50,000 and a discount rate of 12%. a. $(9,062) b. Answer: $22,511 c. $9,062 d. $(22,511)

LO 2

Comprehensive Example Investment information for Best Taste Foods Best Taste Foods is considering investing in new equipment to produce fat-free snack foods.

Illustration 12.12

Initial investment $1,000,000

Cost of equipment overhaul in 5 years $200,000

Salvage value of equipment in 10 years $20,000

Cost of capital (discount rate) 15%

Estimated annual cash flows

Cash inflows received from sales $500,000

Cash outflows for cost of goods sold $200,000

Maintenance costs $30,000

Other direct operating costs $40,000

LO 2

Comprehensive Example Computation of net annual cash flow Compute the net annual cash flows for this project.

Illustration 12.13

Cash inflows received from sales $ 500,000

Cash outflows for cost of goods sold (200,000)

Maintenance costs (30,000)

Other direct operating costs (40,000)

Net annual cash flow $ 230,000

LO 2

Comprehensive Example NPV of Best Taste Foods investment Compute the net present value for this proposed investment.

Illustration 12.14

LO 2

DO IT! 2: Net Present Value Problem data

DO IT! 2: Net Present Value Solution Calculate the net present value on this project and discuss whether it should be accepted.

NPV is greater than zero, Watertown should accept the project.

LO 2

Capital Budgeting Challenges and Refinements LEARNING OBJECTIVE 3

Identify capital budgeting challenges and refinements.

Intangible Benefits Might include increased quality, improved safety, or enhanced employee loyalty. To avoid rejecting projects with intangible benefits: 1. Calculate NPV ignoring intangible benefits 2. Project conservative estimates of value of intangible

benefits, and incorporate these values into NPV calculation

LO 3

Intangible Benefits

Example: Berg Company is considering the purchase of a new mechanical robot.

Illustration 12.15

LO 3

Intangible Benefits Example Problem data

Berg estimates that improved sales will increase cash inflows by $10,000 annually as a result of an increase in perceived quality. Berg also estimates that annual cost outflows would be reduced by $5,000 as a result of lower warranty claims, reduced injury claims, and fewer missed work days. Using these conservative estimates of the value of the additional benefits, should Berg accept the project?

LO 3

Intangible Benefits Example Solution Berg would accept the project.

Illustration 12.16

LO 3

Profitability Index for Mutually Exclusive Projects • Proposals are often mutually exclusive • Managers choose between various positive-NPV

projects because of limited resources • Tempting to choose project with higher NPV

LO 3

Profitability Index for Mutually Exclusive Projects Net present value computation Illustration: Two mutually exclusive projects, each assumed to have a 10-year life and a 12% discount rate.

Illustration 12.17 Project A Project B

Initial investment $40,000 $90,000

Net annual cash inflow 10,000 19,000

Salvage value 5,000 10,000

Present value of net cash flows

($10,000 × 5.65022) + ($5,000 × .32197) 58,112

($19,000 × 5.65022) + ($10,000 × .32197) 110,574

Illustration 12.18 Project A Project B

Present value of net cash flows $58,112 $110,574

Less: Initial investment 40,000 90,000

Net present value $18,112 $ 20,574

LO 3

Profitability Index Calculation of profitability index Illustration: One method of comparing alternative projects is the profitability index.

Illustration 12.19

Present Value of Net Cash Flows ÷ Initial Investment = Profitability Index

Illustration 12.20

LO 3

Profitability Index Review Question

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? a. Project A b. Project B c. Project A or B d. There is not enough data to answer the question

LO 3

Profitability Index Review Answer

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? a. Answer: Project A b. Project B c. Project A or B d. There is not enough data to answer the question

LO 3

Risk Analysis

A simplifying assumption made by many financial analysts is that projected results are known with certainty. • Projected results are only estimates • Sensitivity analysis is used to deal with uncertainty • Uses a number of outcome estimates to get a sense of

variability among potential returns

LO 3

Post-Audit of Investment Projects

Performing a post-audit is important. • If managers know their estimates will be compared to

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

• Provides a formal mechanism to determine whether existing projects should be supported or terminated

• Improve future investment proposals

LO 3

DO IT! 3: Profitability Index Problem data Taz Corporation has decided to invest in renewable energy sources to meet part of its energy needs for production. It is considering solar power versus wind power. After considering cost savings as well as incremental revenues from selling excess electricity into the power grid, it has determined the following.

Solar Wind

Present value of annual cash flows $78,580 $168,450

Initial investment $45,500 $125,300

Determine the net present value and profitability index of each project. Which energy source should it choose?

LO 3

DO IT! 3: Profitability Index Solution

Solar Wind

Present value of annual cash flows $78,580 $168,450

Less: Initial investment 45,500 125,300

Net present value $33,080 $43,150

Profitability index 1.73* 1.34**

*$78,580 ÷ $45,500

**$168,450 ÷ $125,300

While the investment in wind power generates higher net present value, it also requires a substantially higher initial investment. The profitability index favors solar power, which suggests that the additional net present value of wind is outweighed by the cost of the initial investment. The company should choose solar power.

LO 3

Internal Rate of Return

LEARNING OBJECTIVE 4

Use the internal rate of return method.

• Differs from net present value method in that it finds interest yield of potential investment

• Internal rate of return (IRR) - interest rate that will cause present value of proposed capital expenditure to equal present value of expected net annual cash flows (that is, NPV equal to zero)

• How does one determine internal rate of return?

LO 4

Internal Rate of Return Estimation of internal rate of return Stewart Shipping Company is considering the purchase of a new front-end loader at a cost of $244,371. Net annual cash flows from this loader are estimated to be $100,000 a year for three years. To determine the internal rate of return on this front-end loader, the company finds the discount rate that results in a net present value of zero.

Illustration 12.21

LO 4

Internal Rate of Return Formula for internal rate of return-even cash flows An easier approach to solving for internal rate of return when net annual cash flows are equal.

LO 4

Internal Rate of Return Internal rate of return decision criteria

Illustration 12.23

LO 4

Comparing Discounted Cash Flow Methods

Illustration 12.24

Net Present Value Internal Rate of Return

1. Objective Compute net present value (a dollar amount).

Compute internal of return (a percentage).

2. Decision Rule

If net present value is zero or positive, accept the proposal.

If internal rate of return is equal to or greater than the required rate of return, accept the proposal.

If net present value is negative, reject the proposal.

If internal rate of return is less than the required rate of return, reject the proposal.

LO 4

DO IT! 4: Internal Rate of Return Problem data

LO 4

DO IT! 4: Internal Rate of Return Calculation of the internal rate of return

Estimated annual cash inflows $400,000 Estimated annual cash outflows 190,000 Net annual cash flow $210,000

Machine cost $900,000 Net annual cash flow ÷ $210,000 Present value factor 4.28571

Now, find the rate that corresponds to the present value factor.

LO 4

DO IT! 4: Internal Rate of Return Rate for PV factor of 4.28571 for 6 periods

Since the project has an internal rate that is greater than 10% and the required rate of return is only 9%, the project should be accepted.

LO 4

Annual Rate of Return

LEARNING OBJECTIVE 5

Use the annual rate of return method.

Indicates profitability of a capital expenditure by dividing expected annual net income by average investment.

Illustration 12.25

Expected Annual Net Income ÷ Average Investment = Annual Rate of Return

LO 5

Annual Rate of Return Problem data Illustration: Reno Company is considering an investment of $130,000 in new equipment. The equipment is expected to last five years and have zero salvage value at the end of its useful life. Reno uses straight-line depreciation.

Illustration 12.26

LO 5

Annual Rate of Return Solution

Illustration 12.27

+ =

÷ =$13,000 $65,000 20%

O L Averagl e IE nvo esU tf ml ea nf triginal Investment V ue at nd f se u i e 2

A project is acceptable if its rate of return is greater than management’s required rate of return.

LO 5

DO IT! 5: Annual Rate of Return Problem data

Watertown Paper Corporation is considering adding another machine for the manufacture of corrugated cardboard. The machine would cost $900,000. It would have an estimated life of 6 years and no salvage value. The company estimates that annual revenues would increase by $400,000 and that annual expenses excluding depreciation would increase by $190,000. It uses the straight-line method to compute depreciation expense. Management has a required rate of return of 9%. Compute the annual rate of return. LO 5

DO IT! 5: Annual Rate of Return Solution Compute the annual rate of return.

Since the annual rate of return (13.3%) is greater than Watertown’s required rate of return (9%), the proposed project is acceptable.

LO 5

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Managerial Accounting
Chapter Outline
Capital Budgeting and Cash Payback
Cost Flow Information�Typical cash flows relating to capital budgeting
Cost Flow Information�Considerations for capital budgeting decisions
Illustrative Data
Cash Payback�Cash payback equation
Cash Payback�Evaluation of project
Cash Payback�Cash payback period-unequal cash flows
Cash Payback�Review Question
Cash Payback�Review Answer
DO IT! 1 Cash Payback Period
Net Present Value Method
Net Present Value Method�The primary capital budgeting technique
Net Present Value Method�Net present value decision criteria
Equal Annual Cash Flows�Present value of equal net annual cash flows
Equal Annual Cash Flows�Net present value-equal net annual cash flows
Unequal Annual Cash Flows�Illustration
Unequal Annual Cash Flows�Present value of unequal annual cash flows
Unequal Annual Cash Flows�Net present value-unequal annual cash flows
Choosing a Discount Rate�Rate to obtain funds from creditors and stockholders
Choosing a Discount Rate�Comparison of N P V at different discount rates
Simplifying Assumptions
Net Present Value (N P V) Method�Review Question
Net Present Value (N P V) Method�Review Answer
Comprehensive Example�Investment information for Best Taste Foods
Comprehensive Example�Computation of net annual cash flow
Comprehensive Example�NPV of Best Taste Foods investment
DO IT! 2: Net Present Value�Problem data
DO IT! 2: Net Present Value�Solution
Capital Budgeting Challenges and Refinements
Intangible Benefits
Intangible Benefits Example�Problem data
Intangible Benefits Example�Solution
Profitability Index for Mutually Exclusive Projects
Profitability Index for Mutually Exclusive Projects�Net present value computation
Profitability Index�Calculation of profitability index
Profitability Index�Review Question
Profitability Index�Review Answer
Risk Analysis
Post-Audit of Investment Projects
DO IT! 3: Profitability Index�Problem data
DO IT! 3: Profitability Index�Solution
Internal Rate of Return
Internal Rate of Return�Estimation of internal rate of return
Internal Rate of Return�Formula for internal rate of return-even cash flows
Internal Rate of Return�Internal rate of return decision criteria
Comparing Discounted Cash Flow Methods
DO IT! 4: Internal Rate of Return�Problem data
DO IT! 4: Internal Rate of Return�Calculation of the internal rate of return
DO IT! 4: Internal Rate of Return�Rate for PV factor of 4.28571 for 6 periods
Annual Rate of Return
Annual Rate of Return�Problem data
Annual Rate of Return�Solution
DO IT! 5: Annual Rate of Return�Problem data
DO IT! 5: Annual Rate of Return�Solution
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