26-1 Preview of Chapter 26 Financial and Managerial Accounting Weygandt Kimmel Kieso

26-2 A revenue expenditure is an amount that is expensed immediately – (matched with revenues of the period). Repairs that do not extend the life of the asset or do not improve the asset (the repairs merely return the asset back to operating condition). A capital expenditure is an amount spent to acquire or improve a long-term asset such as equipment or buildings. (Cost is “Property, Plant & Equipment” … depreciated over its useful life). BIG Expensive Stuff … machines, building, furniture, buying another company, expanding to a new market Revenue vs Capital Expenditure

26-3 Capital budgeting (capital investment) … process used to determine whether company’s long term investments are worth funding. (ie: New (replacement) machine, new buildings, new products, market expansion, acquisitions, R & D). In a state or city budget “capital improvements” could be a new road, resurfacing streets, new sewer lines, renovate a firehouse, new computer system, replacements police cars, new garbage truck etc. Capital Budgeting “Capital Investment” refers to investment in a business to further its business objectives … may be acquisition of capital (fixed) assets that is expected to be productive over many years.

26-4 Capital budgeting decisions depend on: 1.Availability of funds (not all requests are funded). 2.Relationships among proposed projects. 3.Company’s basic decision-making approach. 4.Risk associated with a particular project. (The “likelihood / possibility / probability” of loss). The Capital Budgeting Evaluation Process

26-5 The Capital Budgeting Evaluation Process 1. Spending/Investment proposals or “requests” are received from departments, plants, subsidiary’s and authorized personnel. 2. Proposals-requests are screened by a capital budget committee. 3. Committee recommends to senior management who decides which projects will be funded.

26-6 Cash Flow Information For purposes of capital budgeting, estimated cash inflows and outflows (cash in, cash out) are the preferred inputs. Why? The Capital Budgeting Evaluation Process Ultimately, the value of all financial investments is determined by the value of cash flows received and paid.

26-7 Examples of Cash Flows The Capital Budgeting Evaluation Process Illustration 26-2 Typical cash flows relating to capital budgeting decisions

26-8 The Capital Budgeting Evaluation Process Ex: Company is considering an investment of $130,000 in new equipment.

26-9 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. Cash Payback Answers the question: How long until I get my money back?

26-10 Cash payback period for Stewart is … $130,000 ÷ $24,000 = 5.42 years Cash Payback

26-11 Shorter payback period = More attractive the investment. In the case of uneven net annual cash flows, the company determines the cash payback period when the : Cash Payback = Cumulative net cash flows from the investment Cost of the investment

26-12 Ex: Company proposes an investment in a new website that is estimated to cost $300,000. Cash payback should not be the only basis for the capital budgeting decision as it ignores the expected profitability of the project. Cash Payback

26-13 Corp. is considering adding another machine to make cardboard. Machine cost = $900,000. Estimated life 6 yrs. No salvage value. Estimated annual cash inflows would increase by $400,000, and annual cash outflows increase by $190,000. Compute payback.

26-14 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 years. Question Cash Payback

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26-16 Discounted cash flow technique using either the: ► Net Present Value method … (NPV) ► Internal Rate of Return method … (IRR)  Generally recognized as the best approach.  Considers both the estimated total cash inflows and the time value of money. Discounted Cash Flow

26-17 Discounted Cash Flow Net Present Value (NPV) method  Discount cash inflows to their present value … then compare them with the capital outlay of the project.  The interest rate used in discounting is the required minimum rate of return.  Proposal is acceptable when NPV is zero or positive.  The higher the positive NPV, the better the investment.

26-18 In most instances a company uses a required “minimum” 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 elements:  Cost of capital.  Risk. Rate also know as required rate of return. hurdle rate. cutoff rate. Choosing a Discount Rate

26-19 Ex: Assume that the $24,000 are uniform over useful life. Assume 12% is the minimum acceptable rate of return. (Hurdle rate) Discounted Cash Flow … NPV method From Table 4 (Present value of an annuity)

26-20 The proposed capital expenditure is acceptable at a required rate of return of 12% because the net present value is positive. Discounted Cash Flow … NPV method Compare present value of cash flows to present value of investment.

26-21 Discounted Cash Flow … NPV method Assume that the $240,000 over 10 years is NOT uniform. Instead, net annual cash flows are higher in early years, lower in later years. (Table 3 … PV of $1 for each amount for each year)

26-22 Proposed capital expenditure is acceptable at a required rate of return of 12% because the net present value is positive. Discounted Cash Flow … NPV method

26-23 Ex: What if the previous rate of 12% did not take into account the risk of the project. Maybe a more appropriate rate is 15%. Choosing a Discount Rate

26-24 Corp. is considering adding another machine to make cardboard. Machine cost = $900,000. Estimated life 6 yrs. No salvage value. Estimated annual cash inflows would increase by $400,000, and annual cash outflows increase by $190,000. Minimum rate of return of 9% required for any investment. Calculate NPV of the project.

26-25 Cost: $900, yr life. Est. inflows increase by $400,000; Est. cash outflows increase by $190,000. Min. return: 9%

26-26 Intangible Benefits Intangible benefits might include increased quality, improved safety, or enhanced employee loyalty. To avoid rejecting projects with intangible benefits: 1.Calculate net present value ignoring intangible benefits. 2.Project rough, conservative estimates of the value of the intangible benefits, and incorporate these values into the NPV calculation. Additional Considerations

26-27 Ex: Company is considering buying a new mechanical robot. Based on the negative net present value of $30,493, the proposed project is not acceptable. Additional Considerations

26-28 Ex: Corp estimates sales will increase cash inflows by $10,000 annually as a result of an increase in quality. Corp also estimates that annual cost outflows would be reduced by $5,000 as a result of lower warranty claims, reduced injury claims, and missed work. Berg would accept the project. Additional Considerations

26-29 Profitability Index for Mutually Exclusive Projects  Proposals are often mutually exclusive.  Managers often must choose between various positive- NPV projects because of limited resources.  Tempting to choose the project with the higher NPV. Additional Considerations

26-30 Ex: Two projects (pick one or the other – not both), each with a 10- year life and a 12% rate. One method to compare: profitability index. Profitability Index for Mutually Exclusive Projects

26-31 Profitability Index for Mutually Exclusive Projects The higher the index, the more “financially attractive” the project.

26-32

26-33 Internal Rate of Return Method  Differs from the net present value method in that it finds the looks at the interest “yield” of the potential investment.  Internal rate of return (IRR): interest rate that causes the present value of the proposed project equal the present value of the expected net cash flows (NPV equal to zero).  How does one determine the internal rate of return? Other Capital Budgeting Techniques

26-34 Ex: Co. is considering buying a new front-end loader for $244,371. Ext. net annual cash flows are $100,000 a year for three years. Determine the internal rate of return on this front-end loader. Internal Rate of Return Method

26-35 $244,371 / $100,000 = An easier approach to find IRR when net annual cash flows are equal. Applying the formula: Internal Rate of Return Method

26-36 Corp. is considering adding another machine to make cardboard. Machine cost = $900,000. Estimated life 6 yrs. No salvage value. Estimated annual cash inflows would increase by $400,000, and annual cash outflows increase by $190,000. Compute IRR. Divide by

26-37 PV Factor Since the required rate of return is only 9%, the project should be accepted. Find the rate that corresponds to the present value factor.

26-38

26-39 Indicates the profitability of a capital expenditure by dividing expected annual net income by the average investment. Annual Rate of Return Method Other Capital Budgeting Techniques

26-40 Ex: Co. is considering an investment of $130,000 in new equipment. Useful life of 5 yrs, zero salvage. (Co. uses the straight-line deprec.) Annual Rate of Return Method

26-41 Annual Rate of Return Method

26-42 Ex: Co. is considering an investment of $130,000 in new equipment. Useful life of 5 yrs, zero salvage. Annual Rate of Return Method 130,

26-43 A project is acceptable if its rate of return is greater than the “ required” rate of return. Annual Rate of Return Method 13,000 / 65,000 = 20 %

26-44 Corp. is considering adding another machine to make cardboard. Machine cost = $900,000. Estimated life 6 yrs. No salvage value. Estimated annual cash inflows would increase by $400,000, and annual cash outflows increase by $190,000. Compute the ARR.

26-45 The proposed project is acceptable. Machine cost = $900,000. Estimated life 6 yrs. No salvage value. 900,000 / 2 = 450,000 60,000 / 450,000 = %

26-46 Cornfield Company is considering a long-term capital investment project in laser equipment. This will require an investment of $280,000, and it will have a useful life of 5 years. Annual net income is expected to be $16,000 a year. Depreciation is computed by the straight-line method with no salvage value. The company’s cost of capital is 10%. (Hint: Assume cash flows can be computed by adding back depreciation expense.) (a) Compute the cash payback period for the project. (Round to two decimals.)

26-47 Investment $280,000 Net income$16,000 Depreciation ($280,000 ÷ 5) 56,000 Annual cash flow÷ 72,000 Cash Payback Period3.89 years (a) Compute the cash payback period for the project. (Round to two decimals.)

26-48 Discount factor (5 10%) Present value of net cash flows: $72,000 x $272,937 Capital investment 280,000 Negative net present value $ (7,063) (b) Compute the net present value for the project. (Round to nearest dollar.)

26-49 The annual rate of return of 11.4% is good. However, the cash payback period is 78% of the project’s useful life, and net present value is negative. Recommendation is to reject the project. Net income$16,000 Average investment ($280,000 ÷ 2) ÷ 140,000 Annual rate of return11.4% (d) Should the project be accepted? Why? (c) Compute the annual rate of return for the project.