PLANNING FOR CAPITAL INVESTMENTS CHAPTER 12 PLANNING FOR CAPITAL INVESTMENTS Managerial Accounting, Fifth Edition

Study Study Objectives Discuss the capital budgeting evaluation process, and explain inputs used in capital budgeting. Describe the cash payback technique. Explain the net present value method. Identify the challenges presented by intangible benefits in capital budgeting. Describe the profitability index. Indicate the benefits of performing a post- audit. Explain the internal rate of return method. Describe the annual rate of return method.

Planning for Capital Investments Capital Budgeting Evaluation Process Net Present Value Method Cash Payback Additional Consid-erations Other Capital Budgeting Techniques Equal cash flows Unequal cash flows Choosing a discount Rate Simplifying Assumption Comprehen-sive example Intangible benefits Profitability index Risk analysis Post-audit of projects Intangible benefits Internal rate of return method Comparing discounted cash flow methods Annual rate of return method Cash flow infor-mation Illustrative data Calculation Evaluation Service Cost - Actuaries compute service cost as the present value of the new benefits earned by employees during the year. Future salary levels considered in calculation. Interest on Liability - Interest accrues each year on the PBO just as it does on any discounted debt. Actual Return on Plan Assets - Increase in pension funds from interest, dividends, and realized and unrealized changes in the fair market value of the plan assets. Amortization of Unrecognized Prior Service Cost - The cost of providing retroactive benefits is allocated to pension expense in the future, specifically to the remaining service-years of the affected employees. Gain or Loss - Volatility in pension expense can be caused by sudden and large changes in the market value of plan assets and by changes in the projected benefit obligation. Two items comprise the gain or loss: difference between the actual return and the expected return on plan assets and, amortization of the unrecognized net gain or loss from previous periods

Capital Budgeting Evaluation Process Many companies follow a carefully prescribed process in capital budgeting. At least once a year: 1) Proposals for projects are requested from each department. 2) The proposals are screened by a capital budgeting committee, which submits its finding to officers of the company. 3) Officers select projects and submit a list of projects to the board of directors. SO 1 Discuss the capital budgeting evaluation process, and explain what inputs are used in capital budgeting.

Capital Budgeting Authorization Process Illustration 12-1 SO 1 Discuss the capital budgeting evaluation process, and explain what inputs are used in capital budgeting.

Capital Budgeting Evaluation Process Most methods to evaluate capital budgeting decisions employ cash flow numbers rather than accrual revenues and expenses. For capital budgeting, estimated cash inflows and outflows are the preferred inputs. WHY? Ultimately the value of financial investments is determined by the value of the cash flows received or paid. SO 1 Discuss the capital budgeting evaluation process, and explain what inputs are used in capital budgeting.

Typical Cash Flows Related to Capital Budgeting Decisions Illustration 12-2 SO 1 Discuss the capital budgeting evaluation process, and explain what inputs are used in capital budgeting.

Capital Budgeting Evaluation Process The capital budgeting decision depends on a variety of considerations: 1) The availability of funds. 2) Relationships among proposed projects. 3) The company’s basic decision-making approach. 4) The risk associated with a particular project. SO 1 Discuss the capital budgeting evaluation process, and explain what inputs are used in capital budgeting.

Facts for Stewart Soups Example Illustration 12-3 SO 1 Discuss the capital budgeting evaluation process, and explain what inputs are used in capital budgeting.

Cash Payback Formula The cash payback technique identifies the time period required to recover the cost of the capital investment from the net annual cash flow produced by the investment. The formula for computing the cash payback period is: Illustration 12-4 SO 2 Describe the cash payback technique.

Cash Payback Formula-Equal Cash Flows Illustration 12-4 $130,000 ÷ $24,000 = 5.42 years The shorter the payback the more attractive the investment. SO 2 Describe the cash payback technique.

Cash Payback Formula-Unequal Cash Flows Illustration 12-5 SO 2 Describe the cash payback technique.

May be useful as an initial screening tool. Cash Payback May be useful as an initial screening tool. Easy to use and understand. May be critical for company that wants quick cash turnaround with weak cash position. Ignores profitability of the project! Ignores the time value of money! SO 2 Describe the cash payback technique.

8.00 years. 3.08 years. 5.00 years. 13.33 years. 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. 8.00 years. 3.08 years. 5.00 years. 13.33 years. $20,000 +12,500 depreciation 32,500 =net annual cash flow $100,000 = Cost of Capital ÷ 32,500 = Net annual cash flow = 3.08 Years cash payback period SO 2 Describe the cash payback technique.

Net Present Value Method The discounted cash flow technique is generally recognized as the best conceptual approach to making capital budgeting decisions. This technique considers both the estimated total cash inflows and the time value of money. Two methods are used with the discounted cash flow technique: 1) Net present value, and 2) Internal rate of return. SO 3 Explain the net present value method.

Net Present Value Method Under the net present value method, cash inflows are discounted to their present value and then compared with the capital outlay required by the investment. The interest rate used in discounting the future cash inflows is the required minimum rate of return. A proposal is acceptable when NPV is zero or positive. The higher the positive NPV, the more attractive the investment. SO 3 Explain the net present value method.

Net Present Value Decision Criteria Illustration 12-6 SO 3 Explain the net present value method.

Present Value of Equal Annual Cash Flows Stewart Soup Company’s annual cash inflows are $24,000. If we assume this amount is uniform over the asset’s useful life, the present value of the annual cash inflows can be computed by using the present value of an annuity of 1 for 10 periods. The computations at rates of return of 12% and 15%, respectively are: Illustration 12-7 SO 3 Explain the net present value method.

Computation of Net Present Values The analysis of the proposal by the net present value method is as follows: Illustration 12-8 The proposed capital expenditure is acceptable at a required rate of return of 12% (not 15%) because the net present value is positive. SO 3 Explain the net present value method.

Present Value of Annual Cash Inflows-Unequal Annual Cash Flows When annual cash inflows are unequal, we cannot use annuity tables to calculate their present value. Instead tables showing the present value of a single future amount must be applied to each annual cash inflow. Illustration 12-9 SO 3 Explain the net present value method.

Analysis of Proposal Using Net Present Value Method Therefore, the analysis of the proposal by the net present value method is as follows: In this example, the present values of the cash inflows are greater than the $130,000 capital investment. Thus, the project is acceptable at both a 12% and 15% required rate of return. Illustration 12-10 SO 3 Explain the net present value method.

Choosing a Discount Rate In most cases the discount rate (required rate of return) is equal to its cost of capital – the amount it must pay to obtain funds from creditors or stockholders. SO 2 Describe the cash payback technique.

Simplifying Assumptions All cash flows come at the end of the year. All cash flows are immediately reinvested in another project that has a similar return. All cash flows can be predicted with certainty. SO 3 Explain the net present value

Review Question $(9,062). $22,511. $9,062. $(22,511). 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%. $(9,062). $22,511. $9,062. $(22,511). Present Value of Cash Flows: $50,000 × 5.65022 = $282,511 Minus capital investment 260,000 Net present value $ 22,511 SO 3 Explain the net present value method.

Additional Considerations – NPV The previous NPV example relied on tangible costs and benefits that can be relatively easily quantified. By ignoring intangible benefits, capital budgeting techniques might incorrectly eliminate projects that could be financially beneficial. A few intangible benefits: Increased quality, and Improved safety. SO 4 Explain the net present value method.

Additional Considerations - NPV To avoid rejecting projects that actually should be accepted, two possible approaches are suggested: Calculate net present value ignoring intangible benefits. Then, if the NPV is negative, ask whether the intangible benefits are worth at least the amount of the negative NPV. Project rough, conservative estimates of the value of the intangible benefits, and incorporate these values into the NPV calculation. SO 4 Identify the challenges presented by intangible benefits in capital budgeting.

Additional Considerations – Intangibles Illustration 12-14 Based on negative NPV the projected is unacceptable. SO 4 Identify the challenges presented by intangible benefits in capital budgeting.

Additional Considerations – Intangibles Illustration 12-15 However, engineers believe buying the machine will improve electrical connections (an intangible benefit ) that may reduce future warranty costs. SO 4 Identify the challenges presented by intangible benefits in capital budgeting.

Additional Considerations - Intangibles Illustration 12-16 SO 4 Identify the challenges presented by intangible benefits in capital budgeting.

The Profitability Index Illustration 12-20 SO 5 Describe the profitability index.

The Profitability Index All projects with NPV should be accepted – in theory. Why aren’t they? Projects are mutually exclusive – only need one new packaging machine. Limited resources. SO 5 Describe the profitability index.

The Profitability Index Illustration 12-17 Illustration 12-18 SO 5 Describe the profitability index.

The Profitability Index Profitability index allows comparison of the relative desirability of projects that require initial investments Illustration 12-20 SO 5 Describe the profitability index.

Review Question Project B. Project A or B. Project A. I give up. 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? Project B. Project A or B. Project A. I give up. Present Value of Net Cash Flows Initial Investment Project A Project B PV of Net Cash Flows 79,600 82,500 Initial Investment 60,000 75,000 Profitability Index 1.33 1.10 SO 5 Describe the profitability index.

Post-Audit of Investment Projects Performing a post-audit is important for a variety of reasons. If managers know that their estimates will be compared to actual results they will be more likely to submit reasonable and accurate data when making investment proposals. A post-audit provides a formal mechanism by which the company can determine whether existing projects should be supported or terminated. Post-audits improve future investment proposals because by evaluating past successes and failures, managers improve their estimation techniques. SO 6 Indicate the benefits of performing a post-audit.

Internal Rate of Return Method The internal rate of return method finds 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 true interest rate involves two steps: STEP 1. Compute the internal rate of return factor using this formula: Illustration 12-22 SO 7 Explain the internal rate of return method.

Internal Rate of Return Method The computation for the Stewart Soup Company, assuming equal annual cash inflows is: $244,371 ÷ $1000,000 = 2.44371 SO 7 Explain the internal rate of return method.

Internal Rate of Return Method STEP 2. Use the factor and the present value of an annuity of 1 table to find the internal rate of return. The internal rate of return is found by locating the discount factor that is closest to the internal rate of return factor for the time period covered by the annual cash flows. For Stewart Soup, the annual cash flows are expected to continue for 3 years. In the table below, the discount factor of 2.44371 represents an interest rate of 11%. SO 7 Explain the internal rate of return method.

Internal Rate of Return Decision Criteria Illustration 12-23 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 the required rate. SO 7 Explain the internal rate of return method.

Comparison of Discounted Cash Flow Methods In practice, the internal rate of return and cash payback methods are most widely used. A comparative summary of the two discounted cash flow methods-net present value and internal rate of return is presented below: Illustration 12-24 SO 7 Explain the internal rate of return method.

Review Question 8%. 10%. 9%. 11. Capital Investment 60,000 A $60,000 project has net cash inflows for 10 years of $9,349. Compute the internal rate of return from this investment. Capital Investment 60,000 Net Annual Cash Flows 9,349 = = 6.4177 8%. 10%. 9%. 11. SO 7 Explain the internal rate of return method.

Annual Rate of Return Formula The annual rate of return technique is based on accounting data. It indicates the profitability of a capital expenditure. The formula is: The annual rate of return is compared with its required minimum rate of return for investments of similar risk. This minimum return is based on the company’s cost of capital, which is the rate of return that management expects to pay on all borrowed and equity funds. SO 8 Describe the annual rate of return method.

Formula for Computing Average Investment Expected annual net income ($13,000) is obtained from the projected income statement. Average investment is derived from the following formula: For Reno, average investment is $65,000: [($130,000 + $0)/2] SO 8 Describe the annual rate of return method.

Solution to Annual Rate of Return Problem The expected annual rate of return for Reno Company’s investment in new equipment is therefore 20%, computed as follows: $13,000 ÷ $65,000 = 20% 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. When choosing among several acceptable projects, the higher the rate of return for a given risk, the more attractive the investment. SO 8 Describe the annual rate of return method.

Review Question Bear Company computes an expected annual net income of $30,000 from an investment . The investment has an initial cost of $200,000 and a terminal value of $20,000. Compute the annual rate of return. Expected Annual Net Income 30,000 Average Investment 110,000 = = 27.3% 15%. 30%. 25%. 27.3%. SO 8 Describe the annual rate of return method.

All About You: The Risks of Adjustable Rates

All About You: The Risks of Adjustable Rates

All About You: The Risks of Adjustable Rates

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