COST MANAGEMENT Accounting & Control Hansen▪Mowen▪Guan COPYRIGHT © 2009 South-Western Publishing, a division of Cengage Learning. Cengage Learning and South-Western are trademarks used herein under license. 1 Chapter 20 Capital Investment

2 Study Objectives 1.Describe the difference between independent and mutually exclusive capital investment decisions. 2.Explain the roles of the payback period and accounting rate of return in capital investment decisions. 3.Calculate the net present value (NPV) for independent projects. 4.Compute the internal rate of return (IRR) for independent projects. 5.Tell why NPV is better than IRR for choosing among mutually exclusive projects. 6.Convert gross cash flows to after-tax cash flows. 7.Describe capital investment for advanced technology and environmental impact settings.

3 Capital Investment Decisions Capital investment decisions are concerned with –The planning process of planning –Setting goals and priorities –Arranging financing –Using certain criteria to select long-term assets

4 Capital Investment Decisions Capital budgeting –The process of making capital investment decisions Types of capital budgeting projects –Independent projects Projects that, if accepted or rejected, will not affect the cash flows of another project. –Mutually exclusive projects Projects that, if accepted, preclude the acceptance of competing projects.

5 Payback and Accounting Rate of Return: Nondiscounting Methods Payback Analysis * At the beginning of Year 3, $60,000 is needed to recover the investment. Since a net cash inflow of $100,000 is expected, only 0.6 year ($60,000 ÷ $100,000) is needed to recover the $60,000. Thus, the payback period is 2.6 years ( ).

6 Payback and Accounting Rate of Return: Nondiscounting Methods Provides information than can: –Help control the risks associated with the uncertainty of future cash flows. –Help minimize the impact of an investment on a firm’s liquidity problems. –Help control the risk of obsolescence. –Help control the effect of the investment on performance measures. Deficiencies: –Ignores the time value of money –Ignores the performance of the investment beyond the payback period Payback Analysis

7 Accounting Rate Of Return (ARR) Payback and Accounting Rate of Return: Nondiscounting Methods Average annual net cash flows, less average depreciation Average investment (I + S) ÷ 2 I = original investment S = salvage value Major deficiency: ignores the time value of money

8 NPV = P – I where: P= the present value of the project’s future cash inflows I =the present value of the project’s cost (usually the initial outlay) Net present value is the difference between the present value of the cash inflows and outflows associated with a project. The Net Present Value Method The NPV model assumes that all cash flows generated by a project are immediately reinvested.

9 Polson Company has developed a new cell phone that is expected to generate an annual revenue of $750,000. Necessary production equipment would cost $800,000 and can be sold in five years for $100,000. Working capital is expected to increase by $100,000 and is expected to be recovered at the end of five years. Annual operating expenses are expected to be $450,000. The required rate of return is 12 percent. The Net Present Value Method

10 The Net Present Value Method

11 The Net Present Value Method c difference due to rounding

12 If NPV > 0: 1. The initial investment has been recovered 2. The required rate of return has been recovered For the cell phone project, NPV = $294,600 Polson should manufacture the cell phones. Decision Criteria for NPV The Net Present Value Method

13 The internal rate of return (IRR) is the interest rate that sets the project’s NPV at zero. Thus, P = I for the IRR. Internal Rate of Return Example:A project requires a $240,000 investment and will return $99,900 at the end of each of the next three years. What is the IRR? $240,000 =$99,900( df ) $240,000 ÷ $99,900 =2.402 i =12%

14 If the IRR > Cost of Capital, accept the project If the IRR = Cost of Capital, accept or reject If the IRR < Cost of Capital, reject the project Decision Criteria: Internal Rate of Return

15 NPV versus IRR: Mutually Exclusive Projects Two major differences between net present value and the internal rate of return: –Reinvestment of cash inflows NPV assumes reinvestment at the required rate of return IRR assumes reinvestment at the internal rate of return –Measurement of profitability NPV measures profitability in absolute dollars IRR measures profitability as a percentage

16 NPV versus IRR: Mutually Exclusive Projects

17 NPV versus IRR: Mutually Exclusive Projects a $1,440,000 + [(1.20 x $686,342) - (1.08 x $686,342)]. This last term is what is needed to repay the capital and its cost at the end of Year 2. b $686,342 + (1.20 x $686,342).

18 Annual revenues$240,000$300,000 Annual operating costs120,000160,000 System investment360,000420,000 Project life5 years5 years Milagro Travel Agency Example Standard T2 Custom Travel The cost of capital is 12 percent NPV versus IRR: Mutually Exclusive Projects

19 NPV versus IRR: Mutually Exclusive Projects

20 NPV versus IRR: Mutually Exclusive Projects

21 NPV versus IRR: Mutually Exclusive Projects

22 Computing After-Tax Cash Flows Steps in computing cash flows –Forecast revenues, expenses, and capital outlays –Adjust cash flows for inflation and tax effects The cost of capital is composed of two elements –The real rate –The inflationary element

23 Disposition of Old Machine Book Value Sale Price M1$ 600,000$ 780,000 M21,500,0001,200,000 Acquisition of Flexible System Purchase cost$7,500,000 Freight60,000 Installation600,000 Additional working capital 540,000 Total$8,700,000 Computing After-Tax Cash Flows

24 a Sale price minus book value is $780,000 - $600,000. b Sale price minus book value is $1,200,000 - $1,500,000. Computing After-Tax Cash Flows

25 The two machines are sold: Sales price, M1$ 780,000 Sales price, M21,200,000 Tax savings 48,000 Net proceeds$2,028,000 The net investment is: Total cost of flexible system$8,700,000 Less: Net proceeds 2,028,000 Net investment (cash outflow)$6,672,000 Computing After-Tax Cash Flows

26 A company plans to make a new product that requires new equipment costing $1,600,000. The new product is expected to increase the firm’s annual revenue by $1,200,000. Materials, labor, etc. will be $500,000 per year. Revenues$1,200,000 Less:Cash operating expenses(500,000) Depreciation (straight-line) (400,000) Income before income taxes$ 300,000 Less:Income taxes (40%) (120,000) Net income$ 180,000 The income statement for the project is as follows: Computing After-Tax Cash Flows After-Tax Operating Cash Flows: Life of the Project

27 Revenues × (1 - tax rate)$720,000 –Cash expenses × (1 - tax rate)(300,000) +Noncash expenses × tax rate*160,000 =Cash Flow$580,000 After-Tax Operating Cash Flows: Life of the Project Computing After-Tax Cash Flows *Non-cash expenses shield revenues from taxation, thus generating cash flows (i.e., cash savings)

28 The tax laws classify most assets into three classes (class = allowable years): ClassTypes of Assets 3Most small tools 5Cars, light trucks, computer equipment 7Machinery, office equipment Assets in any of the three classes can be depreciated using either straight-line or MACRS (Modified Accelerated Cost Recovery System) with a half-year convention. MACRS Depreciation Computing After-Tax Cash Flows

29 Computing After-Tax Cash Flows MACRS Depreciation –Half the depreciation for the first year can be claimed regardless of when the asset is actually placed in service. –The other half year of depreciation is claimed in the year following the end of the asset’s class life. –If the asset is disposed of before the end of its class life, only half of the depreciation for that year can be claimed.

30 Computing After-Tax Cash Flows

31 A company is evaluating a potential investment in a flexible manufacturing system (FMS). The choice is to continue producing with its traditional equipment, expected to last 10 years, or to switch to the new system, which is also expected to have a useful life of 10 years. The company’s discount rate is 12 percent. Present value ($4,000,000 × 5.65)$22,600,000 Investment 18,000,000 Net present value$ 4,600,000 How Estimates of Operating Cash Flows Differ Capital Investment: Advanced Technology and Environmental Considerations

32 Capital Investment: Advanced Technology and Environmental Considerations

33 Capital Investment: Advanced Technology and Environmental Considerations

34 Future Value Let: F= future value i= the interest rate P= the present value or original outlay n= the number or periods Present Value Concepts Future value can be expressed by the formula: F = P(1 + i) n

35 Assume the investment is $1,000. The interest rate is 8%. What is the future value if the money is invested for one year? Two? Three? Present Value Concepts Future Value F=$1,000(1.08)=$1, (after one year) F=$1,000(1.08) 2 =$1, (after two years) F=$1,000(1.08) 3 =$1, (after three years)

36 P = F/(1 + i) n The discount factor df, 1/(1 + i), is computed for various combinations of i and n. P = F (df) Present Value Concepts Present Value Compute the present value of $300 to be received three years from now. The interest rate is 12%. From Exhibit 20B-1, the discount factor is The present value (P) is: P= F (df) = $300 × = $213.60

37 Present Value Concepts

COST MANAGEMENT Accounting & Control Hansen▪Mowen▪Guan COPYRIGHT © 2009 South-Western Publishing, a division of Cengage Learning. Cengage Learning and South-Western are trademarks used herein under license. 38 End Chapter 20