Chapter 8 Capital Asset Selection and Capital Budgeting.

Slides:



Advertisements
Similar presentations
Capital Budgeting.
Advertisements

Capital Budgeting Chapter 12. Capital budgeting: process by which organization evaluates and selects long-term investment projects – Ex. Investments in.
MANAGERIAL ACCOUNTING
Copyright © 2008 Prentice Hall All rights reserved 9-1 Capital Investment Decisions and the Time Value of Money Chapter 9.
Capital Investment Analysis
COST MANAGEMENT Accounting & Control Hansen▪Mowen▪Guan COPYRIGHT © 2009 South-Western Publishing, a division of Cengage Learning. Cengage Learning and.
© John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1eSlide # 1 Cost Management Measuring, Monitoring,
Capital Investments Chapter 12. Capital Budgeting How managers plan significant outlays on projects that have long-term implications such as the purchase.
Capital Investment Analysis ACG 2071 Module 12 Chapter 25 Fall 2007.
CAPITAL BUDGETING TECHNIQUES
Capital Budgeting Net Present Value Rule Payback Period Rule
Chapter 9 Net Present Value and Other Investment Criteria
Kinney ● Raiborn Cost Accounting: Foundations and Evolutions, 9e © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated,
Acct Chapter 10 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of.
Chapter Fourteen Capital Investment Decisions COPYRIGHT © 2012 Nelson Education Ltd.
11-1 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Capital Investment Decisions 11 PowerPresentation® prepared by David J. McConomy,
Capital Budgeting and Cost Analysis
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Chapter 11 Capital Budgeting.
CAPITAL BUDGETING AND CAPITAL BUDGETING TECHNIQUES FOR ENTERPRISE Chapter 5.
Financial and Managerial Accounting
©The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin Chapter Ten Planning for Capital Investments.
PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA Copyright.
WHY DIDN’T I THINK OF THAT? What does every baseball player need to complete the uniform? A cap. What a business opportunity for C&C Sports! Or is it?
4 C H A P T E R Capital Investment Decisions.
Chapter 3 – Opportunity Cost of Capital and Capital Budgeting
C Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.
Long-Term Investment Decisions
Capital expenditure decisions: an introduction
Kinney ● Raiborn Cost Accounting: Foundations and Evolutions, 8e © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated,
ACCTG101 Revision MODULES 10 & 11 TIME VALUE OF MONEY & CAPITAL INVESTMENT.
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Chapter 11 Capital Budgeting.
Chapter 21 Capital Budgeting and Cost Analysis. Project and Time Dimensions of Capital Budgeting.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license.
8- 1  2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young Capital Budgeting Chapter 8.
Long-Term (Capital Investment) Decisions
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 26 Capital Investment Decisions
©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Capital Budgeting Chapter 11.
Capital Budgeting Decisions
Capital & Capital Budgeting
Capital Budgeting The Capital Budgeting Decision Time Value of Money Methods of Capital Project Evaluation Cash Flows Capital Rationing The Value of a.
C H A P T E R 4 Capital Investment Decisions Capital Investment Decisions.
0 CHAPTER 10 Long-Term (Capital Investment) Decisions © 2009 Cengage Learning.
Chapter 14 Capital Budgeting Cost Accounting Foundations and Evolutions Kinney, Prather, Raiborn.
T9.1 Chapter Outline Chapter 9 Net Present Value and Other Investment Criteria Chapter Organization 9.1Net Present Value 9.2The Payback Rule 9.3The Discounted.
Chapter 8 Long-Term (Capital Investment) Decisions.
McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-1 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights.
Warren Reeve Duchac Accounting 26e Capital Investment Analysis 26 C H A P T E R human/iStock/360/Getty Images.
Chapter 15 Capital Budgeting Cost Accounting Foundations and Evolutions Kinney and Raiborn Seventh Edition COPYRIGHT © 2009 South-Western, a part of Cengage.
19-1 Capital Investment Payback and Accounting Rate of Return: Nondiscounting Methods 2 Payback Period: the time required for a firm to recover.
Accounting 4310 Appendix Capital Investment Decisions.
20-1 HANSEN & MOWEN Cost Management ACCOUNTING AND CONTROL.
Capital Budgeting. Typical Capital Budgeting Decisions Capital budgeting tends to fall into two broad categories...  Screening decisions. Does a proposed.
1 Chapter Nine Capital Budgeting. 2 Capital Budgeting Decisions require sizable commitments of cash. are expected to generate returns that will last more.
CHAPTER 10 PowerPoint Author: LuAnn Bean, Ph.D., CPA, CIA, CFE Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution.
©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Capital Budgeting Chapter 11.
CHAPTER © jsnyderdesign / iStockphoto 9 CAPITAL BUDGETING.
Needles Powers Crosson Financial and Managerial Accounting 10e Capital Investment Analysis 24 C H A P T E R © human/iStockphoto ©2014 Cengage Learning.
CAPITAL BUDGETING DECISIONS CHAPTER Typical Capital Budgeting Decisions Plant expansion Equipment selection Equipment replacement Lease or buy Cost.
Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith.
Live as if you were to die tomorrow & Learn as if you were to live for ever.
26-1 Preview of Chapter 26 Financial and Managerial Accounting Weygandt Kimmel Kieso.
© John Wiley & Sons, 2011 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 2eSlide # 1 Cost Management Measuring, Monitoring,
PROBLEM SOLVING.
Capital Budgeting 2 2.
Long-Term (Capital Investment) Decisions
Other Long-Run Decisions
Capital Budgeting Decisions
PLANNING FOR CAPITAL INVESTMENTS
Presentation transcript:

Chapter 8 Capital Asset Selection and Capital Budgeting

1. How do managers choose which capital projects to fund? 2. Why do most capital budgeting methods rely on analysis of cash flows? 3. What are the differences among payback period, the net present value method, profitability index, and internal rate of return? C8 Learning Objectives

4. How do the underlying assumptions and limitations of each capital project evaluation method affect its use? 5. How do taxes and depreciation methods affect cash flows? C8 Continuing... Learning Objectives

6. Why are quality management, training, and research and development controlled largely by capital budget analyses? 7. Why do managers occasionally need to quantify qualitative information in making capital budgeting decisions? C8 Continuing... Learning Objectives

8. Why are environmental issues becoming an increasingly important influence on the capital budget? 9. How and why should management conduct a post-investment audit of a capital project? C8 Continuing... Learning Objectives

10.What calculations are necessary to control for the time value of money? (Appendix 1) 11.How is the accounting rate of return for a project determined? (Appendix 2) C8 Continuing... Learning Objectives

Capital Assets Lease Nuclear Power Plant Copy Machine

Capital Budgeting Is Capital budgeting is the process of evaluating long-range investment proposals for the purpose of allocating limited resources effectively and efficiently.

Capital Budgeting Questions Is the activity worth the investment? Which assets can be used for the activity? Of the suitable assets, which are the best investments? –Screening decision –Preference decision Which of the best investments should the company choose? –Mutually exclusive projects –Independent projects –Mutually inclusive projects

Cash Flows Cash receipts and disbursements that arise from the purchase, operation, and disposition of capital assets Cash receipts –Project revenues that have been earned and collected –Savings generated by reduced project operating costs –Inflows from asset’s sale and release of working capital at end of asset’s useful life Cash disbursements –Expenditures to acquire asset –Additional working capital investments –Amounts paid for related operating costs

Interest It should not be considered in project evaluation. Interest is a cash flow created by the method of financing a project.

Return of Capital vs. Return on Capital Return of Capital Recovery of original investment Return on Capital Income for each investment period = Interest included in receipt or payment

Use a Timeline to Determine Cash Flows t0 Cash In Cash Out Time Point t1t2t3t4 Net Cash Flow $500 $500 $500 $500

Payback Period The longer it takes to recover the initial investment, the greater is the project’s risk Management sets a maximum acceptable payback period Often used as a screening technique A measure of the time it will take a project’s cash inflows to equal the original investment

Assumptions of Payback Period Speed of investment recovery is the key consideration Timing and size of cash flows are accurately predicted Risk (uncertainty) is lower for a shorter payback project

Purchase of Machine Example Machine costs $60,000 Will be used to produce and sell 3,000 units per year at $14 for the next 5 years Variable costs are $5 per unit Annual fixed costs are $5,000 Cutoff rate of 12 percent All revenues and costs are in cash amounts

Annual Incremental Cash Inflows

Payback Period Payback Period = Investment required  Annual cash returns = $60,000  $22,000 = 2.7 years

Limitations of Payback Period Ignores cash flows after payback Basic method treats cash flows and project life deterministically without explicit consideration of probabilities Ignores time value of money Cash flow pattern preferences are not explicitly recognized

Discounted Cash Flow Methods Net present value (NPV) Profitability index (PI) Internal rate of return (IRR)

Net Present Value Method Accept if: –If NPV = 0, actual ROR = desired ROR –If NPV > 0, actual ROR > desired ROR Reject if: –If NPV < 0, actual ROR < desired ROR Does not determine expected ROR Determines whether the rate of return (ROR) on a project is equal to, higher than, or lower than the desired ROR

Remember! Changing discount rate affects NPV Changing timing and size of cash flows affects NPV NPV can be used to select the best project when choosing among investments that can perform the same task or achieve the same objective NPV should not be used to compare independent investment projects that do not have approximately the same original asset cost or asset life

Net Present Value Example

Assumptions of Net Present Value Discount rate used is valid Timing and size of cash flows are accurately predicted Life of project is accurately predicted If the shorter-lived of two projects is selected, the proceeds of that project will continue to earn the discount rate of return through the theoretical completion of the longer-lived project

Limitations of Net Present Value Basic method treats cash flows and project life deterministically without explicit consideration of probabilities NPV does not measure expected rates of return on projects being compared Cash flow pattern preferences are not explicitly recognized IRR of project is not reflected

Profitability Index Compares projects with different costs PI should be at least equal to 1.0 Gauges the firm’s efficiency at using its capital Does not indicate expected ROR Ratio that compares present value of net cash inflows with present value of net investment

Continuing... Profitability Index PV of Cash Flows Profitability Index (PI) = Investment required $79,310 = =1.3 $60,000

Assumptions of Profitability Index Same as NPV Size of PV of net inflows relative to size of PV of investment measures efficient use of capital

Limitations of Profitability Index Same as NPV Gives a relative answer but does not reflect dollars of NPV

Internal Rate of Return Is the project’s expected rate of return The discount rate where PV of net cash flows = cost of project –Discount rate where NPV = 0 IRR compared with hurdle rate(which is the lowest acceptable return on investment) Acceptable if IRR > hurdle rate

Internal Rate of Return Discount factor = PV of future flows/Annual cash flows Discount factor = $60,000/$22,000 = 2.7 The factor of 2.7 corresponds to an interest rate between 24 and 25 percent when the number of periods is five. The IRR is between 24 and 25 percent.

Assumptions of IRR Hurdle rate is valid Timing and size of cash flows are accurately predicted Life of project is accurately predicted If the shorter-lived of two projects is selected, the proceeds of that project will continue to earn the IRR through the theoretical completion of the longer-lived project

Limitations of IRR Projects are ranked for funding based on IRR rather than dollar size Does not reflect dollars of NPV Basic method treats cash flows and project life deterministically without explicit consideration of probabilities Cash flow pattern preferences are not explicitly recognized It is possible to calculate multiple rates of return on the same project

The Effect of Taxation On Cash Flows Managers should use after-tax cash flows to determine project’s acceptability Depreciation expense is a tax shield for revenues –Tax benefit equal to depreciation amount multiplied by tax rate Type of depreciation method affects amount of annual taxable income Tax laws can change every year; use most current regulations Tax rates and tax related asset lives may also change; use most current information

Annual Incremental After-Tax Cash Inflows

Payback Period Payback Period = Investment required  Annual cash returns = $60,000  $18,000 = 3.3 years

Net Present Value of After-Tax Example

Profitability Index PV of Cash Flows Profitability Index (PI) = Investment required $64,890 = =1.1 $60,000

Internal Rate of Return Discount factor = PV of future flows/Annual cash flows Discount factor = $60,000/$18,000 = The factor of corresponds to an interest rate between 14 and 16 percent when the number of periods is five. The IRR is between 14 and 16 percent.

Uneven Cash Flows Now, assume that the salvage value in the example is $5,000 at the end of the fifth year.

Summary of Present Value of Investment

Net Present Value of Salvage Value Example

High-Tech Investments The decision is more a question of “how much” and “when” than “whether” Generally requires massive monetary investment

Possible Reasons for Not Investing –Worker displacement –Morale problems –Implementation problems –Computers not considered competitive assets –Difficult to justify investment using traditional analyses

Considerations in High-Tech Investment Analysis Discount or hurdle rate may need to be set lower Both quantitative and qualitative benefits need to be considered –Quality improvements –Shortened delivery time –Improved competitive position High-tech investments are not “free-standing” Opportunity cost of not acquiring automated equipment is often critical

Post-Investment Audit Complete after project has stabilized Use same analysis techniques as used for original decision to accept project Used to pinpoint areas of operation not in line with expectations Helps evaluate accuracy of original cost/benefit predictions Compare actual project results with expected results

Accounting Rate of Return (ARR) Not based on cash flows Compared with hurdle rate which may be higher than the discount rate Compared with ARR of other projects Measures the expected rate of earnings obtained on the average capital investment over a project’s life

Continuing... Accounting Rate of Return (ARR) Average Annual Income from Project ARR = Average Investment in Project $22,000 - ($60,000/5) Before Taxes= =33.3% ($60,000 - $0)/2 $18,000 - ($60,000/5) After Taxes= =20.0% ($60,000 - $0)/2

Assumptions of ARR Effect on company accounting earnings relative to average investment in a project is a key consideration Size and timing of investment cost, project life, salvage value, and increases in earnings can be accurately predicted

Limitations of ARR Ignores cash flows Ignores time value of money Treats earnings, investment, and project life deterministically without explicit consideration of probabilities