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# ACCT8021-Exam 2 Review- chapter 12 ACCT 8021

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This 11 page Study Guide was uploaded by Doris.Shaw on Monday October 10, 2016. The Study Guide belongs to ACCT 8021 at University of Cincinnati taught by Professor Mintchik in Fall 2016. Since its upload, it has received 24 views. For similar materials see Management Control Systems in Accounting at University of Cincinnati.

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Management Control Systems Review Sheet for the Sec. exam—— Chapter 12. Cost Management and Strategy Part One: Be capable ● To explain the strategic role of capital-investment analysis. A capital investment is a project that involves a large expenditure of funds and expected future benefits over a number of years. - Capital-investment decisions should support the underlying strategy of the organization. - Through well-planned capital investments (strategic analysis), business entities are able to restore profitability, regain or expand market share, respond to changing business climates, reduce costs, improve quality, and strengthen strategic business processes throughout their value chain. ● To describe how accountants can add value to the capital-budgeting process. Capital budgeting is the process of identifying, evaluating, selecting, and controlling capital investments. - 4 contributions that accounting makes to the capital-budgeting process: - Linkage to an organization’s master budget (planning); - Linkage to strategy (planning) and to the organization’s balanced scorecard (control) [Strategic control systems; Multi-criteria decision models;Analytic hierarchy process (AHP)] - Generation of relevant data for investment analysis purposes (decision making); - Conducting post-audits (control) of capital-investment projects. ● To name main discounted and non-discounted models to evaluate the capital budgeting decisions and to explain the main difference between them. Discounted cash flow (DCF) models: represent capital-budgeting decision models that incorporate the present value of future cash flows (the time-value-of-money). → Includes the net present value (NPV) model, the internal rate of return (IRR) model, and the profitability index (PI) model. Non-DCF models: for capital budgeting are those that are not based on the present value of future cash flows. Includes the payback model and the accounting (book) rate of return (ARR) model. Main difference: Whether taking into consideration the time value of money. - (DCF) models evaluate capital-investment projects by converting anticipated future cash flows to a present-value basis. ● To name advantages and limitations of the each of the following methods for analysis of the capital investment: payback period, accounting rate of return, NPV, IRR, MIRR, Profitability Index. See the summary chart below: 1 Management Control Systems Review Sheet for the Sec. exam—— Chapter 12. Cost Management and Strategy Model Definition Formula Advantages Limitations Payback period= Total (Net) 1.fails to consider returns over the initial capital investment÷ 1.Easy to compute and comprehend; entire life of the investment Annual after-tax cash inflows 2.in its unadjusted state, the model an investment is the length 2.Businesspeople have an intuitive ignores the time value of money of time required for the understanding of “payback” periods cumulative after-tax cash When annual cash flows are 3.Payback period can serve as a rough 3.The decision rule for Payback unequal, the payback period accepting/rejecting projects is inflows from an investment must be computed on a year measure of risk—the longer the ill-defined (ambiguous or to recover the initial payback period, the higher the investment outlay. by year basis by subtracting perceived risk subjective) the net cash flow from the 4.Use of this model may encourage unpaid investment balance excessive investment in each year. short-lived projects 1.No adjustment for the time value of money(undiscounted data are used) 2.Decision rule for project Accounting rate of return, acceptance is not well defined 1.Readily available data 3.The ARR measure relies on Ratio of average annual net income to the initial (or ARR = Average annual net 2.Consistency between data for capital accounting numbers, not cash ARR operating income ÷ Average budgeting purposes and data for flows (which is what the market average) investment (book investment (Book Value) subsequent performance evaluation values) value) 4.Depreciation may be calculated several ways and, in addition, other accounting method alternatives may have an impact on reported net income. NPV an investment is equal to 2 Management Control Systems Review Sheet for the Sec. exam—— Chapter 12. Cost Management and Strategy the difference between the PV of after-tax cash inflows 1. Considers the time value of money Can possibly lead to suboptimal present value of the — PV of cash outflows 2. Focuses on after-tax cash flows capital budgeting under condition of project’s cash inflows and 3. Consistent with goal of maximizing capital rationing the present value of the shareholder value project’s cash outflows For uniform cash 1. Inherent assumption regarding 1. Considers time value of money reinvestment rate could be an estimate of the true rate inflows—solving for i in the 2. Focuses on after-tax cash flows unrealistic of return on an investment; following equation: PV IRR as the rate of return that annuity factor for i × Annual 3. Ratios are intuitively appealing to 2. Complex to compute if done managers manually produces an NPV of zero. after-tax cash inflow = Initial investment 3. May not lead to optimum capital budget Rate at which: PV costs PV terminal value, where the left-hand term is the PV of outlays, discounted at the 1. Considers the time value of money 1. Complex to compute, if done is IRR adjusted to account manually for an assumed rate of WACC, and the numerator of 2. Focuses on after-tax cash flows 2. May not lead to optimum capital the right-hand term is the 3. Ratios are intuitively appealing to MIRR return associated with compounded future vale of the managers budget interim project 3. Discrepancy as to whether there interim cash inflows, 4. Avoids overly optimistic rates of cash inflows. reinvested at the WACC, and return associated with the use of IRR is a reinvestment rate assumption inherent in the IRR calculation the denominator is (1+ MIRR)^n, where n= number of periods. Profitability Index, Ratio of PI= PV of after-tax cash 1. Considers time value of money When capital budget is not limited, 2. Focuses on after-tax cash flows PI PV of cash inflows (or, inflows (or NPV) ÷ initial 3. Useful under conditions of capital use could lead to suboptimal capital NPV) to initial investment investment budget rationing 3 Management Control Systems Review Sheet for the Sec. exam—— Chapter 12. Cost Management and Strategy ● To identify the relevant cash inflows and cash outflows as well as the exact timing when this cash inflow and outflow happen (suggested exercises for review: Mendoza case in the slides, 12-28, 12-29). Cash flows for capital-investment analysis must be stated on an after-tax basis. (1) project initiation → Asset Acquisition - Cash outflows: installation costs, to acquire the investment and to begin operations (employee training costs; machine-testing costs). - Incremental net working capital commitments - Cash inflow or outflow, net of tax, associated with the disposal of the asset being replaced. (2) project operation - Outflows: operating expenditures and; additional capital investment(s) after the initial outlay; net of tax - Commitments for additional net working capital needed to support operations. - Operating Inflows of cash (or reductions in cash operating expenses) generated by the investment, and cash released from reductions in net working capital. (3) project disposal → Investment Disposal - End-of-project cash expenses that should be included on an after-tax basis (asset-removal costs, restoration costs, employee-related costs, such as severance pay, relocation costs, retraining costs) - Cash inflows or outflows, net of tax, related to the investment’s disposal. - Cash inflows from the reduction/release of net working capital. - Taxes paid on a gain are treated as a cash outflow; - Taxes saved by the deductibility of a loss are shown as a cash inflow. ● To adjust each relevant cash inflow and outflow for the tax-impact (i.e., be capable to calculate after-tax cash flows) (Suggested exercises: Mendoza case, exercises 12-16, 12-20). (Remember: (i.e., tax-related benefit of depreciation expense, the amount by which depreciation expense decreases the income tax) ➔ Depreciation-related tax shield = Marginal tax rate * Depreciation expense; ➔ After-tax Cash Inflow of Cash Revenue = (1-Marginal tax rate)*Pre-tax Cash Revenue; ➔ After-tax Cash Outflow of Cash Expenses = (1-Marginal tax rate) * Pre-tax Cash Expense. ● To account appropriately in the model for the increased or decreased working capital ( Increased requirements of the working capital are treated as the immediate additional cash outflow in year 0 with the consequent recovery at the end/closure of the project. Decreased requirements of the working capital are treated as the cash inflow in the period in which the decrease 4 Management Control Systems Review Sheet for the Sec. exam—— Chapter 12. Cost Management and Strategy takes place. All cash flows related to working capital do not have any tax-related implications. So, no tax-related adjustments are necessary for cash inflows and cash outflows related to working capital.) 1. Project Operation - After-Tax Cash Operating Receipts: two cash effects: a cash inflow, and a cash outflow represented by the increased income tax liability After-tax cash receipt = Taxable cash receipt * (1- Tax rate) - After-Tax Cash Operating Expenses: two cash effects: a cash outlay, and a reduction of income taxes. After-tax cash expense= Pretax cash expense * (1- Tax rate) - After-Tax Cash Operating Income: combine incremental cash operating revenues (or cost savings) and incremental operating expenses to produce incremental. After-tax cash operating income= Pretax cash operating income * (1- Tax rate) Be aware of: that non-cash revenues (e.g., sales on credit) are cash outflows in the particular year because they generate cash tax liability but not the actual cash inflow; that non-cash expenses are cash inflows in the particular year because they decrease tax liability without the actual cash outflow. - Noncash Revenues: → is effectively a cash outflow. Having tax effects also affect cash flows because of increases tax liability. - Noncash Expenses: → Increases cash flow. An increase in noncash expenses (e.g., depreciation, amortization costs), decreases taxable income, which reduces income taxes for the current period. 2. Project Disposal - Investment Disposal: could trigger a taxable gain or loss. - Any cash received from the disposal of the asset at the end of its life must be adjusted by the tax effect of the transaction. - After-Tax Proceeds from Asset Disposal 5 Management Control Systems Review Sheet for the Sec. exam—— Chapter 12. Cost Management and Strategy 3. Additional Measurement Issues ● Inflation: assuming that cash revenues and expenses are not affected by inflation. But in an actual analysis, would incorporate inflation adjustments for future cash flows: the discount rate that is used in capital-budgeting models is an inflation-adjusted rate. ● Opportunity Costs—Include Them in Your Cash-Flow Analysis. They are always relevant for decision making, including the analysis of proposed capital expenditures. E.g. the opportunity cost is equal to the after-tax amount that the firm could get by selling the land; as such, this amount should be included as a relevant cash flow for capital-budgeting purposes. - Sunk Costs—Ignore These. They are irrelevant for decision-making purposes. - Allocated Overhead Costs—Be Careful of These! The basic rule: ask whether overhead costs (administrative and/or manufacturing) will increase if a given project is accepted, or whether these costs will be largely unaffected in total. In the former case, the incremental overhead should be included (as an after-tax cash outflow) for capital-budgeting purposes. In the latter case, regardless of the amount allocated to the project for accounting purposes, these costs should not be charged against the project for decision-making purposes. ● To explain the essence of the common biases in evaluation of the capital budgeting decisions: escalation commitment, incrementalism, uncertainty intolerance. ➔ Common Behavioral Problems: Cost Escalation, Incrementalism, and Uncertainty Intolerance - Escalating commitments are more likely to occur when current managers are the ones responsible for the negative results of past actions. (essence: manager attempt to recoup past losses, a decision maker may consider past costs or losses as relevant in making capital-budgeting decisions.) - Managers may choose to invest in multiple small additions that require no approval, rather than investing in a major capital project such as computer-integrated manufacturing (CIM) or a flexible manufacturing system (FMS) that would vastly improve the firm’s competitive position. Projects that cost less than those that must be approved as a capital investment are undertaken instead. Failure to make necessary capital investments can reduce the firm’s competitiveness, erode its market share, and jeopardize its long-term profitability and survival. - Intolerance of uncertainty may lead managers to require short payback periods for capital investments. Once a project pays for itself, the amount of risk is substantially reduced. This makes projects with short payback periods the preferred choice to some decision makers. However, many capital investments of strategic import do not have short payback periods. These projects may require a lengthy time to install, test, adjust, train personnel, and gain market acceptance; examples include investments in new manufacturing technologies, new 6 Management Control Systems Review Sheet for the Sec. exam—— Chapter 12. Cost Management and Strategy product development, and expansion into new territories. Requiring too short a payback period makes the acceptance of such projects unlikely, even if the firm would enjoy long-term benefits from these projects. ● To explain the importance of the goal congruence for evaluation of capital budgeting decisions. Importance: Better align the goals of decision makers with the goals of the overall organization, For the manager, the need to align DCF decision models (such as NPV) with models used to evaluate subsequent financial performance. Addressing the goal-congruency problem: conflicts can arise when DCF-based models are used for decision-making purposes and accrual-based accounting income numbers are used subsequently for evaluating the financial performance of managers and organizational subunits. Top management cannot expect goal congruence under these conditions. ➔ Three possible solutions are offered: may help reduce this conflict and achieve greater congruency between the goals of decision makers and the goals of the organization as a whole. 1. Use of Economic Value Added (EVA) 2. Separating Incentive Compensation from Budgeted Performance 3. Use of Post-Audits ● To provide definition of the real options and give examples. Definition: Real options represent flexibilities and/or growth opportunities embedded in capital-investment projects. - /Or options on real assets, which represent investments in both tangible property (e.g., a new manufacturing facility) and intangible property (e.g., a new information system). / ➔ Examples o f Real Options: - Option to Delay Investment Project (i.e., an Investment-Timing Option) - Option to Expand a Profitable Investment Project - Option to Abandon and Investment Project - Option to Curtail or Scale Back an Investment Project Real Options Analysis Complements, Not Replaces, DCF Analysis ● To give example of the four common types of real options (p. 481). (1) the option to expand an investment (i.e., to make follow-on investments if the immediate investment project succeeds); (2) the option to abandon a project on the basis of new information revealed, over time, regarding states of nature that affect projected returns to the project; (3) the option to wait and learn before investing (i.e.the option to delay an investment–some refer to this as an investment-timing option) 7 Management Control Systems Review Sheet for the Sec. exam—— Chapter 12. Cost Management and Strategy (4) the option to scale back the magnitude of a project (e.g., by varying output or its production methods). Real options are analogous to financial options—puts and calls. - Items (1) and (3) are analogous to call options - Items (2) and (4) are similar in nature to put options. Important things to keep in mind: 1. When depreciation expense is calculated according to MACRS, the salvage value is ignored in the calculations. Important terms: NPV, MIRR, IRR, payback period, accounting rate of return, relevant cash flows, after-tax cash flows, working capital, capital rationing, tax shield, sensitivity analysis, profitability index, cost escalation, incrementalism, goal congruence, uncertainty intolerance, real options. A tax shield is the reduction in income taxes that results from taking an allowable deduction from taxable income. A depreciation tax shield is a tax reduction technique under which depreciation expense is subtracted from taxable income. The amount by which depreciation shields the taxpayer from income taxes is the applicable tax rate, multiplied by the amount of depreciation. Sensitivity analysis is the process of selectively varying a key input variable, for example, the discount rate, to identify the range over which a capital-budgeting decision is valid. 8 Management Control Systems Review Sheet for the Sec. exam—— Chapter 12. Cost Management and Strategy Part Two- Calculation; Be capable: ● To calculate the appropriate depreciation expense under the variety of conditions (straight-line depreciation, MACRS, double-declining balance, sum of the years digits, with and without salvage value) to calculate the tax benefit of the particular depreciation expense, to adjust the tax benefit for the “time value” of money (i.e., be capable to calculate present value of the tax benefit or the value of the tax benefit in the particular point of time. ( (Suggested exercises for review: Brief exercises 12-16. 12-19, 12-20, 12-21, 12-22, 12-23, exercise 12-32, 12-35) Annual depreciation (straight-line basis)= Depreciable cost/Useful life in years (note that we are assuming that for tax purposes a salvage value of $0 is assumed ) ● To calculate the appropriate after-tax benefit of the disposal of the particular equipment, adjusted for the present value of money. (Suggested exercises for review: Brief exercise 12-24) ● To calculate future value of the single sum and of the annuity (Suggested exercises for review: brief exercise 12-30) ● To calculate after-tax weighted average cost of capital (Suggested exercises: 12-33, 12-27, example from the textbook.) ➔ The following sources of capital require adjustment for tax effect: regular debt, bonds ( after tax interest rate on debt = (1-marginal tax rate)*pre-tax interest rate . - we need to estimate the current yield ( yield-to-maturity ) of the debt instruments in a company’s capital structure. Thus, use the effective interest rate. After-tax cost of debt = Effective interest rate* (1- t); t= marginal income tax rate ➔ The following sources of capital should not be adjusted for tax-effect: preferred stocks, common stocks. (i.e., they are not the expense from accounting point of view and do not generate any tax benefits) 9 Management Control Systems Review Sheet for the Sec. exam—— Chapter 12. Cost Management and Strategy ● To calculate PV and NPV, using both tables and Excel, for both single amounts and annuities (Suggested exercises: 12-17, 12-18) The net present value (NPV) of an investment is equal to the difference between the present value of the project’s cash inflows and outflows. The present value (PV) of a future cash flow is its current equivalent dollar value, using an appropriate discount rate, using the firm’s WACC. - The decision rule is to accept a proposed investment: • If NPV > 0, accept the project (that is, the project adds to the value of the company) • If NPV < 0, reject the project (that is, the project does not add value to the company) ● To explain what happens with NPV when the discount rate (aka, hurdle rate) or timing of the cash flows changes in certain direction (suggested exercise 12-31). Firm’s WACC as the discount rate for capital-budgeting purposes is appropriate only for average-risk projects. In the situation where a project under consideration exhibits higher or lower risk than average, an adjustment to the firm’s WACC is needed (upwards for higher-risk projects, downwards for lower-risk projects). Individuals refer to a project-specific discount rate as the hurdle rate for a project. They consider this the minimum acceptable rate of return; also referred to as the required rate of return. In order to accept a given capital-investment project, the projected economic return must exceed the “hurdle rate.” ● To calculate IRR using Excel and explain the major limitation of IRR (i.e., reinvestment assumption) that lead to emergence of MIRR. - The decision rule using the IRR model is simple: - Accept an investment: if IRR > discount rate (WACC), meaning that the project has a positive NPV(base the decision on the NPV) - Major limitation of IRR - IRR metric ignores the reinvestment potential of intermediate positive cash flows from a project. - IRR calculations build in reinvestment assumptions that make bad projects look better and good ones look great. Such practice can result in major capital-budgeting distortions. ∴ MIRR is a modification of the conventional IRR measure. - MIRR assumes all positive cash flows are reinvested at a particular rate of return (usually at the WACC) for the remaining duration of the project. ● To calculate the payback period using after-tax cash flows (for both equal and unequal annual cash-flows). (equal) Payback period= Total initial capital investment/Annual after-tax cash inflows 10 Management Control Systems Review Sheet for the Sec. exam—— Chapter 12. Cost Management and Strategy (unequal ) Payback period= 2+ ($204,000/$208,000) years= 2.98 years. ● To calculate the payback period using after-tax cash flows, adjusted for time value of money (for both equal and unequal annual cash-flows). This is the approach that is formally known as “present value payback period” (Suggested exercises: 12-37, 12-38, 12-39). The present value payback period of an investment is the length of time required for the cumulative present value of after-tax cash inflows to recover the initial investment outlay. It relies on the use of discounted cash inflows An important implication: if the discounted payback period is less than the life of the project, then the project must have a positive NPV. ● To calculate accounting rate of return (Suggested exercises: 12-37, 12-39). ARR = Average annual net operating income/Average investment Note that some companies define the denominator of the ARR as the net original investment. ● To calculate profitability index and interpret the results (in-class exercise). ➔ capital rationing (capital constraint) Capital rationing refers to the case where investment capital for a given accounting period is limited— hence the need for these funds to be “rationed.” eg. Many small companies have either self-imposed or externally imposed constraints on their ability to raise capital. Under capital rationing, the appropriate decision rule is: allocate capital to investment projects on the basis of the NPV per dollar of the investment capital associated with each project. PI = NPV/Initial investment - the preference rule is: the higher the profitability index, the more desirable the project. 11

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