Chapter 9 "Budgeting Decisions" Notes
Chapter 9 "Budgeting Decisions" Notes ACCT 2102
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This 5 page Class Notes was uploaded by Breana Carey on Thursday April 7, 2016. The Class Notes belongs to ACCT 2102 at Georgia State University taught by Kathleen S. Partridge (P) in Fall 2015. Since its upload, it has received 143 views. For similar materials see PRIN OF ACCT II in Accounting at Georgia State University.
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Date Created: 04/07/16
Accounting 2102: Chapter 9 "Capital Budgeting" Thursday, April 7, 2016 23:38 Capital Budgeting Decisions Capital Budgeting is the process of evaluating a organizations investment in the long run o w/capital budgeting we look more into the future, usually 5-10 years Investing capital assets: Capital assets are those assets that are expected to provide economic benefit for several years (usually listed under property, plant and equipment) 2 kinds of return are to be expected w/a long term asset Return Of Investment: means recouping the original investment -- getting your money back Return on Investment: means that you'll get over and above what you put into the investment. a. (i.e You spend 60$ on a investment and you yet back 80$ you've earned a 20$ return on investment) Making Capital Budgeting Choices: Many large companies have a large committee to review their choices because of the amount of money those projects require. 2 Kinds of capital budgeting choices: 1. Screening Decision: a proposed project is compared to its performance benchmarks to determine whether the project should be continued o The minimum required rate of return is called the Hurdle Rate 2. Preference Decision: managers determine which project will actually receive funds by rank ordering them based on selected criteria. Most capital budgeting decisions are based on cash flows, depreciation is not included because depreciation is not a cash flow. Time Value of Money: Present Value of 1$ A dollar received today is worth more than a dollar received anytime into the future because it can be invested today and earn additional money The process where you determine how much money to be received in the future is worth today is called discounting. The discounted amount is the present value of the future amount AKA Discount Rate Calculating present value: You need to know 3 things: (1) the future amount to be received (2) the interest rate an (3) when the future amount will be received Present value means you calculate by multiplying the number by the PVF PVF = Future Value x Present Value The discount rate will change with the period that you decide Interest can be discounted daily, annually, semi- annually and quarterly. The discount rate at present value The relationship between the discount rate is inversely related when the discount rate then the present value will Present Value of a Annuity While some investments need a lump sum of money others will create a general flow of payments Annuity: is a stream of equal cash flows received at equal time intervals. Net Present Value The net present value approach (NPV) requires that you calculate the present value of each cash flow then you add or 'net' those present values to arrive at projects next capital value Steps: 1. Identify an get the amount of each cash flows 2. Determine the appropriate discount rate The appropriate discount rate will change from company to company The discount rate is the average of the company's interest rate on borrowed funds Two other factors that affect discount rate are (1) the finance theory states that risks and rate of return are positively related meaning that if risks then the rate of return will as well (2) a discount rate should increase if inflation is expected to happen over the life of the project 3. Calculate the present value of each cash flow You need to multiply the present value and multiply the right value factor 4. Calculate the net present value Once you've the calculated the present value then you add them together to get a net value of the project. Internal Rate of return: Internal rate of return is the actual rate of return expected on a project. The internal rate of return (IRR) considers the amount to be earned on the project. Compared to the discount rate if it is equal or greater than we should accept the proposal. NOTE: When projects rate of return equals the discount rate than the NPV equals 0 Projects with even cash flows are a little easier to calculate, you need this formula The net initial investment is the net cash flow in year 0 1 Solve the present value of a annuity factor that equals 0 2 Look for the present value factor on the annuity table. The column where the present value factor is located is your internal rate of return. Projects with uneven cash flows are more difficult to solve because projects with uneven cash flows can't use the annuity table and essentially you have to use trial and error to understand what discount rate to use that will bring out NPV to 0 Screening and Preference Decisions: Profits with different sizes can be evaluated using the profitability index which compares the NPV project cash flows to the present value of the net initial investment. The project with the highest profitability index is the preferred project. o Other Capital Budgeting Techniques Payback period The payback period is the time it takes in years for a investment to return back to the original amount invested in capital Projects with even cash flows payback period is calculated by Projects with uneven cash flows are calculated by adding up all the annual cash flows until the cumulative total cash flows equal net investment Accounting Rate of return Accounting rate of return means that the return generated by an investment based on its net operating income. NOTE: this method doesn’t go by cash flows Accounting rate of return is calculated by calculating all of the additional revenues generated by the investment and then subtracting all additional operating expenses NOTE: If the project doesn’t have a stable operating income then you would do average annual net operating income/the total life of the project
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