ACC 202 Chapter 13
ACC 202 Chapter 13 ACC 202
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This 3 page Class Notes was uploaded by Marissa Sarlls on Sunday January 10, 2016. The Class Notes belongs to ACC 202 at University of Kentucky taught by Jana Wilhelm in Spring 2016. Since its upload, it has received 18 views. For similar materials see Managerial Accounting (202, Wilhelm) in Accounting at University of Kentucky.
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Date Created: 01/10/16
Chapter 13: Capital Budgeting Decisions An overview Capital budgeting—the process of planning significant investments in projects that have long-term implications such as the purchase of new equipment or the introduction of a new product o Four methods: pay-back, net present value, internal rate of return, & simple rate of return o Screening decisions—a decision as to whether a proposed investment project is acceptable o Preference decisions—a decision in which the alternatives must be ranked Capital budgeting decisions: o Cost reduction decisions o Expansion decisions o Equipment selection decisions o Lease or buy decisions o Equipment replacement decisions Typical cash outflows o Initial investment in equipment, other assets, and installation costs Any salvage value realized form the sale of old equipment can be recognized as outflow o Expand Working capital—current assets less current liabilities When a company takes on a new project, the balances in the current assets accounts often increase o Many projects require periodic outlays for repairs & maintenance & additional operating costs Typical cash inflows o A project will normally increase revenues or reduce costs A reduction in costs is equivalent to an increase in revenues o Cash inflows are frequently realized from selling equipment for its salvage value when a project ends o Any working capital that was tied up in the project can be released for use elsewhere at the end of the project Working capital is released when a company sells off its inventory or collects its accounts receivable Time value of money—the concept that a dollar today is worth more than a dollar a year from now o Capital investments that promise earlier cash flows are preferable o Discounting cash flows translates the value of future cash flows to their lesser present value Payback Method Payback period—the length of time that it takes for a project to fully recover its initial cost out of the net cash inflows that it generates (“time it takes for investment to pay for itself”) o When annual net cash inflow is same every year: Payback period= Investment Required AnnualNetCash Inflow o When cash inflows change year to year: o Unrecoveredinvestmentat beginof year∈whichinvestmentis paid off Payback period=¿of yearsup¿theyearinvestmenti s paidoff Cashinflow∈period∈whichinvestmentis paid off o Does not recognize the time value of money Often used in industries where products become obsolete quickly, like electronics If new equipment is replacing old equipment, then any salvage value to be received when disposing of the old equipment should be deducted from the cost of the new equipment, and only the incremental investment should be used in payback computation Any depreciation deducted in arriving at the projects NOI must be added back to obtain the project’s expected annual net cash inflow Net Present Value Method Net present value—the difference between the present value of an investment project’s cash inflows and the present value of its cash outflows o Assume that all cash flows other than the initial investment occur at the end of the periods o Assume that all cash flows generated by an investment project are immediately reinvested at a rate of return equal to the rate used to discount the future cash flows; also known as the discount rate A positive net present value indicates that the project’s return exceeds the discount rate (accept) A negative net present value indicates that the project’s return is less than the discount rate PV of cash flows=Cost×Discountvalue Cost of capital—the average rate of return a company must pay to its long-term creditors and shareholders for the use of their funds o Minimum required rate of return o Cost of capital serves as a screening device NPV method automatically provides for return of the original investment Out-of-pocket costs—actual cash outlays for salaries, advertising, and other operating expenses Total cost approach includes all cash flows associated with each alternative o Most flexible method for comparing competing projects. o All cash inflows and all cash outflows are included in the solution Internal Rate of Return Method Internal rate of return—the discount rate at which the net present value of an investment project is zero; the rate of return of a project over its useful life o Computed by finding the discount rate that equates the PV of the project’s cash outflows with the PV of its cash inflows (aka NPV=0) Investmentcapital o Factor of theinternalrateof return= Annualnetcashinflow If internal rate of return is equal to or greater than required rate of return, project is acceptable Uncertain Cash Flows Intangible benefits such as greater reliability, greater speed, etc. Negativenet presentvalue o Intangiblebenefitsneeded=¿beoffset ¿ Present value factor If NPV is negative, need to determine if machine gives intangible benefits like more sales because it is more efficient, etc. The Ranking of Investment Projects Sometimes preference decisions are called rationing decisions, or ranking decisions When using the internal RofR method to rank competing investment projects, the preference rule is: The higher the internal RofR, the more desirable the project Project profitability index—ratio of the NPV of a project’s cash flows to the investment required NPV of project o Project profitabilityindInvestmentrequired o PPI= PV o f futurecashinflows−Investmentrequired Investmentrequired o The higher the PPI, the more desirable the project o Investment required refers to any cash outflows that occur at the beginning of the project, reduced by any salvage value recovered from the sale of old equipment Also includes any investments in working capital that the project may need Simple Rate of Return Method Simple rate of return—the rate of return computed by dividing a project’s annual incremental accounting net operating income by the initial investment required o Simple RofR=Annualincremental NOI Initialinvestment o The annual incremental NOI included in the numerator should be reduce by the depreciation charges that result from making the investment o The initial investment should be reduced by any salvage value realized from sale of old equipment o Focuses on accounting NOI rather than cash flows Postaudit Postaudit—the follow-up after a project has been approved and implemented to determine whether expected results were actually realized Data used in postaudit analysis should be actual observed data **Charts: Chart with numbers less than 1 are for one year periods (year 1, year 5, etc). nd Years 1-5 use 2 chart with numbers greater than 1. More vocabulary: Annuity—a series of identical cash flows Compound interest—the process of paying interest on interest in an investment Discount rate—the rate of return that is used to find the present value of a future cash flow Discounting—the process of finding the present value of a future cash flow Present value—the value now of an amount that will be received in some future period
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