Accounting 210 Chapter 12 Notes
Accounting 210 Chapter 12 Notes ACCT210
Popular in Managerial Accounting
verified elite notetaker
Popular in Accounting
This 11 page Class Notes was uploaded by Kristin Koelewyn on Monday April 25, 2016. The Class Notes belongs to ACCT210 at University of Arizona taught by Heather Altman in Spring 2016. Since its upload, it has received 13 views. For similar materials see Managerial Accounting in Accounting at University of Arizona.
Reviews for Accounting 210 Chapter 12 Notes
Report this Material
What is Karma?
Karma is the currency of StudySoup.
You can buy or earn more Karma at anytime and redeem it for class notes, study guides, flashcards, and more!
Date Created: 04/25/16
Accounting 210: Chapter 12 Notes Planning for Capital Investments - Describe Capital Budgeting Inputs and Apply the Cash Payback Technique: o Corporate capital budget authorization process: ▯ 1.Proposals for projects are requested from each department. ▯ 2.Proposals are screened by a capital budget committee. ▯ 3. Officers determine which projects are worthy of funding. ▯ 4.Board of directors approves capital budget. - Authorization Process: o Many companies follow a carefully prescribed process in capital budgeting. - Cash Flow Information: o For purposes of capital budgeting, estimated cash inflows and outflows are the preferred inputs. o Ultimately, the value of all financial investments is determined by the value of cash flows received and paid. o Cash Outflows: ▯ Initial investment ▯ Repairs and maintenance ▯ Increased operating costs ▯ Overhaul of equipment o Cash Inflows: ▯ Sale of old equipment ▯ Increased cash received from customers ▯ Reduced cash outflows related to operating costs ▯ Salvage value of equipment o Capital Budgeting Decisions Depend on: ▯ 1.Availability of funds. ▯ 2.Relationships among proposed projects. ▯ 3.Company’s basic decision-making approach. ▯ 4.Risk associated with a particular project. - Illustrative Data: o Stewart Shipping Company is considering an investment of $130,000 in new equipment. o Cash Payback ▯ Cash payback technique identifies the time period required to recover the cost of the capital investment from the net annual cash inflow produced by the investment. o Cash Payback for Stewart is: $130,000 / $24,000 = 5.42 years o Shorter payback period = More attractive the investment o In the case of uneven net annual cash flows, the company determines the cash payback period when the: ▯ Cumulative net cash flows from the investment = Cost of the investment o Illustration: Chen Company proposes an investment in a new website that is estimated to cost $300,000. ▯ Cash payback should not be the only basis for the capital budgeting decision as it ignores the expected profitability of the project. o Question: A $100,000 investment with a zero scrap value has an 8- year life. Compute the payback period if straight-line depreciation is used and net income is determined to be $20,000. ▯ A. 8.00 years ▯ B. 3.08 years ▯ C. 5.00 years ▯ D. 13.33 years o DO IT: Watertown Paper Corporation is considering adding another machine for the manufacture of corrugated cardboard. The machine would cost $900,000. It would have an estimated life of 6 years and no salvage value. The company estimates that annual cash inflows would increase by $400,000 and that annual cash outflows would increase by $190,000. Compute the cash payback period. - Use the Net Present Value Method: o Discounted cash flow technique: ▯ Generally recognized as the best approach. ▯ Considers both the estimated total cash inflows and the time value of money. ▯ Two methods: • (NPV). • (IRR). o Cash inflows are discounted to their present value and then compared with the capital outlay required by the investment. o The interest rate used in discounting is the required minimum rate of return. o Proposal is acceptable when NPV is either zero or positive. o The higher the positive NPV, the more attractive the investment. - Equal Annual Cash Flows: o Illustration: Stewart Shipping Company’s annual cash flows are $24,000. If we assume this amount is uniform over the asset’s useful life, we can compute the present value of the net annual cash flows. o Calculate the present value: ▯ The proposed capital expenditure is acceptable at a required rate of return of 12% because the net present value is positive. - Unequal Annual Cash Flows: o Illustration: Stewart Shipping Company expects the same total net cash flows of $240,000 over the life of the investment. Because of a declining market demand for the new product the net annual cash flows are higher in the early years and lower in the later years. o Calculate the net present value: ▯ Proposed capital expenditure is acceptable at a required rate of return of 12% because the net present value is positive. - Choosing a Discount Rate: o In most instances a company uses a required rate of return equal to its cost of capital — that is, the rate that it must pay to obtain funds from creditors and stockholders. o Discount rate has two elements: o Cost of Capital o Risk o Illustration: Stewart Shipping used a discount rate of 12%. Suppose this rate does not take into account the risk of the project. A more appropriate rate might be 15%. - Simplifying Assumptions: o All cash flows come at the end of each year. o All cash flows are immediately reinvested in another project that has a similar return. o All cash flows can be predicted with certainty. - NPV Method Question: Compute the net present value of a $260,000 investment with a 10-year life, annual cash inflows of $50,000 and a discount rate of 12%. o A. $(9,062) o B. $22,511 o C. $9,062 o D. $(22,511) - Comprehensive Example: o Best Taste Foods is considering investing in new equipment to produce fat-free snack foods. o Compute the net annual cash flow: o DO IT: Watertown Paper Corporation is considering adding another machine for the manufacture of corrugated cardboard. The machine would cost $900,000. It would have an estimated life of 6 years and no salvage value. The company estimates that annual cash inflows would increase by $400,000 and that annual cash outflows would increase by $190,000. Management has a required rate of return of 9%. Calculate the net present value on this project and discuss whether it should be accepted. ▯ Calculate the net present value on this project and discuss whether it should be accepted. - Intangible Benefits: o Intangible benefits might include increased quality, improved safety, or enhanced employee loyalty. o To avoid rejecting projects with intangible benefits: ▯ 1.Calculate net present value ignoring intangible benefits. ▯ 2.Project rough, conservative estimates of the value of the intangible benefits, and incorporate these values into the NPV calculation. o Example: Berg Company is considering the purchase of a new mechanical robot. o Berg would accept the project. - Profitability Index for Mutually Exclusive Projects o Proposals are often mutually exclusive. o Managers often must choose between various positive-NPV projects because of limited resources. o Tempting to choose the project with the higher NPV. o Illustration: Two mutually exclusive projects, each assumed to have a 10-year life and a 12% discount rate. o Illustration: One method of comparing alternative projects is the profitability index. - Risk Analysis: o A simplifying assumption made by many financial analysts is that projected results are known with certainty. ▯ Projected results are only estimates. ▯ Sensitivity analysis is used to deal with uncertainty. • Sensitivity analysis uses a number of outcome estimates to get a sense of the variability among potential returns. - Post- Audit of Investment Projects: o Performing a post-audit is important. ▯ If managers know that their estimates will be compared to actual results they will be more likely to submit reasonable and accurate data when making investment proposals. ▯ Provides a formal mechanism to determine whether existing projects should be supported or terminated. ▯ Improve future investment proposals. o DO IT: Taz Corporation has decided to invest in renewable energy sources to meet part of its energy needs for production. It is considering solar power versus wind power. After considering cost savings as well as incremental revenues from selling excess electricity into the power grid, it has determined the following. ▯ While the investment in wind power generates the higher net present value, it also requires a substantially higher initial investment. The profitability index favors solar power, which suggests that the additional net present value of wind is outweighed by the cost of the initial investment. The company should choose solar power. - Use the Internal Rate of Return Method: o Differs from the net present value method in that it finds the interest yield of the potential investment. o Internal rate of return (IRR) - interest rate that will cause the present value of the proposed capital expenditure to equal the present value of the expected net annual cash flows (NPV equal to zero). o How does one determine the internal rate of return? o Illustration: Stewart Shipping Company is considering the purchase of a new front-end loader at a cost of $244,371. Net annual cash flows from this loader are estimated to be $100,000 a year for three years. Determine the internal rate of return on this front-end loader. o An easier approach to solving for the internal rate of return when net annual cash flows are equal. ▯ $244,371 / $100,000 = 2.44371 - Comparing Discounted Cash Flow Methods o Either method will provide management with relevant quantitative data for making capital budgeting decisions. - Use the Annual Rate of Return Method: o Indicates the profitability of a capital expenditure by dividing expected annual net income by the average investment. o Illustration: Reno Company is considering an investment of $130,000 in new equipment. The new equipment is expected to last five years and have zero salvage value at the end of its useful life. Reno uses the straight-line method of depreciation. ▯ A project is acceptable if its rate of return is greater than management’s required rate of return. - DO IT: Watertown Paper Corporation is considering adding another machine for the manufacture of corrugated cardboard. The machine would cost $900,000. It would have an estimated life of 6 years and no salvage value. The company estimates that annual revenues would increase by $400,000 and that annual expenses excluding depreciation would increase by $190,000. It uses the straight-line method to compute depreciation expense. Management has a required rate of return of 9%. Compute the annual rate of return. o The proposed project is acceptable.
Are you sure you want to buy this material for
You're already Subscribed!
Looks like you've already subscribed to StudySoup, you won't need to purchase another subscription to get this material. To access this material simply click 'View Full Document'