ACC 212 Notes And Study Guide
ACC 212 Notes And Study Guide ACC 211
Popular in Managerial Accounting 212
Popular in Department
verified elite notetaker
One Day of Notes
verified elite notetaker
verified elite notetaker
verified elite notetaker
verified elite notetaker
One Day of Notes
verified elite notetaker
This 12 page Class Notes was uploaded by ec on Wednesday August 26, 2015. The Class Notes belongs to ACC 211 at University of Miami taught by Sicre in Summer 2015. Since its upload, it has received 35 views.
Reviews for ACC 212 Notes And Study Guide
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: 08/26/15
ACC 212 CHAPTER 8 THE CAPITAL BUDGET EMILIE CROONENBERGHS Personal expenditures made for comfort or convenience companies make business expenditures large and small to further the goals of the business usually to increase pro ts 0 Business expenditures are really investments from which the company hopes to earn both a return of the investment and a return on the investment 0 Business expenditures for acquiring expensive assets that will be used for more than one year are called capital investments 0 Capital investments aso known as capital projects are investments in property plant and equipment 0 Capital budgeting is the planning and decision process for making investments in capital projects 0 Two of the evaluation techniques used to assess potential capital projects rely heavily on a knowledge of the time value of money Z The Business Planning Process 0 Managers use accounting information for two types of business decisions planning and control 00 The Mission Overall Company Goals 0 People form an organization to accomplish a purpose or several purposes the organizations goals 0 These goals de ne why the organization exists goals are the why of the business 0 Organizational goals constitute the overall objectives the company so those goals should not be subject to shortterm economic pressures The goals of the business organization are usually a combination of non nancial and nancial aspirations Almost all goals have either a direct or indirect effect on the company39s nancial wellbeing 0 Non nancial Goals Non nancial goals do not mention money they refer to activities that may or may not result in pro ts 0 Financial Goals 0 The primary nancial goal is to earn pro t this means that the goal is to earn a return on investment for the business owner or owners o It is dif cult to determine when these nancial goals have been attained 00 Goal Awareness 0 One goals have been set the company should communicate them to every person in the organization 0 Many companies use a mission statement a summary of the main goals of the organization to communicate the rm39s goals to all employees Stating lofty goals in a mission statement is not a guarantee of reaching those goals Businesses must act in a manner consistent with their goals to ensure progress 0 Core Values What the Company Stands For ACC 212 CHAPTER 8 THE CAPITAL BUDGET EMILIE CROONENBERGHS Core Values de ne our perception of what is most important in life and also de ne a sense of right and wrong ofjust or injust Companies must have similar set of core values in order to succeed 3 Vision The Hope for the Future Company leadership must develp a vision of the company39s future Vision is where the company is going and how will it get there Company vision is not all about income and nancial results 3 Strategy The Business Plan of Attack Once a company has established its mission its core values and its vision for the future it must establish a workable strategy to achieve them It must also have a plan of attack or a strategy to create those earnings A strategy includes low prices and high volume or high quality superior service and high prices Some companies have pro t based on fast inventory turnover while others have an earnings strategy based on higher margins and slower turnover Putting together a successful business strategy involves analyzing the situation that exists and the situation that is anticipated which includes amount other things evaluating the company competitors and social economic and market conditions A three step approach to establishing a strategy is to determine where you are today where you would like to be in the future and nally how you are going to get there The balanced scorecard is an integrated set of performance measures organized around four distinct perspectives nancial customer internal and innovation and learning EXHIBIT 81 The balanced scoreboard can help managers successfully create an implement a balanced business strategy Once a business has established its mission vision and strategy the rm must then create a strategic plan a longrange plan that sets forth the actions the rm will take to attain its goals 3 The Strategic Plan The What The steps outlined in the strategic plan sometimes referred to as a longrange budget are the what of doing business A company39s strategic plan tends to have objectives that are quanti able and a time frame for attainment of the objectives After an organization develops a strategic plan that speci es the actions it will take to reach its goals the company then decides how to allocate its monetary resources to implement its strategies and who will be responsible for the dayto day activities of the business This step in the planning process is the preparation of budgets 0 The Capital Budget The How ACC 212 CHAPTER 8 THE CAPITAL BUDGET EMILIE CROONENBERGHS The capital budget is the how of the planning process The capital budget is the budget that outlines how a rm intends to invest its scarce resources in longlived productive assets The capital budget lays out plans for acquiring and replacing longlived expensive assets such as land buildings machinery and equipment oz The Operating Budget The Who Companies not only must budget for longterm activities they also must plan and budget for daytoday business activities The budget that pertains to routine company operations for one to ve years in the future is called the operating budget The operating budget establishes who is responsible for the daytoday operation of the organization so we refer to it as the who of the planning process EXHIBIT 82 The overall function of management accounting in this process is to provide a substantial portion of the information that company management needs not only to achieve the what the how and the who but also to ensure that these functions are achieved within the context of the why gt The Cagital Budget What Is It The capital budget plans for the acquisition and replacement of longlived expensive items such as land buildings machinery and equipment These long lived items are called capital assets The capital budget focuses on the longterm operations of the company to determine how an organization intends to invest its scarce resources in longlived productive assets During the capital budgeting process companies determine whether they should purchase items how much they should spend and how much pro t the items promise to generate 0 Capitalizing Assets Capital budgeting deals with decisions regarding investments that will bene t the company for many years If a purchased item is expected to provide economic bene ts beyond the year in which it is purchased it should be capitalized which means that its cost is recorded as an increase in longterm assets and will be depreciated over the items estimated useful life If a purchased item is not expected to provide economic bene t to the company beyond the year of purchase its cost should be re ected as an expense on the income statement for that year Judgment plays an important role in determining whether a purchased item should be capitalized or expensed From a practical standpoint it is senseless to expend the additional accounting effort to capitalize and then depreciate the wastebasket ACC 212 CHAPTER 8 THE CAPITAL BUDGET EMILIE CROONENBERGHS Because whether the wastebasket is capitalized and depreciated over its estimated useful life or expensed immediately the effect on the company39s nancial statements would be so minimal that no economic decision maker will be in uenced by the alternative selected 0 Capitalization Amount Companies set a cost threshold that helps determine the appropriate accounting treatment for capitalizing longlived items There are no hard and fast rules for setting the capitalization threshold but most businesses choose an amount between 500 and 5000 as their capitalization amount 0 Characteristics of Capital Projects Capital budgeting deals will planning for purchases of items that will capitalized meaning they will be classi ed as assets when purchased and then depreciated over their estimated useful lives 1 Long Life capital projects are expected to bene t the company for at least two years which is the whole idea behind capitalizing the cost of a purchased item 2 High Cost technically the purchase of any longlived item for which the cost exceeds a company39s capitalization amount is considered a capital project 3 Quickly Sunk Costs costs that cannot be recovered are called sunk cost A capital project usually required a rm to incur substantial cost in the early stages of the project 4 High Degree of Risk capital projects have a high degree of business risk because they involve the future which always entails uncertainty Because of the long lives high costs and sunk costs of capital projects companies must try to estimate the returns from those projects in future years Z The Cost of Cagital and the Concegt of Scarce Resources The interest is the return on your investment In evaluating potential capital projects a company must determine a benchmark rate of return to help select which capital project or projects it will undertake The benchmark return rate for selecting projects is usually the company39s cost of cost of capital which is the cost of obtaining nancing from all available nancing sources Cost of capital is also referred to as the cost of capital rate the required rate of return or the hurdle rate Companies can obtain nancing from two sources borrowing from creditors debt nancing and investment by owners equity nancing 0 Weighted Average Cost of Capital The funding for a company39s capital projects usually comes from a combination of debt and equity nancing ACC 212 CHAPTER 8 THE CAPITAL BUDGET EMILIE CROONENBERGHS The combined cost of debt and equity nancing is called the weighted average cost of capital The rate for the weighted average cost of capital represents the combined rate of the cost of both debts and equity nancing The weighted average cost of capital is sometimes referred to as the blended cost of capital The cost of debt capital is the interest a company pays on all forms of borrowing The amount of interest a company pays is easy to determine because it is reported on the company39s income statement as interest expense The cost of a company39s equity nancing is more challenging to determine than the cost of its debt nancing because the cost of equity capital is what equity investors relinquish when they invest in one company rather than another The amount an equity investor earns is a combination of dividends received and the appreciation in the market value of the stock the investor owns Unlike debt nancing costs interest expense the cost of equity nancing is not reported in nancial statements in its entirety Firms do report pro ts distributions to stockholders in the form of dividends but the larger part of the cost of equity capital is the appreciation in the market value of stockholders ownership interest This market value is not reported on nancial statements Firms use their weighted average cost of capital as a benchmark rate of return to evaluate capital projects 3 scarce Resources The number and size of capital projects a company undertakes is not limited by a lack of viable alternative projects What limits companies is that they simply do not have access to enough money to take advantage of all the opportunities available to them This limitation on the amount available to spend is commonly called scarce FESOUFCES gt Evaluating Potential Calgital Projects Because capital projects are usually longlived costly and high risk managers must carefully evaluate capital expenditure decisions especially in light of their nancial limitations The evaluating process generally includes the following four steps 1 Identifying possible capital projects 2 Determining the relevant cash ows for alternative projects 3 Selecting a method of evaluating the alternatives 4 Evaluating the alternatives and selecting the capital project or projects to befunded 0 Identifying Possible Capital Projects Businesses usually make capital expenditures to maximize pro ts by increasing revenues reducing costs or a combination of the two ACC 212 CHAPTER 8 THE CAPITAL BUDGET EMILIE O 69 CROONENBERGHS A project that satis es the company39s desire to maximize pro ts will be identi ed as a potential capital expenditure Firms often generate revenue increases by investing in projects that increase capacity or draw more customers To reduce operating costs a manufacturer might upgrade production equipment so less direct labor or less electricity is required Reducing cost has exactly the same effect as increasing revenue Although the majority of potential capital projects are intended to either increase revenue or reduce costs in certain instances a company must make a capital expenditure that will result in neither The evaluation of potential capital projects that promise to either increase revenue or reduce costs As the need for increasing revenue or reducing costs presents itself a company should explore all alternatives course of action Brainstorming sessions and input from multiple sources both within and outside a rm can help generate ideas for alternative options Determining Relevant Cash Flows for Alternative Projects Capital projects that promise to increase a company39s pro ts by either increasing revenue or reducing costs expenses However under accrual accounting revenue is not the same as cash in ow and expense is not the same as cash out ow in the short run Because capital projects usually are long lived most business managers believe it is appropriate to analyze an alternative using cash in ow and cash out ow over the life of the project They do this by determining the net cash ow of project the projects expected cash in ows minus its cash out ows for a speci c time period Only relevant net cash ows should be considered in a capital budgeting decision Relevant net cash ows are future cash ows that differ between or among alternatives A relevant cash ow must be one that will occur in the future not one that has already occurred and it must be affected by the investment decision Once a company obtains and assesses the relevant net cash ows for each alternatives project the next step is to choose a method to measure the value of each project 3 Selecting a Method of Evaluating the Alternatives Over time accountants and managers have developed many capital budgeting decision methods to evaluate potential capital projects These are the four methods 1 Net Present Value 2 Internal Rate of Return 3 Payback Period 4 Accounting Rate of Return 0 Selecting Capital Projects ACC 212 CHAPTER 8 THE CAPITAL BUDGET EMILIE CROONENBERGHS To select a capital project rms decide rst whether to accept or reject a project using one or more capital budgeting techniques to measure the project39s value If the project does not generate an acceptable rate or return it will probably be rejected Once a project has been accepted as viable that project can then be ranked with other acceptable projects based on expected performance Z Cagital Budgeting Decision Methods We present four capital budgeting methods net present value internal rate of return payback period and accounting rate of return The rst two methods which are discounted cash ow methods are used more frequently in business because they include the concept of the time value of money A dollar received or paid at some point in the future does not have the same value as a dollar received or paid today The reason for the difference in value is that if cash is available now it can be invested now and earn a return as time passes This increase in the value of cash over time due to investment income is referred to as the time value of money The concept of the time value of money is used to determine either the future value of money invested today or the present value of money to be received at some point in the future Capital projects deal with cash ows that begin in the present and extend into the future sometimes for many years Therefore the evaluation of these kinds of projects uses the concepts of present value Determining the present value of cash to be received in future periods is called discounting cash ows Discounted Cash Flow Methods Business manager use two discounted cash ow methods to evaluate potential capital projects net present value and internal rate or return Net Present Value The net present value NVP of a proposed capital project is the present value of cash in ows minus the present value of cash out ows associated with a capital project Note that NPV is different from the present value The former is the difference between the present value of capital projects cash in ow and the present value of its cash out ow The latter is the amount of future payment or series of payments is in today39s dollars evaluated at the appropriate discount rate NPV is used to determine whether a proposed capital project39s anticipated return is higher or lower than the weighted average cost of capital ACC 212 CHAPTER 8 THE CAPITAL BUDGET EMILIE CROONENBERGHS A company calculates the NPV of capital project by discounting the net cash ows for all years of the project using the company39s weighted average cost of capital as the discount rate A positive NVP rate indicated that the expected return on a proposed project is higher than the company39s cost of capital A negative NPV indicated that the expected return on a proposed project is lower than the company39s cost of capital An NPV of zero shows that the expected return on a project is exactly equal to the company39s cost of capital The cash ows associated with the computer upgrader are shows EXHIBIT 84 Unless other speci ed we assume all other cash ows for this project will occur at the end of each period We also ignore depreciation in our analysis because depreciation is a noncash expense under accrual accounting and the NPV method focuses on cash ow rather than accrual operating income We use the table to nd the present value factor of a ve year annuity with a discount rate of 14 The factor for ve years with a discount rate of 14 We nd the NPV of the project by subtracting the present value of cash out ows from the present value of cash in ows Net Present Value Calculations with Uneven Cash Flows When the expected cash ows are uneven we nd the present value of each year39s net cahs ow and then add those amounts Each of the amounts for the ve years shown in exhibit 88 can be discounted to present value using the table The calculation of the present values using the highlighted factors in the 14 percent discount rate column is shown in exhibit 810 This positive NPV indicates that the project 5 acceptable for the company Although the NPV method indicates whether a proposed capital project is acceptable it does have limitations as a ranking method to compare alternative projects A direct comparison of the NPV39s of various projects may lead to poor decisions regarding project selection because NPV is measured in dollars rather than percentages While choosing the project with the high NPV seems wise this is not always a good choice because NPV analysis does not consider the relative investments required by the projects We solve the problem of selecting among projects by using a pro tability index 3 Pro tability Index ACC 212 CHAPTER 8 THE CAPITAL BUDGET EMILIE o o 9 CROONENBERGHS The pro tability index provides a means of ranking alternative but acceptable capital projects by using an index calculated by dividing the present value of the projects net cash in ows by its required investment By dividing its present value of net cash in ows by the required investment we determine the index The higher the pro tability index the higher the rate of return for the project Although the NPV method indicated whether a project39s return rate is lower or higher than the required rate of return it does not provide the projects expected percentage return The internal rate of return method is a technique that provides this information Internal Rate of Return The internal rate of return IRR of a propose capital project is the calculated expected percentage return promised by a project just like the NPV method the IRR method considers all cash ows for a proposed project and adjusts for the time value of money This method also known as the real rate of return or the timeadjusted rate of return determines the discount rate that makes the present value of a project39s cash in ows and the present value of a projects out ows exactly the same To calculate a project39s IRR we use the same present value tables we use to calculate net present value but we apply them differently In this application we use the tables to determine a discount rate a percentage rather than using a preselected discount rate to determine present value amounts expressed in dollars This time when we use the table instead of using an interest rate to determine the present value factor we will use a present value factor to determine the interest rate To do this the rst step is to determine the present value factor we will loom up on the table To calculate the present value factor we divide the required initial investment by the annual net cash in ow Present Value Factor Required Initial Investment Annual Net Cash ln ow Now that we know the present value factor we can nd IRR by moving down the time period column on the table to eight periods as that is the life of the project Next we follow across the row corresponding to eight periods until we nd a factor that is close to the one we calculated Once we determine the IRR we compare it to the cost of capital to gauge the project39s acceptability An IRR that exceeds the rms cost of capital indicates an acceptable project In a real life situation the calculated factor will usually fall between two factors on the present value table EXHIBIT 813 0 Comparing Projects Using the IRR Method ACC 212 CHAPTER 8 THE CAPITAL BUDGET EMILIE CROONENBERGHS Managers can just the IRR to rank projects This can be done when both projects are acceptable so you need to choose between both of them 0 Comparing MVP and IRR O 06 o 9 0 Both NPV and IRR are well respected techniques used to determine the acceptability of a propose capital project for two reasons First they are based on cash ows not accounting incomes Second both methods consider the time value of money NPV is used to determine whether the promised return from a proposed capital project meets the minimum acceptable return requirements cost of capital A drawback of this method is that the calculated NPV is stated in dollars rather than percentages Thus comparison between projects of different size is dif cult The pro tability index overcomes this difficulty IRR is used to calculate a proposed capitals project actual expected rate of return Because this method is calculated using percentages rather than dollars it can be used as a direct comparison of various proposed projects Nondiscounted Cash Flow Methods Other methods that ignore the time value of money exist however and many companies use them to some degree Payback Period As its name implies the payback period is a capital budgeting technique that measures the length of time a capital project must generate positive net cash ows to equal or quotpay backquot the original investment in the project When net cash in ows are equal from one year to the next we determine the payback period by dividing the required initial investment by the annual net cash in ows Payback Period in Year Required Initial Investment Annual Net Cash ln ow If a project has uneven cash ows we can determine the payback period by adding the net cash in ows year by year until the total equals the required initial investment We nd the payback period by totaling the net cash in ows until we reach the amount invested The payback period highlights the liquidity if an investment and companies use it as a screening device to reject projects with unreasonably low net cash ow expectations This method is simple to use is easily understood and offers some limited insight into a project39s liquidity The payback period is not often used to nal capital investment decisions because it does not consider three crucial elements 1 the expected returns of a project after the payback period 2 how the returns will compare to the rms cost of capital or 3 the time value of money ACC 212 CHAPTER 8 THE CAPITAL BUDGET EMILIE CROONENBERGHS Because the payback period ignores the rms cost of capital total cash ow and time value of money concerns managers do not normally accept or reject a project based solely on the payback period method If used at all the payback period is usually a screening device only to eliminate potential projects from further evaluation Companies often establish a maximum payback period for potential projects If a proposed capital project promises a payback longer than the established maximum period that project would be eliminated from further evaluation 02 Accounting Rate of Return The accounting rate of return method uses accrual accounting operating income rather than net cash ow as the basis for evaluating alternative capital budgeting process The accounting rate of return is the rate of return for a capital project based on the anticipated increase in accounting operating income due to the project relative to the amount of capital investment required This method focuses n a proposed project39s required investment and how that project changes a company39s operating income First use Straight line Depreciation Assets cost estimated residual value straight line depreciation Estimated useful life Then accounting rate of return Increase in operating income accounting rate of return Required investment The accounting rate of return is simple to calculate and provides some measure of project39s pro tability however it has two major drawbacks First the accounting rate of return method focuses on accounting income rather than cash ow In capital budgeting most analysis believe that a focus on cash ow is preferable to a focus on accounting income Second like the payback period method the accounting rate of return does not consider the time value of money Many managers consider the accounting rate of return to be superior to the payback period because it offers at least a limited measure of a proposed capital project39s rate of return As with payback period however managers should not accept or reject a project based solely on the accounting rate or return Both of these methods should be used only as screening devices or in conjunction with discounted cash ow methods of evaluating capital project alternatives Z Factors Leading to Poor Cagital Project Selection At the very least selecting the wrong capital project is enormously costly At worst investing in the wrong projects can lead to nancial ruin for any company regardless of its size or past performance ACC 212 CHAPTER 8 THE CAPITAL BUDGET EMILIE CROONENBERGHS In addition to the dif culties inherent in the capital budgeting process cause by the uncertainty associated with the future there are two factors that can lead to poor capital project selection They are natural optimism on the part of managers and the tendency of some managers to turn the capital project evaluation process into a game 0 Natural Optimism Human beings are essentially optimistic As mangers they are a natural tendency to estimate both the cash in ows and out ows associated with a proposed project they are sponsoring with an overly optimistic outlook This means they will likely overstate the estimated cash in ows and understate the estimated cash out ows At the very minimum this natural optimism limits the effectiveness of any of the evaluation techniques we have discussed in this chapter because all of them use in ow and out ow estimates as the basis of evaluation 0 Capital Budgeting Games The managers who propose potential capital projects understand that there is usually not enough money available to fund all projects even if they all promise return greated than the cost of capital A manager who proposes a capital project is competing with other manager s project for a limited number of capital investment dollars For this reason the capital project evaluation process is sometimes treated like some sort of game with little consideration of the potentially disastrous consequences
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'