Managerial Accounting ACCT 2301
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This 13 page Class Notes was uploaded by Morris Beer II on Thursday October 22, 2015. The Class Notes belongs to ACCT 2301 at Texas Tech University taught by Bigbee in Fall. Since its upload, it has received 35 views. For similar materials see /class/226438/acct-2301-texas-tech-university in Accounting at Texas Tech University.
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Date Created: 10/22/15
Chapter 12 Capital Investment Decisions adapted from Fundamental Cornerstones of Managerial Accounting Heitger Mowen and Hansen 2008 Capital Investment Decisions Capital investment decisions are quotconcerned with the process of planning setting goals and priorities arranging financing and using certain criteria to select longterm assets page 510 Because of the magnitude of the investment involved and because of the longterm and strategic nature of the investment these decisions are very important to the business As such these decisions should be attended to carefully by managers Capital Investment Projects Capital investments typically relate to 1 replacing equipment 2 leasing or buying equipment 3 plant acquisitions and other decisions relating to longterm capacityrelated assets Two types of projects are discussed in your text Independent projects projects that if accepted or rejected do not affect the cash flows of other projects Mutualy exclusive projects projects that if accepted preclude acceptance of all other competing projects Capital Investment Projects In general given the magnitude and long term nature of the investment firms would prefer to 1 recover its costs and 2 earn an quotadequatequot return on its investment Earning an quotadequatequot return implies that the firm should consider the opportunity cost of its investment capital in the analysis Opportunity Cost of Capital Opportunity cost of capital the benefits of investing capital in one investment alternative that are foregone when that capital is invested in some other alternative When expected cash flows occur in different time periods the opportunity cost of capital becomes relevant to our decision This opportunity cost is reflected in the quottime value of money Capital Budgeting Methods Methods that do not consider the time value of money Nondiscounting modes Payback period Accounting rate of return Methods that consider the time value of money Discounting modes Net present value NPV Internal rate of return IRR Payback Period Payback period the time required for a business to recover its initial cash investment in a project The payback period for a project generating uniform cash flows can be defined as Payback period Original investmentAnnual cash flow Projects with shorted payback periods are preferred all else being equal An advantage ofthe payback period analysis is that it is simple to explain and compute Disadvantages of payback method include 1 the time value of money is ignored and 2 cash flows beyond end of payback period are ignored Accounting Rate of Return The accounting rate of return AROR is defined as AROR Average incomeInitial Investment Advantages ofthe accounting rate of return method include 1 the method is simple to explain and compute using financial statements and 2 the method is consistent with performance measures in common use in divisional settings ie ROI Disadvantages of the accounting rate of return method include 1 the analysis ignores the time value of money 2 accounting income is usually not equal to cash flow and 3 accounting income is subject to manipulation by managers Discounted Cash Flow Basics Considerations in using discounted cash flow techniques Discount cash flows not accounting earnings Cash can be invested and earn interest Accounting earnings include accruals that estimate future cash flows Include working capital requirements Consider cash needed for additional inventory and accounts receivable Include opportunity costs but not sunk costs Sunk costs are not relevant to decisions about future alternatives Net Present Value NPV Net present value NPV the difference between the present value of the inflows and outflows of the project as discounted using the firm s required rate of return The required rate of return is the minimum acceptable rate of return usually equal to the firm s opportunity cost of capital A positive negative NPV implies the project earns a return that is greater than less than the required rate of return In essence the NPV measures the profitability of the project in terms of the present value of the cash flows pertaining to the project Net Present Value NPV Procedures Identify the cash flows for each period Determine the appropriate discount rate Multiply the cash flow by the appropriate presentvalue factor single or annuity for each cash flow Tables with presentvalue factors are available in your textbook Sum of the present values of all cash flows net present value NPV If NPVZ 0 NPV lt 0 then accept reject the project Projects with higher NPVs are preferred all else equal Internal Rate of Return IRR Internal rate of return IRR the interest rate that equates the present value of future cash inflows to the present value of the cash outflows With a single cash flow PV FV 1 irr or irr FV PV 1 With multiple identical cash flows IRR is still relatively easy to compute by reference to present value tables With uneven cash flows solving for IRR by hand becomes very difficult However IRR is easily computed with handheld calculators and with ExceL Projects with higher IRRs are preferred all else equal NPV versus IRR Comparison of IRR and NPV methods IRR indicates the relative return on investment NPV indicates the magnitude of an investment s return IRR assumes all cash flows are reinvested at the project s constant IRR NPV assumes all cash flows are reinvested at the specified discount rate Finance theory tells us that NPV is preferred when analyzing mutually exclusive projects
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