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Cost Management ACCOUNTING AND CONTROL

Cost Management ACCOUNTING AND CONTROL. HANSEN & MOWEN. 20. CHAPTER. Capital Investment. 1. Capital Investment Decisions. OBJECTIVE.

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Cost Management ACCOUNTING AND CONTROL

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  1. Cost ManagementACCOUNTING AND CONTROL HANSEN & MOWEN

  2. 20 CHAPTER Capital Investment

  3. 1 Capital Investment Decisions OBJECTIVE Capital investment decisions are concerned with the process of planning, setting goals and priorities, arranging financing, and using certain criteria to select long-term assets.

  4. 1 Capital Investment Decisions OBJECTIVE Capital budgeting is the process of making capital investment decisions. Two types of capital budgeting projects: Projects that, if accepted or rejected, will not affect the cash flows of another project. Projects that, if accepted, preclude the acceptance of competing projects. Independent Projects Mutually Exclusive Projects

  5. 2 Payback and Accounting Rate of Return: Nondiscounting Methods OBJECTIVE Payback Analysis *At the beginning of Year 3, $60,000 is needed to recover the investment. Since a net cash inflow of $100,000 is expected, only 0.6 year ($60,000/$100,000) is needed to recover the $60,000. Thus, the payback period is 2.6 years (2 + 0.6).

  6. 2 Payback and Accounting Rate of Return: Nondiscounting Methods OBJECTIVE The payback period provides information to managers that can be used as follows: • To help control the risks associated with the uncertainty of future cash flows. • To help minimize the impact of an investment on a firm’s liquidity problems. • To help control the risk of obsolescence. • To help control the effect of the investment on performance measures. • Deficiencies of the payback period: • Ignores the time value of money • Ignores the performance of the investment beyond the payback period

  7. 2 Payback and Accounting Rate of Return: Nondiscounting Methods OBJECTIVE Accounting Rate Of Return (ARR) ARR = Average income ÷ Original investment or Average investment Average annual net cash flows, less average depreciation Average investment = (I + S)/2 I = the original investment S = salvage value Assume that the investment is uniformly consumed

  8. 2 Payback and Accounting Rate of Return: Nondiscounting Methods OBJECTIVE Accounting Rate Of Return (ARR) The major deficiency of the accounting rate of return is that it ignores the time value of money.

  9. 3 The Net Present Value Method OBJECTIVE Net present value is the difference between the present value of the cash inflows and outflows associated with a project. NPV = P – I where: P = the present value of the project’s future cash inflows I = the present value of the project’s cost (usually the initial outlay)

  10. 3 The Net Present Value Method OBJECTIVE Polson Company has developed a new cell phone that is expected to generate an annual revenue of $750,000. Necessary production equipment would cost $800,000 and can be sold in five years for $100,000. In addition, working capital is expected to increase by $100,000 and is expected to be recovered at the end of five years. Annual operating expenses are expected to be $450,000. The required rate of return is 12 percent.

  11. 3 The Net Present Value Method OBJECTIVE Step 1. Cash Flow Identification Year Item Cash Flow 0 Equipment $-800,000 Working capital -100,000 Total $-900,000 1-4 Revenues $ 750,000 Operating expenses -450,000 Total $ 300,000 5 Revenues $ 750,000 Operating expenses -450,000 Salvage 100,000 Recovery of working capital 100,000 Total $ 500,000

  12. 3 The Net Present Value Method OBJECTIVE Step 2B. NPV Analysis Year Cash Flow Discount Factor Present Value 0 $-900,000 1.000 $-900,000 1-4 300,000 3.307 911,100 5 500,000 0.567 283,500 Net present value $ 294,600 Step 2A. NPV Analysis Year Cash Flow Discount Factor Present Value 0 $-900,000 1.000 $-900,000 1 300,000 0.893 267,900 2 300,000 0.797 239,100 3 300,000 0.712 213,600 4 300,000 0.636 190,800 5 500,000 0.567 283,500 Net present value $ 294,900 Present Value of $1 Present Value of an Annuity of $1 Present Value of $1

  13. 3 The Net Present Value Method OBJECTIVE Decision Criteria for NPV If NPV > 0, this indicates: 1. The initial investment has been recovered 2. The required rate of return has been recovered Thus, Polson should manufacture the cell phones.

  14. 3 The Net Present Value Method OBJECTIVE Reinvestment Assumption The NVP model assumes that all cash flows generated by a project are immediately reinvested to earn the required rate of return throughout the life of the project.

  15. 4 Internal Rate of Return OBJECTIVE Theinternal rate of return (IRR)is the interest rate that sets the project’s NPV at zero. Thus, P = I for the IRR. Example:A project requires a $240,000 investment and will return $99,900 at the end of each of the next three years. What is the IRR? $240,000 = $99,900(df) $240,000 / $99,400 = 2.402 i = 12%

  16. 4 Internal Rate of Return OBJECTIVE Decision Criteria: If the IRR > Cost of Capital, the project should be accepted. If the IRR = Cost of Capital, acceptance or rejection is equal. If the IRR < Cost of Capital, the project should be rejected.

  17. NPV versus IRR: Mutually Exclusive Projects 5 OBJECTIVE There are two major differences between net present value and the internal rate of return: • NPV assumes cash inflows are reinvested at the required rate of return, whereas the IRR method assumes that the inflows are reinvested at the internal rate of return. • NPV measures the profitability of a project in absolute dollars, whereas the IRR method measures it as a percentage.

  18. NPV versus IRR: Mutually Exclusive Projects 5 OBJECTIVE NPV and IRR: Conflicting Signals

  19. NPV versus IRR: Mutually Exclusive Projects 5 OBJECTIVE Modified Comparison of Projects A and B *1.08($686,342) + $686,342. Modified Cash Flows with Additional Opportunity a$1,440,000 + [(1.20 x $686,342) - (1.08 x $686,342)]. This last term is what is needed to repay the capital and its cost at the end of Year 2. b$686,342 + (1.20 x $686,342).

  20. NPV versus IRR: Mutually Exclusive Projects 5 OBJECTIVE Milagro Travel Agency Example Standard T2 Custom Travel Annual revenues $240,000 $300,000 Annual operating costs 120,000 160,000 System investment 360,000 420,000 Project life 5 years 5 years The cost of capital is 12 percent

  21. NPV versus IRR: Mutually Exclusive Projects 5 OBJECTIVE Cash Flow Pattern, NPV and IRR Analysis: Standard T2 versus Custom Travel

  22. NPV versus IRR: Mutually Exclusive Projects 5 OBJECTIVE Cash Flow Pattern, NPV and IRR Analysis: Standard T2 versus Custom Travel

  23. NPV versus IRR: Mutually Exclusive Projects 5 OBJECTIVE aFrom Exhibit 20B-2. bFrom Exhibit 20B-2, df = 3.0 implies that IRR =20%. Cash Flow Pattern, NPV and IRR Analysis: Standard T2 versus Custom Travel

  24. Computing After-Tax Cash Flows 6 OBJECTIVE The cost of capital is composed of two elements: 1.The real rate 2.The inflationary element

  25. Computing After-Tax Cash Flows 6 OBJECTIVE aFrom Exhibit 20B-2. b6,670,000 bolivares = 1.15 x 5,800,000 bolivares (adjustment for one year of inflation) 7,670,500 bolivares = 1.15 x 1.15 x 5,800,000 bolivares (adjustment for two years of inflation). cFrom Exhibit 20B-1. The Effects of Inflation on Capital Investment

  26. Computing After-Tax Cash Flows 6 OBJECTIVE Disposition of Old Machine Book Value Sale Price M1 $ 600,000 $ 780,000 M2 1,500,000 1,200,000 Acquisition of Flexible System Purchase cost $7,500,000 Freight 60,000 Installation 600,000 Additional working capital 540,000 Total $8,700,000

  27. Computing After-Tax Cash Flows 6 OBJECTIVE Tax Effects of the Sale of M1 and M2 aSale price minus book value is $780,000 - $600,000. bSale price minus book value is $1,200,000 - $1,500,000.

  28. Computing After-Tax Cash Flows 6 OBJECTIVE The net investment is: Total cost of flexible system $8,700,000 Less: Net proceeds 2,028,000 Net investment (cash outflow) $6,672,000 The two machines are sold: Sales price, M1 $ 780,000 Sales price, M2 1,200,000 Tax savings 48,000 Net proceeds $2,028,000

  29. Computing After-Tax Cash Flows 6 OBJECTIVE After-Tax Operating Cash Flows: Life of the Project A company plans to make a new product that requires new equipment costing $1,600,000. The new product is expected to increase the firm’s annual revenue by $1,200,000. Materials, labor, etc. will be $500,000 per year. The income statement for the project is as follows: Revenues $1,200,000 Less: Cash operating expenses -500,000 Depreciation (straight-line) -400,000 Income before income taxes $ 300,000 Less: Income taxes (@ 40%) 120,000 Net income $ 180,000

  30. Computing After-Tax Cash Flows 6 OBJECTIVE = [(1– Tax rate) x Revenues] – [(1– Tax rate) x Cash expenses] + (Tax rate x Noncash expenses) Cash flow After-tax revenues $720,000 After-tax cash expenses -300,000 Depreciation tax shield 160,000 Operating cash flow $580,000 Computation of Operating Cash Flows: Decomposition Terms After-Tax Operating Cash Flows: Life of the Project

  31. Computing After-Tax Cash Flows 6 OBJECTIVE MACRS Depreciation Rates The tax laws classify most assets into the following three classes (class = allowable years): ClassTypes of Assets 3 Most small tools 5 Cars, light trucks, computer equipment 7 Machinery, office equipment Assets in any of the three classes can be depreciated using either straight-line or MACRS (Modified Accelerated Cost Recovery System) with a half-year convention.

  32. Computing After-Tax Cash Flows 6 OBJECTIVE MACRS Depreciation Rates MACRS Depreciation Rates • Half the depreciation for the first year can be claimed regardless of when the asset is actually placed in service. • The other half year of depreciation is claimed in the year following the end of the asset’s class life. • If the asset is disposed of before the end of its class life, only half of the depreciation for that year can be claimed.

  33. Computing After-Tax Cash Flows 6 OBJECTIVE Value of Accelerated Methods Illustrated

  34. Capital Investment: Advanced Technology and Environmental Considerations 7 OBJECTIVE How Estimates of Operating Cash Flows Differ A company is evaluating a potential investment in a flexible manufacturing system (FMS). The choice is to continue producing with its traditional equipment, expected to last 10 years, or to switch to the new system, which is also expected to have a useful life of 10 years. The company’s discount rate is 12 percent. Present value ($4,000,000 x 5.65) $22,600,000 Investment 18,000,000 Net present value $ 4,600,000

  35. Capital Investment: Advanced Technology and Environmental Considerations 7 OBJECTIVE Investment Data: Direct, Intangible, and Indirect Benefits

  36. Capital Investment: Advanced Technology and Environmental Considerations 7 OBJECTIVE Investment Data: Direct, Intangible, and Indirect Benefits

  37. Present Value Concepts A Appendix Future Value Let: F = future value i = the interest rate P = the present value or original outlay n = the number or periods Future value can be expressed by the following formula: F = P(1 + i)n

  38. Present Value Concepts A Appendix Assume the investment is $1,000. The interest rate is 8%. What is the future value if the money is invested for one year? Two? Three?

  39. Present Value Concepts A Appendix Future Value F = $1,000(1.08) = $1,080.00 (after one year) F = $1,000(1.08)2 = $1,166.40 (after two years) F = $1,000(1.08)3 = $1,259.71 (after three years)

  40. Present Value Concepts A Appendix Present Value P = F/(1 + i)n The discount factor, 1/(1 + i), is computed for various combinations of I and n. Example:Compute the present value of $300 to be received three years from now. The interest rate is 12%. Answer: From Exhibit 23B-1, the discount factor is 0.712. Thus, the present value (P) is: P = F(df) = $300 x 0.712 = $213.60

  41. Present Value Concepts A Appendix Present Value of an Uneven Series of Cash Flows Present Value of a Uniform Series of Cash Flows

  42. End of Chapter 20

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