MANAGEMENT

ACCOUNTING

Lecture 7

DECISION MAKING
Strategic Decision Making

Dr. Abdullah Hamoud

Main source: Hansen & Mowen (2007). Managerial Accounting (8th ed.). Thomson.

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 Types of Decisions

Strategic Decision Making

Is selecting among alternative

strategies so that long term
competitive advantage is
established.

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 Strategic Decision Making

Capital investment
decision models

Non-discounting Discounting
models models
Ignore the time value of Explicitly consider the
money time value of money

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 Strategic Decision Making

Capital Investment Decisions Methods

Methods used to guide managers’

investment decisions are:
⚫ Non-discounting
⚫ Payback period
⚫ Accounting rate of return

⚫ Discounting
⚫ Net present value (NPV)
⚫ Internal rate of return (IRR)
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 Strategic Decision Making

Discounting

Net present value (NPV)

▪ Net present value (NPV) is the difference

between the present value of the cash
inflows & outflows associated with a
project.

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 NPV: What You Need to Know

⚫ Present value of project’s cost

⚫ Cash inflow to be received in each period
⚫ Useful life of project
⚫ Required rate of return (hurdle rate)
⚫ Time period
⚫ Present value of project’s future cash inflows
⚫ Discount factor

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 Analyzing NPV

❑ Net present value measures the profitability of an

investment.
❑ If the NPV is positive, it measures the increase in
wealth. For a firm, this means that the size of a
positive NPV measures the increase in the value
of the firm resulting from an investment.
❑ To use the NPV method, a required rate of return
must be defined. The required rate of return is the
minimum acceptable rate of return. It is also
referred to as the discount rate, the hurdle rate,
and the cost of capital

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 Analyzing NPV

When NPV is positive:

1) The initial investment has been recovered
2) The required rate of return has been achieved
3) A return in excess of (1) & (2) has been
received

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 Analyzing NPV

Thus:
- If NPV is greater than zero, the investment is
profitable and, therefore, is acceptable.
- If NPV equals zero, the decision maker will
find acceptance or rejection of the investment
equal because the investment will earn
exactly the required rate of return.
- If NPV is less than zero, the investment
should be rejected. In this case, it is earning
less than the required rate of return.
-
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 Example-1

Honley Medical’s Specialty Products Division has

developed a new home blood pressure (BP) instrument
that it believes is superior to anything on the market.
The marketing manager is excited about the new
product’s prospects after completing a
detailed market study that revealed expected annual
cash revenues of $300,000.
The BP instruments have a projected product life
cycle of five years. Equipment to produce the
instruments would cost $320,000.

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 Example-1

After five years, that equipment can be sold for

$40,000. In addition to equipment, working capital is
expected to increase by $40,000 because of increases
in inventories and receivables.
The firm expects to recover the investment in working
capital at the end of the project’s life. Annual cash
operating expenses are estimated at $180,000.
Assuming that the required rate of return is 12 percent,
should Honley Medical manufacture the new BP
instruments?

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 Solution-1
The first step in
CASH FLOW: Step 1 calculating the
NPV is to
determine the
total cash flows
of the project.

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 Solution-1
The second step is
NPV of CASH FLOW: Step 2 to calculate the
present value of the
annual cash flows.

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 Solution-1

Then;
Honley Medical should manufacture the new
BP instruments.

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 Strategic Decision Making

Discounting

Internal Rate of Return (IRR):

▪ Internal Rate of Return (IRR) is the interest

rate that sets the present value of a project’s
cash inflows equal to the present value of a
project’s cost.
▪ In other words, it is the interest rate that sets
the project’s NPV at zero.
IRR measures a project’s rate of return against
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a hurdle rate for accepting projects.
 Compute IRR

Step 1: Compute discount factor

Discount Factor = Investment ÷ Annual cash flows

df = I/CF
Step 2: go to present value table (Exhibit 13B-2) and find
the row corresponding to the life of the project, then move
across that row until the computed discount factor is
found. The interest rate corresponding to this discount
factor is the IRR.

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 Example-1

Honley Medical is considering investing $1,200,000 in

a new ultrasound system product. Net annual cash
inflows of $499,500 will occur for 3 years.

Calculate IRR

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 Solution-1

Step 1: Compute discount factor using the following

formula:
df = I/CF
= $1,200,000 / $499,500 = 2.402

Step 2: Compute IRR by using present value table

(Exhibit 13B-2)
IRR= (12%)

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 Example-2

Honley Medical is choosing between 2 different processes to

prevent production of contaminants. Design A requires initial
outlay of $180,000 while Design B requires an initial outlay of
$210,000. Honley Medical has a 12% cost of capital.
The projected annual benefits, incremental annual operating
costs (over current process), capital outlays (each design
requires some new production equipment), and project life for
each design follow:

Which process should be selected?

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 Solution-2

CASH FLOW PATTERNS: Panel A

Cash flow patterns are
even but different as are
investment costs.

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 Solution-2

IRR ANALYSIS: Panel B

IRR produces same

result for both
designs.

Design A

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 Solution-2

NPV ANALYSIS: Panel C

Design A
NPV shows that
Design B is best.

Design B
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 Solution-2

It is noted that:
While both projects offer a 20% return
evaluated by IRR,
Design B offers a NPV of $42,350 while
Design A offers a NPV of $36,300.

Accordingly, the company should select

Design B over Design A
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 Example-3

Kenn Day, manager of Day Laboratory, is investigating the

possibility of acquiring some new test equipment. To acquire
the equipment requires an initial outlay of $300,000. To raise
the capital, Kenn will sell stock valued at $200,000 (the stock
pays dividends of $24,000 per year) and borrow $100,000. The
loan for $100,000 would carry an interest rate of 6 percent.
Kenn figures that his weighted average cost of capital is 10
percent [(2/3 x 0.12) + (1/3 x 0.06)]. This weighted cost of
capital is the discount rate that will be used for capital
investment decisions.
Kenn estimates that the new test equipment will produce a cash
inflow of $50,000 per year. Kenn expects the equipment to last
for 20 years.

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 Example-3

Required:
1. Compute the payback period.
2. Assuming that depreciation is $14,000 per year, compute the
accounting rate of return (on total investment).
3. Compute the NPV of the test equipment.
4. Compute the IRR of the test equipment.
5. Should Kenn buy the equipment?

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 Solution-3
1. The payback period is $300,000/$50,000 = 6 years.
2. The accounting rate of return is ($50,000 -
$14,000)/$300,000 = 12%.
3. From Exhibit 13B-2, the discount factor for an annuity with
i at 10 percent and n at 20 years is 8.514. Thus, the NPV is
(8.514 x $50,000) - $300,000 = $125,700.
4. The discount factor associated with the IRR is 6.00
($300,000/$50,000). From Exhibit 13B-2, the IRR is
between 14 and 16 percent (using the row corresponding to
period 20).
5. Since the NPV is positive and the IRR is greater than
Kenn’s cost of capital, the test equipment is a sound
investment. This, of course, assumes that the cash flow
projections are accurate.
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 IRR when cash flows are uneven

Can IRR be calculated if

the cash flows are uneven?

Yes. But you must use trial &

error, a business calculator, or a
spreadsheet.

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 Exercises

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 Excercies-1

Cameron Company is considering the purchase of

new equipment that will speed up the process for
extracting copper.
The equipment will cost $1,500,000 and have a life of
five years with no expected salvage value. The
expected cash flows associated with the project
follow:

Required:
Compute the equipment’s accounting rate of return.
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 Excercies-2

Merlene Jensen is considering investing in one of the

following two projects. Either project will require an
investment of $20,000. The expected revenues less
cash expenses for the two projects follow. Assume
each project is depreciable.

Required:
Which project should be chosen based on the
accounting rate of return?
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 Excercies-3

Suppose that a project has an accounting rate of

return 25% (based on average investment) and
that the average net income of the project is
$100,000.

How much did the company invest in the project?

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 Excercies-4

Suppose that a project has an accounting rate of

return 50% and that the investment is $200,000.

What is the average income earned by the

project?

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 Excercies-5

Suppose that a project has an accounting rate of

return 50% and that the investment is $200,000.

What is the average income earned by the

project?

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 Excercies-6
Murrie Medical Clinic is investigating the possibility of
investing in new blood analysis equipment. Two local
manufacturers of this equipment are being considered as
sources of the equipment. After-tax cash inflows for the two
competing projects are as follows:

Both projects require an initial investment of $200,000. In

both cases, assume the equipment has a life of five years
with no salvage value.
Required: Assuming a discount rate of 12 percent,
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compute the net present value of each piece of equipment.
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 Excercies-7

Wallace Company is considering two projects.

Their required rate of return is 10%.

Project A Project B
Initial investment $170,000 $48,000
Annual cash flows $41,352 $12,022
Life of the project 6 years 5 years

Which of the two projects, A or B, is better in

terms of internal rate of return?

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 Excercies-8

Pitt Company is considering two alternative

investments. The company requires a 12% return
from its investments. Neither option has a
salvage value.

Compute the IRR for both projects and

recommend one of them
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