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Investments

Learning Objectives

After studying this chapter, you should be able to:

[1] Discuss capital budgeting evaluation, and explain inputs used in capital

budgeting.

[2] Describe the cash payback technique.

[3] Explain the net present value method.

[4] Identify the challenges presented by intangible benefits in capital budgeting.

[5] Describe the profitability index.

[6] Indicate the benefits of performing a post-audit.

[7] Explain the internal rate of return method.

[8] Describe the annual rate of return method.

12-1

Preview of Chapter 12

Managerial Accounting

Sixth Edition

Weygandt Kimmel Kieso

12-2

Corporate capital budget authorization process:

1.

department.

12-3

2.

3.

4.

explain inputs used in capital budgeting.

requested from

departments, plants, and

authorized personnel.

capital budget committee.

3. Officers determine

which projects are

worthy of

funding .

Illustration 12-1

12-4

4. Board of directors

approves capital budget

LO 1

Cash Flow Information

For purposes of capital budgeting, estimated cash inflows

and outflows are the preferred inputs.

Why?

Ultimately, the value of all financial investments is

determined by the value of cash flows received and paid.

12-5

explain inputs used in capital budgeting.

Cash Flow Information

Illustration 12-2

Typical cash flows relating

to capital budgeting

decisions

12-6

explain inputs used in capital budgeting.

Cash Flow Information

Capital budgeting decisions depend on:

12-7

1.

Availability of funds.

2.

3.

4.

explain inputs used in capital budgeting.

Illustrative Data

Stewart Shipping Company is considering an investment of

$130,000 in new equipment.

Illustration 12-3

12-8

explain inputs used in capital budgeting.

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.

Illustration 12-4

$130,000 $24,000 = 5.42 years

12-9

Cash Payback

Shorter payback period = More attractive the investment.

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 equal the cost of the

investment.

12-10

Cash Payback

Shorter payback period = More attractive the investment.

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

12-11

Cost of the

investment

Cash Payback

Illustration: Chen Company proposes an investment in a new

website that is estimated to cost $300,000.

Illustration 12-5

Cash payback should not be the only basis for the capital budgeting

decision as it ignores the expected profitability of the project.

12-12

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.

12-13

Cash Payback

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.

12-14

a.

8.00 years.

b.

3.08 years.

c.

5.00 years.

d.

13.33 years.

Discounted cash flow technique:

time value of money.

12-15

Two methods:

Net Present Value (NPV) method

then compared with the capital outlay required by the

investment.

minimum rate of return.

investment.

12-16

Proposal is

acceptable when net

present value is zero

or positive.

12-17

Illustration 12-6

Net present value decision

criteria

LO 3

Equal Annual Cash Flows

Illustration: Stewart Shipping Companys annual cash flows

are $24,000. If we assume this amount is uniform over the

assets useful life, we can compute the present value of the net

annual cash flows.

Illustration 12-7

12-18

Equal Annual Cash Flows

Illustration: Calculate the present value.

Illustration 12-8

of return of 12% because the net present value is positive.

12-19

Unequal Annual Cash Flows

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.

12-20

Unequal Annual Cash Flows

12-21

Illustration 12-9

Computation of present value

of unequal annual cash flows

Unequal Annual Cash Flows

Illustration: Calculate the net present value.

Illustration 12-10

return of 12% because the net present value is positive.

12-22

12-23

Choosing a Discount Rate

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.

Discount rate has two elements:

12-24

Cost of capital.

Risk.

hurdle rate.

cutoff rate.

Choosing a Discount Rate

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%.

Illustration 12-11

12-25

Simplifying Assumptions

project that has a similar return.

12-26

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%.

12-27

a.

$(9,062).

b.

$22,511.

c.

$9,062.

d.

$(22,511).

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.

12-28

whether it should be accepted.

12-29

Comprehensive Example

Best Taste Foods is considering investing in new equipment to

produce fat-free snack foods.

Illustration 12-12

Investment information for Best Taste

12-30

Comprehensive Example

Compute the net annual cash flow.

Illustration 12-13

12-31

Comprehensive Example

Compute the net present value.

Illustration 12-14

12-32

Additional Considerations

Intangible Benefits

Intangible benefits might include increased quality, improved

safety, or enhanced employee loyalty.

To avoid rejecting projects with intangible benefits:

12-33

1.

2.

intangible benefits, and incorporate these values into the NPV

calculation.

intangible benefits in capital budgeting.

Additional Considerations

Example - Berg Company is considering the purchase of a

new mechanical robot.

Illustration 12-15

net present value of

$30,493, the proposed

project is not

acceptable.

12-34

LO 4

Additional Considerations

Example - Berg estimates that sales will increase cash inflows by

$10,000 annually as a result of an increase in quality. Berg also

estimates that annual cost outflows would be reduced by $5,000 as a

result of lower warranty claims, reduced injury claims, and missed work.

Berg would

accept the

project.

Illustration 12-16

12-35

LO 4

12-36

Additional Considerations

Profitability Index for Mutually Exclusive Projects

12-37

Managers often must choose between various positiveNPV projects because of limited resources.

Additional Considerations

Profitability Index for Mutually Exclusive Projects

Illustration: Two mutually exclusive projects, each assumed to

have a 10-year life and a 12% discount rate.

Illustration 12-17

Illustration 12-18

12-38

LO 5

Additional Considerations

Profitability Index for Mutually Exclusive Projects

Illustration: One method of comparing alternative projects is the

profitability index.

Illustration 12-18

Illustration 12-20

12-39

LO 5

Additional Considerations

Question

Assume Project A has a present value of net cash inflows of $79,600

and an initial investment of $60,000. Project B has a present value of

net cash inflows of $82,500 and an initial investment of $75,000.

Assuming the projects are mutually exclusive, which project should

management select?

12-40

a.

Project A.

b.

Project B.

c.

Project A or B.

d.

LO 5 Describe the profitability index.

Additional Considerations

Risk Analysis

A simplifying assumption made by many financial analysts is

that projected results are known with certainty.

12-41

to get a sense of the variability among potential returns.

12-42

Additional Considerations

Post-Audit of Investment Projects

Performing a post-audit is important.

12-43

actual results they will be more likely to submit reasonable

and accurate data when making investment proposals.

existing projects should be supported or terminated.

12-44

Internal Rate of Return Method

12-45

Differs from the net present value method in that it finds the

interest yield of the potential investment.

the present value of the proposed capital expenditure to

equal the present value of the expected net annual cash

flows (NPV equal to zero).

Internal Rate of Return Method

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.

Illustration 12-21

Estimation of internal rate of return

12-46

LO 7

Internal Rate of Return Method

An easier approach to solving for the internal rate of return when net

annual cash flows are equal.

Illustration 12-22

Applying the

formula:

12-47

Internal Rate of Return Method

Illustration 12-23

Internal rate of return

decision criteria

12-48

LO 7

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

internal rate of return on this project and discuss whether it

should be accepted.

12-49

Estimated annual cash inflows

Estimated annual cash outflows

$400,000

+

190,000

210,000

Machine cost

900,000

PV Factor

210,000

4.28571

Now, find the rate that corresponds to the present value factor.

12-50

PV Factor

4.28571

Since the required rate of return is only 9%, the project should be accepted.

12-51

Comparing Discounted Cash Flow Methods

Illustration 12-24

for making capital budgeting decisions.

12-52

Annual Rate of Return Method

Indicates the profitability of a capital expenditure by dividing

expected annual net income by the average investment.

Illustration 12-25

12-53

Annual Rate of Return Method

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.

Illustration 12-26

12-54

Annual Rate of Return Method

Illustration 12-27

130,000 + 0

2

Expected annual

rate of return

$13,000

$65,000

= $65,000

= 20%

managements required rate of return.

12-55

LO 8

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.

12-56

12-57

investment project in laser equipment. This will require an

investment of $280,000, and it will have a useful life of 5 years.

Annual net income is expected to be $16,000 a year.

Depreciation is computed by the straight-line method with no

salvage value. The companys cost of capital is 10%. (Hint:

Assume cash flows can be computed by adding back

depreciation expense.)

(a) Compute the cash payback period for the project. (Round

to two decimals.)

12-58

(a) Compute the cash payback period for the project. (Round

to two decimals.)

Investment

Net income

Depreciation ($280,000 5)

Annual cash flow

Cash Payback Period

12-59

$280,000

$16,000

56,000

72,000

3.89

years

(b) Compute the net present value for the project. (Round to

nearest dollar.)

Discount factor (5 periods @ 10%)

3.79079

$72,000 x 3.79079

Capital investment

Negative net present value

12-60

$272,937

280,000

$ (7,063)

Net income

Average investment ($280,000 2)

Annual rate of return

$16,000

140,000

11.4%

The annual rate of return of 11.4% is good. However, the cash payback

period is 78% of the projects useful life, and net present value is negative.

Recommendation is to reject the project.

12-61

Copyright

Copyright 2012 John Wiley & Sons, Inc. All rights reserved.

Reproduction or translation of this work beyond that permitted in

Section 117 of the 1976 United States Copyright Act without the

express written permission of the copyright owner is unlawful.

Request for further information should be addressed to the

Permissions Department, John Wiley & Sons, Inc. The purchaser

may make back-up copies for his/her own use only and not for

distribution or resale. The Publisher assumes no responsibility for

errors, omissions, or damages, caused by the use of these

programs or from the use of the information contained herein.

12-62

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