Introduction to Management Accounting

1. Introduction to Management Accounting

2. Introduction to Management Accounting Chapter 11 Capital Budgeting

3. Learning Objective 1 Capital Budgeting Capital budgeting describes the long-term planning for making and financing major long-term projects. 1. Identify potential investments. 2. Choose an investment. 3. Follow-up or “postaudit.”

4. Discounted-Cash-Flow Models (DCF) These models focus on a project’s cash inflows and outflows while taking into account the time value of money. DCF models compare the value of today’s cash outflows with the value of the future cash inflows.

5. Net Present Value Model The net-present-value (NPV) method computes the present value of all expected future cash flows using a minimum desired rate of return.

6. Net Present Value Model The minimum desired rate of return depends on the risk of a proposed project – the higher the risk, the higher the rate. The required rate of return (also called hurdle rate or discount rate) is the minimum desired rate of return based on the firm’s cost of capital.

7. Prepare a diagram of relevant expected cash inflows and outflows. 1 Find the present value of each expected cash inflow or outflow. 2 Sum the individual present values. 3 Applying the NPV Method

8. NPV Example Original investment (cash outflow): $5,827 Useful life: four years Annual income generated from investment (cash inflow): $2,000 Minimum desired rate of return: 10%

9. NPV Example Present Value of $1 Total Sketch of Cash Discounted Present Flows at End of Year At 10% Value 0 1 2 3 4 Approach 1: Discounting Cash Flows Cash flows Annual savings .9091 $1,818 2,000 .8264 1,653 2,000 .7513 1,503 2,000 .6830 1,366 2,000 Present value of Future inflows $6,340 Initial Outlay 1.0000 (5,827) $(5,827) Net present value $ 513

10. NPV Example Approach 2: Using an Annuity Table Sketch of Cash Flows at End of Year 0 1 2 3 4 Annual Savings 3.1699 $6,340 $2,000 $2,000 $2,000 $2,000 Initial Outlay 1.0000 (5,827) $(5,827) Net present value $ 513

11. Predicted cash flows occur timely. Money can be borrowed or loaned at the same interest rate. Assumptions of the NPV Model There is a world of certainty. There are perfect capital markets.

12. Decision Rules Managers determine the sum of the present values of all expected cash flows from the project. If the sum of the present values is positive, the project is desirable. If the sum of the present values is negative, the project is undesirable.

13. Internal Rate of Return Model The IRR determines the interest rate at which the NPV equals zero. If IRR > minimum desired rate of return, then NPV> 0 and accept the project. If IRR < minimum desired rate of return, then NPV< 0 and reject the project.

14. Real Option Model This model recognizes the value of contingent investments. Contingent investments are investments that a company can adjust as it learns more about their potential for success.

15. Learning Objective 2 Sensitivity Analysis Sensitivity analysis shows the financial consequences that would occur if actual cash inflows and outflows differ from those expected.

16. Sensitivity Analysis Example Suppose that a manager knows that the actual cash inflows in the previous example could fall below the predicted level of $2,000. How far below $2,000 must the annual cash inflow drop before the NPV becomes negative?

17. Sensitivity Analysis Example NPV = 0 (3.1699 × Cash flow) – $5,827 = 0 Cash flow = $5,827 ÷ 3.1699 = $1,838 If the annual cash flow is less than $1,838, the NPV is negative, and the project should be rejected. Annual cash inflows can drop only $2,000 – $1,838 = $162 or 8.1%

18. Learning Objective 3 Comparison of Two Projects Two common methods for comparing alternatives are: Total project approach Differential approach

19. Total Project Approach The total project approach computes the total impact on cash flows for each alternative and then converts these total cash flows to their present values. The alternative with the largest NPV of total cash flows is best.

20. Differential Approach The differential approach computes the differences in cash flows between alternatives and then converts these differences to their present values. This method cannot be used to compare more than two alternatives.

21. Learning Objective 4 Relevant Cash Flows for NPV The four types of inflows and outflows should be considered when the relevant cash flows are arrayed: • Initial cash inflows and outflows at time zero • Investments in receivables and inventories • Future disposal values • Operating cash flows

22. Operating Cash Flows The only relevant cash flows are those that will differ among alternatives. Depreciation and book values should be ignored. A reduction in cash outflow is treated the same as a cash inflow.

23. Learning Objective 5 Income Taxes and Capital Budgeting Another type of cash flow (outflow) that must be considered when making capital-budgeting decisions: Income taxes In capital budgeting, the relevant tax rate is the marginal income tax rate. This is the tax rate paid on additional amounts of pretax income.

24. Effects of Depreciation Deductions U.S. tax authorities allow accelerated depreciation. The focus is on the tax reporting rules, not those for public financial reporting. The recovery period is the number of years over which an asset is depreciated for tax purposes.

25. TAX Effects of Depreciation Deductions Depreciation expense is a noncash expense and so is ignored for capital budgeting, except that it is an expense for tax purposes and so will provide a cash inflow from income tax savings.

26. Tax Deductions, Cash Effects, and Timing Assume the following: Cash inflow from operations: $60,000 Tax rate: 40% What is the after-tax inflow from operations? $60,000 × (1 – tax rate) = $60,000 × .6 = $36,000

27. Tax Deductions, Cash Effects, and Timing What is the after-tax effect of $25,000 depreciation? $25,000 × 40% = $10,000 tax savings

28. Modified Accelerated Cost Recovery System Under U.S. income tax laws, companies depreciate most assets using the Modified Accelerated Cost Recovery System (MACRS). This system specifies a recovery period and an accelerated depreciation schedule for all types of assets.

29. Learning Objective 6 Gains or Losses on Disposal Suppose a 5-year piece of equipment purchased for $125,000 is sold at the end of year 3 after taking three years of straight-line depreciation. What is the book value? $125,000 – (3 × $25,000) = $50,000

30. Gains or Losses on Disposal If the equipment is sold for $50,000 (book value), there is no gain or loss and so there is no tax effect. If it is sold for more than $50,000, there is a gain and an additional tax payment. If it is sold for less than $50,000, there is a loss and a tax savings.

31. Gains or Losses on Disposal Assume that the equipment is sold for $70,000 and the tax rate is 40%. What is the tax savings on the sale? ($70,000 – $50,000) = 20,000 × 40% = $8,000 What is the net cash inflow from the sale? $70,000 – $8,000 = $62,000

32. Learning Objective 7 Payback Model Payback time, or payback period, is the time it will take to recoup, in the form of cash inflows from operations, the initial dollars invested in a project. P = I ÷ O Assume that $12,000 is spent for a commercial stove with an estimated useful life of 4 years.

33. What is the payback period Payback Model Example Annual savings of $4,000 in cash outflows are expected from operations. P = $12,000 ÷ $4,000 = 3 years

34. = Increase in expected average annual operating income* ÷ Initial required investment Accounting Rate-of-Return Model The accounting rate-of-return (ARR) model expresses a project’s return as the increase in expected average annual operating income divided by the required initial investment. ARR *Average annual incremental cash inflow from operations minus incremental average annual depreciation

35. Accounting Rate-of-Return Example • Assume the following: • Investment is $5,827. • Useful life is four years. • Estimated disposal value is zero. • Expected annual cash inflow • from operations is $2,000. Annual depreciation = (cost – disposal value)/useful life Annual depreciation = ($5,827 – 0)/4 = $1,456.75

36. average annual incremental cash inflow – Incremental annual depreciation ÷ Initial required investment Accounting Rate-of-Return Example ARR = ARR = ($2,000 – $1457) ÷ $5,827 = 9.3%

37. Learning Objective 8 Performance Evaluation Many managers are reluctant to accept DFC models as the best way to make capital-budgeting decisions. Why? Their superiors evaluate them using a non-DCF model.

38. Reconciliation of Conflict Use DCF for both capital-budgeting decisions and performance evaluation. Use Economic Value Added (EVA) Follow-up evaluation of capital decisions

39. Post Audit Most large companies conduct a follow-up evaluation of selected capital-budgeting decisions.

40. Post Audit Focus: Investment expenditures are on time and within budget. Comparing actual versus predicted cash flows. Improving future predictions of cash flows. Evaluating the continuation of the project.

41. Learning Objective 9 Inflation What is inflation? It is the decline in general purchasing power of the monetary unit. The key in capital budgeting is consistent treatment of the minimum desired rate of return and the predicted cash inflows and outflows.

42. Watch for Consistency Such consistency can be achieved by including an element for inflation in both the minimum desired rate of return and in the cash-flow predictions. Many firms base their minimum desired rate of return on market interest rates (nominal rates) that include an inflation element.

43. The End End of Chapter 11