20-1 HANSEN & MOWEN Cost Management ACCOUNTING AND CONTROL

HANSEN & MOWENHANSEN & MOWEN

Cost ManagementCost ManagementACCOUNTING AND CONTROLACCOUNTING AND CONTROL

Capital InvestmentCapital Investment

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.

Capital Investment DecisionsCapital Investment Decisions 1

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

Capital Investment DecisionsCapital Investment Decisions 1

Payback AnalysisPayback AnalysisPayback AnalysisPayback Analysis

Payback and Accounting Rate of Return: Payback and Accounting Rate of Return: Nondiscounting MethodsNondiscounting Methods 2

*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).

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

Accounting Rate Of Return (ARR)

ARR = Average income ÷ Original investment or Average investment

Average investment = (I + S)/2

I = the original investment

S = salvage value

Assume that the investment is uniformly consumed

I = the original investment

S = salvage value

Assume that the investment is uniformly consumed

Average annual net cash flows, less

average depreciation

Average annual net cash flows, less

average depreciation

The major deficiency of the accounting rate of return is that it ignores the time value of money.

Accounting Rate Of Return (ARR)

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)

Net present value is the difference between the present value of the cash inflows and outflows associated with a project.

The Net Present Value MethodThe Net Present Value Method 3

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.

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

Salvage100,000

Recovery of working capital 100,000

Total$ 500,000

Step 2A. NPV Analysis

Year Cash Flow Discount Factor Present Value

0 $-900,000 1.000$-900,000

1 300,000 0.893267,900

2 300,000 0.797239,100

3 300,000 0.712213,600

4 300,000 0.636190,800

5 500,000 0.567 283,500Net present value$ 294,900

Present Value Present Value of $1of $1

Step 2B. NPV Analysis

Year Cash Flow Discount Factor Present Value

0 $-900,000 1.000 $-900,0001-4 300,000 3.307 911,1005 500,000 0.567 283,500

Net present value $ 294,600

Present Value Present Value of $1of $1

Present Value of Present Value of an Annuity of $1an Annuity of $1

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.

Decision Criteria for NPV

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.

The internal 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%

Internal Rate of ReturnInternal Rate of Return 4

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.

Decision Criteria:

Internal Rate of ReturnInternal Rate of Return 4

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.

5NPV versus IRR: Mutually NPV versus IRR: Mutually Exclusive ProjectsExclusive Projects

NPV and IRR: Conflicting SignalsNPV and IRR: Conflicting SignalsNPV and IRR: Conflicting SignalsNPV and IRR: Conflicting Signals

Modified Cash Flows with Additional OpportunityModified Cash Flows with Additional OpportunityModified Cash Flows with Additional OpportunityModified Cash Flows with Additional Opportunity

Modified Comparison of Projects A and BModified Comparison of Projects A and BModified Comparison of Projects A and BModified Comparison of Projects A and B

*1.08($686,342) + $686,342.

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).

Annual revenues $240,000 $300,000Annual operating costs 120,000 160,000System investment 360,000 420,000Project life 5 years 5 years

Milagro Travel Agency Example

Standard T2

Custom Travel

The cost of capital is 12 percent

Cash Flow Pattern, NPV and IRR Analysis: Cash Flow Pattern, NPV and IRR Analysis: Standard T2 versus Custom TravelStandard T2 versus Custom Travel

aFrom Exhibit 20B-2.

bFrom Exhibit 20B-2, df = 3.0 implies that IRR =20%.

The cost of capital is composed of two elements:

1. The real rate

2. The inflationary element

6Computing After-Tax Cash FlowsComputing After-Tax Cash Flows

The Effects of Inflation on Capital InvestmentThe Effects of Inflation on Capital InvestmentThe Effects of Inflation on Capital InvestmentThe Effects of Inflation on Capital Investment

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.

Disposition of Old Machine

Book Value Sale Price

M1 $ 600,000$ 780,000

M2 1,500,0001,200,000

Acquisition of Flexible System

Purchase cost

$7,500,000Freight

60,000Installation

600,000Additional working capital

540,000 Total

$8,700,000

Tax Effects of the Sale of M1 and M2Tax Effects of the Sale of M1 and M2Tax Effects of the Sale of M1 and M2Tax 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.

The two machines are sold:

Sales price, M1 $ 780,000Sales price, M2 1,200,000Tax savings 48,000 Net proceeds $2,028,000

The net investment is:

Total cost of flexible system $8,700,000Less: Net proceeds 2,028,000 Net investment (cash outflow) $6,672,000

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.

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

The income statement for the project is as follows:

After-Tax Operating Cash Flows: Life of the Project

Cash flow = [(1– Tax rate) x Revenues] – [(1– Tax rate) x Cash expenses] + (Tax rate x Noncash expenses)

After-tax revenues $720,000

After-tax cash expenses -300,000

Depreciation tax shield 160,000

Operating cash flow $580,000

After-Tax Operating Cash Flows: Life of the Project

Computation of Operating Cash Flows: Computation of Operating Cash Flows: Decomposition TermsDecomposition Terms

The tax laws classify most assets into the following three classes (class = allowable years):

Class Types of Assets3 Most small tools5 Cars, light trucks, computer equipment7 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.

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.

MACRS Depreciation Rates

MACRS Depreciation RatesMACRS Depreciation RatesMACRS Depreciation RatesMACRS Depreciation Rates

Value of Accelerated Methods IllustratedValue of Accelerated Methods IllustratedValue of Accelerated Methods IllustratedValue of Accelerated Methods Illustrated

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)

$22,600,000Investment

18,000,000 Net present value

$ 4,600,000

How Estimates of Operating Cash Flows Differ

7Capital Investment: Advanced Technology Capital Investment: Advanced Technology and Environmental Considerationsand Environmental Considerations

Investment Data: Direct, Intangible, Investment Data: Direct, Intangible, and Indirect Benefitsand Indirect Benefits

7Capital Investment: Advanced Technology Capital Investment: Advanced Technology and Environmental Considerationsand Environmental Considerations

Investment Data: Direct, Intangible, Investment Data: Direct, Intangible, and Indirect Benefitsand Indirect Benefits

Future ValueLet:

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

APresent Value ConceptsPresent Value Concepts

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?

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)

Future 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

Present Value

Present Value of an Uneven Series of Cash FlowsPresent Value of an Uneven Series of Cash FlowsPresent Value of an Uneven Series of Cash FlowsPresent Value of an Uneven Series of Cash Flows

Present Value of a Uniform Series of Cash FlowsPresent Value of a Uniform Series of Cash FlowsPresent Value of a Uniform Series of Cash FlowsPresent Value of a Uniform Series of Cash Flows

End of End of Chapter 20Chapter 20

20-1 HANSEN & MOWEN Cost Management ACCOUNTING AND CONTROL

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