Cost Management ACCOUNTING AND CONTROL HANSEN MOWEN 1

Cost Management ACCOUNTING AND CONTROL HANSEN & MOWEN 1

20 Capital Investment 2

Capital Investment Decisions 1 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. 3

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

Payback and Accounting Rate of Return: Nondiscounting Methods 2 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). 5

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

Payback and Accounting Rate of Return: Nondiscounting Methods 2 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 7

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

The Net Present Value Method 3 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) 9

The 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. 10

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

The Net Present Value Method 3 Step 2 A. NPV Analysis Year Cash Flow Discount Factor 0 $-900, 000 Present Value 1 300, 000 of $1 2 300, 000 3 300, 000 4 300, 000 5 500, 000 Net present value 1. 000 0. 893 0. 797 0. 712 0. 636 0. 567 Present Value $-900, 000 267, 900 239, 100 213, 600 190, 800 283, 500 $ 294, 900 Step 2 B. NPV Analysis Year Cash Flow 0 $-900, 000 Present Value of 1 -4 300, 000 an Annuity of. Value $1 Present 5 500, 000 of $1 Net present value Discount Factor 1. 000 3. 307 0. 567 Present Value $-900, 000 911, 100 283, 500 $ 294, 600 12

The Net Present Value Method 3 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. 13

The Net Present Value Method 3 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. 14

Internal Rate of Return 4 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% 15

Internal Rate of Return 4 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. 16

NPV versus IRR: Mutually Exclusive Projects 5 There are two major differences between net present value and the internal rate of return: q 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. q NPV measures the profitability of a project in absolute dollars, whereas the IRR method measures it as a percentage. 17

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

NPV versus IRR: Mutually Exclusive Projects 5 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). 19

NPV versus IRR: Mutually Exclusive Projects 5 Milagro Travel Agency Example Standard T 2 Annual revenues Annual operating costs System investment Project life $240, 000 120, 000 360, 000 5 years Custom Travel $300, 000 160, 000 420, 000 5 years The cost of capital is 12 percent 20

NPV versus IRR: Mutually Exclusive Projects 5 Cash Flow Pattern, NPV and IRR Analysis: Standard T 2 versus Custom Travel 21

NPV versus IRR: Mutually Exclusive Projects 5 Cash Flow Pattern, NPV and IRR Analysis: Standard T 2 versus Custom Travel 22

NPV versus IRR: Mutually Exclusive Projects 5 Cash Flow Pattern, NPV and IRR Analysis: Standard T 2 versus Custom Travel a. From Exhibit 20 B-2. b. From Exhibit 20 B-2, df = 3. 0 implies that IRR =20%. 23

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

Computing After-Tax Cash Flows 6 The Effects of Inflation on Capital Investment a. From Exhibit 20 B-2. b 6, 670, 000 bolivares = 1. 15 x 5, 800, 000 bolivares (adjustment for one year of inflation) 7, 670, 500 bolivares = 1. 15 x 5, 800, 000 bolivares (adjustment for two years of inflation). c. From Exhibit 20 B-1. 25

Computing After-Tax Cash Flows 6 Disposition of Old Machine Book Value Sale Price M 1 M 2 $ 600, 000 1, 500, 000 $ 780, 000 1, 200, 000 Acquisition of Flexible System Purchase cost Freight Installation Additional working capital Total $7, 500, 000 600, 000 540, 000 $8, 700, 000 26

Computing After-Tax Cash Flows 6 Tax Effects of the Sale of M 1 and M 2 a. Sale b. Sale price minus book value is $780, 000 - $600, 000. price minus book value is $1, 200, 000 - $1, 500, 000. 27

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

Computing After-Tax Cash Flows 6 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 Less: Cash operating expenses $1, 200, 000 -500, 000 Depreciation (straight-line) Income before income taxes Less: Income taxes (@ 40%) Net income -400, 000 $ 300, 000 120, 000 $ 180, 000 29

Computing After-Tax Cash Flows 6 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 Computation of Operating Cash Flows: Decomposition Terms 30

Computing After-Tax Cash Flows 6 MACRS Depreciation Rates The tax laws classify most assets into the following three classes (class = allowable years): Class 3 5 7 Types of Assets Most small tools Cars, light trucks, computer equipment 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. 31

Computing After-Tax Cash Flows 6 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 32

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

Capital Investment: Advanced Technology Environmental Considerations and 7 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 x 5. 65) Investment Net present value $22, 600, 000 18, 000 $ 4, 600, 000 34

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

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

Present Value Concepts A 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 37

Present Value Concepts A 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? 38

Present Value Concepts A 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) 39

Present Value Concepts A 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 23 B-1, the discount factor is 0. 712. Thus, the present value (P) is: P = F(df) = $300 x 0. 712 = $213. 60 40

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

End of Chapter 20 42