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CHAPTER 12

MANAGERIAL ACCOUNTING

Study Objectives

Discuss the capital budgeting evaluation process, and explain what inputs are used in capital budgeting.

Describe the cash payback technique.

Explain the net present value method.

Identify the challenges presented by intangible benefits in capital budgeting.

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Study Objectives: Continued

Explain the internal rate of return method.

Describe the annual rate of return method.

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Capital Budgeting Evaluation ProcessStudy Objective 1

Many companies follow a carefully prescribed process in capital budgeting. At least once a year:

1) Proposals for projects are requested from each department.

2) The proposals are screened by a capital budgeting committee, which submits its finding to officers of the company.

3) Officers select projects and submit list of projects to the board of directors.

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Capital Budgeting Evaluation Process

The capital budgeting decision depends

depends on a variety of considerations:

1) The availability of funds.

2) Relationships among proposed

projects.

3) The company’s basic decision-making

approach.

4) The risk associated with a particular

project.

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Cash Payback FormulaStudy Objective 2

The cash payback technique identifies the time period required to recover the cost of the capital investment fromthe annual cash inflow produced by the investment. The formula for computing the cash payback period is:

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Estimated Annual Net Income from Capital Expenditure

Assume that Reno Co. is considering an investment of $130,000 in new equipment. The new equipment is expected to last 5 years. It will have zero salvage value at the end of its useful life. The straight-line method of depreciation is used for accounting purposes. The expected annual revenues and costs of the new product that will be produced from the investment are: (Text Illustration 12-25)

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Computation of Annual Cash Inflow

Cash income per year equals net income plus depreciation expense.

Annual (or net) cash inflow is approximated by taking net income and adding back depreciation expense. Depreciation expense is added back because depreciation on the capital expenditure does not involve an annual outflowof cash.

Net income $13,000

Add: Depreciation expense 26,000

Cash income $39,000

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Cash Payback Period

$130,000 $39,000 3.33 years÷ =

The cash payback period in this example is therefore 3.33 years, computed as follows:

When the payback technique is used to decide among acceptable alternative projects, the shorter the payback period, the more attractive the investment. This is true for two reasons:

1) the earlier the investment is recovered, the sooner the cash funds can be used for other purposes, and

2) the risk of loss from obsolescence and changed economic conditions is less in a shorter payback period.

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Net Present Value MethodStudy Objective 3

• The present value method technique is generally recognized as the best conceptual approach to making capital budgeting decisions.

• This technique considers both the estimated total cash inflows and the time value of money.

• Two methods are used with the discounted cash flow technique:

1) net present value and

2) internal rate of return

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Net Present Value Method• Under the net present value method, cash

inflows are discounted to their present value and then compared with the capital outlay required by the investment.

• The interest rate used in discounting the future cash inflows is the required minimum rate of return.

• A proposal is acceptable when NPV is zero or positive.

• The higher the positive NPV, the more attractive the investment.

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Net Present Value Decision Criteria

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Present Value of Annual Cash Inflows-Equal Annual

Cash Flows

Stewart Soup Company’s annual cash inflows are $24,000. If we assume this amount is uniform over the asset’s useful life, the present value of the annual cash inflows can be computed by using the present value of an annuity of 1 for 10 periods. The computations at rates of return of 12% and 15%, respectively are:

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Computation of Net Present Values

The proposed capital expenditure is acceptable at a required rate of return of 12% but NOT AT 15%.

The analysis of the proposal by the net present value method is as follows:

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Present Value of Annual Cash Inflows-Unequal Annual Cash Flows

When annual cash inflows are unequal, we cannot use annuity tables to calculate their present value. Instead tables showing the present value of a single future amount must be applied to each annual cash inflow.

$260,000 $155,667 $140,061

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Analysis of Proposal Using Net Present Value Method

Positive (negative) net present value $ 25,667 $10,061

Therefore, the analysis of the proposal by the net present value method is as follows:

In this example, the present values of the cash inflowsare greater than the $130,000 capital investment. Thusthe project is acceptable at both a 12% and 15%required rate of return.

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Additional ConsiderationsStudy Objective 4

• The previous NPV example relied on tangible costs and benefits that can be relatively easily quantified.

• By ignoring intangible benefits, such as increased quality, improved safety, etc. capital budgeting techniques might incorrectly eliminate projects that could be financially beneficial to the company.

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Additional Considerations

To avoid rejecting projecting that

actually should be accepted, two

possible approaches are suggested:

1. Calculate net present value ignoring intangible benefits. Then, if the NPV is negative, ask whether the intangible benefits are worth at least the amount of the negative NPV.

2. Project rough, conservative estimates of the value of the intangible benefits, and incorporate these values into the NPV calculation.

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Formula for Internal Rate of Return Factor

• The internal rate of return method finds the interest yield of the potential investment.

• This is the interest rate that will cause the present value of the proposed capital expenditure to equal the present value of the expected annual cash inflows.

• Determining the true interest rate involves two steps:

STEP 1.Compute the internal rate of return factor using this formula:

Internal Rate of Return MethodStudy Objective 5

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Internal Rate of Return Method

$244,371 ÷ $1000,000 = 2.44371

The computation for the Stewart Soup Company,assuming equal annual cash inflows is:

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Internal Rate of Return Method

STEP 2. Use the factor and the present value of an annuity of 1 table to find the internal rate of return.

• The internal rate of return is found by locating the discount factor that is closest to the internal rate of return factor for the time period covered by the annual cash flows.

• For Stewart Soup, the annual cash flows are expected to continue for 3 years. In the table below, the discount factor of 2.44371 represents an interest rate of 11%.

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Internal Rate of Return Decision Criteria

The decision rule is: Accept the project when the internal rate of return is equal to or greater than the required rate of return. Reject the project when the internal rate of return is less than the required rate.

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Comparison of Discounted Cash Flow Methods

• In practice, the internal rate of return and cash payback methods are most widely used.

• A comparative summary of the two discounted cash flow methods-net present value and internal rate of return- is presented below:

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• The annual rate of return technique is based on accounting data. It indicates the profitability of a capital expenditure. The formula is:

Annual Rate of Return FormulaStudy Objective 6

The annual rate of return is compared with its requiredminimum rate of return for investments of similar risk. This minimum return is based on the company’s cost of capital,which is the rate of return that management expects to pay onall borrowed and equity funds.

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Formula for Computing Average Investment

For Reno, average investment is $65,000: [($130,000 + $0)/ 2]

Expected annual net income ($13,000) is obtained fromthe projected income statement. Average investment isderived from the following formula:

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Solution to Annual Rate of Return Problem

$13,000 ÷ $65,000 = 20%

The expected annual rate of return for Reno Company’s investment in new equipment is therefore 20%, computedas follows:

The decision rule is: A project is acceptable if its rate of return is greater than management’s minimum rate of return. It is unacceptable when the reverse is true. Whenchoosing among several acceptable projects, the higher the rate of returnfor a given risk, the more attractive the investment.