Chapter 12-1 CHAPTER 12 PLANNING FOR CAPITAL INVESTMENTS Managerial Accounting, Fifth Edition Chapter 12-2 Study Chapter 12-3 Study Objectives Discuss the capital budgeting evaluation process, and explain inputs 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 Describe the profitability index Indicate the benefits of performing a post-audit Explain the internal rate of return method Describe the annual rate of return method Planning Planning for for Capital Capital Investments Investments Capital Capital Budgeting Budgeting Evaluation Process Process Cash flow information Illustrative data Chapter 12-4 Cash Cash Payback Payback Calculation Evaluation Net Net Present Present Value Value Method Method Equal cash flows Unequal cash flows Choosing a discount Rate Simplifying Assumption Comprehensive example Other Other Capital Capital Budgeting Techniques Techniques Intangible benefits Profitability index Risk analysis Post-audit of projects Additional Additional Considerations erations Intangible benefits Internal rate of return method Comparing discounted cash flow methods Annual rate of return method Capital Budgeting Evaluation Process 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 a list of projects to the board of directors SO Discuss the capital budgeting evaluation process, and explain what inputs are used in capital budgeting Capital Budgeting Authorization Process Illustration 12-1 SO Discuss the capital budgeting evaluation process, and explain what inputs are used in capital budgeting Capital Budgeting Evaluation Process     Chapter 12-7 Most methods to evaluate capital budgeting decisions employ cash flow numbers rather than accrual revenues and expenses For capital budgeting, estimated cash inflows and outflows are the preferred inputs WHY? Ultimately the value of financial investments is determined by the value of the cash flows received or paid SO Discuss the capital budgeting evaluation process, and explain what inputs are used in capital budgeting Typical Cash Flows Related to Capital Budgeting Decisions Illustration 12-2 Chapter 12-8 SO Discuss the capital budgeting evaluation process, and explain what inputs are used in capital budgeting Capital Budgeting Evaluation Process The capital budgeting decision depends on a variety of considerations: 1) 2) 3) The availability of funds Relationships among proposed projects The company’s basic decision-making approach 4) The risk associated with a particular project Chapter 12-9 SO Discuss the capital budgeting evaluation process, and explain what inputs are used in capital budgeting Facts for Stewart Soups Example Illustration 12-3 SO Chapter 12-10 Discuss the capital budgeting evaluation process, and explain what inputs are used in capital budgeting Post-Audit of Investment Projects Performing a post-audit is important for a variety of reasons If managers know that their estimates will be compared to actual results they will be more likely to submit reasonable and accurate data when making investment proposals A post-audit provides a formal mechanism by which the company can determine whether existing projects should be supported or terminated Post-audits improve future investment proposals because by evaluating past successes and failures, managers improve their estimation techniques Chapter 12-36 SO Indicate the benefits of performing a post-audit Internal Rate of Return Method 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 Compute the internal rate of return factor using this formula: Illustration 12-22 Chapter 12-37 SO Explain the internal rate of return method Internal Rate of Return Method The computation for the Stewart Soup Company, assuming equal annual cash inflows is: $244,371 ÷ Chapter 12-38 $1000,000 = 2.44371 SO Explain the internal rate of return method Internal Rate of Return Method STEP Use the factor and the present value of an annuity of 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 years In the table below, the discount factor of 2.44371 represents an interest rate of 11% Chapter 12-39 SO Explain the internal rate of return method Internal Rate of Return Decision Criteria Illustration 12-23 Chapter 12-40 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 SO Explain the internal rate of return method 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: Chapter 12-41 Illustration 12-24 SO Explain the internal rate of return method Review Question A $60,000 project has net cash inflows for 10 years of $9,349 Compute the internal rate of return from this investment 8% b 10% c 9% d 11 a Chapter 12-42 Capital Investment = 60,000 Net Annual Cash Flows 9,349 = 6.4177 SO Explain the internal rate of return method Annual Rate of Return Formula The annual rate of return technique is based on accounting data It indicates the profitability of a capital expenditure The formula is: The annual rate of return is compared with its required minimum 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 on all borrowed and equity funds Chapter 12-43 SO Describe the annual rate of return method Formula for Computing Average Investment Expected annual net income ($13,000) is obtained from the projected income statement Average investment is derived from the following formula: For Reno, average investment is $65,000: [($130,000 + $0)/2] Chapter 12-44 SO Describe the annual rate of return method Solution to Annual Rate of Return Problem The expected annual rate of return for Reno Company’s investment in new equipment is therefore 20%, computed as follows: $13,000 ÷ $65,000 = 20% 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 When choosing among several acceptable projects, the higher the rate of return for a given risk, the more attractive the investment Chapter 12-45 SO Describe the annual rate of return method Review Question Bear Company computes an expected annual net income of $30,000 from an investment The investment has an initial cost of $200,000 and a terminal value of $20,000 Compute the annual rate of return a b c d Chapter 12-46 15% 30% 25% 27.3% Expected Annual Net Income = 30,000 = 27.3% Average Investment 110,000 SO Describe the annual rate of return method All About You: The Risks of Adjustable Rates Chapter 12-47 All About You: The Risks of Adjustable Rates Chapter 12-48 All About You: The Risks of Adjustable Rates Chapter 12-49 COPYRIGHT Copyright © 2010 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 consent 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 Chapter 12-50 .. .CHAPTER 12 PLANNING FOR CAPITAL INVESTMENTS Managerial Accounting, Fifth Edition Chapter 12- 2 Study Chapter 12- 3 Study Objectives Discuss the capital... the more attractive the investment Chapter 12- 12 SO Describe the cash payback technique Cash Payback Formula-Unequal Cash Flows Illustration 12- 5 Chapter 12- 13 SO Describe the cash payback technique... project Chapter 12- 9 SO Discuss the capital budgeting evaluation process, and explain what inputs are used in capital budgeting Facts for Stewart Soups Example Illustration 12- 3 SO Chapter 12- 10