bg management accounting chapter 10 4335

CHAPTER 10 10.1 An overview about capital budgeting Any decision that involves a cash outlay now to obtain a future return is a capital budgeting decision Typical capital budgeting decisions include: Cost reduction decisions Expansion decisions Equipment selection decisions Lease or buy decisions Equipment replacement decisions 10.1.1 Typical Capital Budgeting Decision Capital budgeting tends to fall into two broad categories: Œ Screening decisions: Does a proposed project meet some present standard of acceptance?  Preference decisions: Selecting from among several competing courses of action 10.1.2 Cash flows CASH OUTFLOW Most projects have at least three types of cash outflows: - They often require an immediate cash outflow in the form of an initial investment in equipment, other assets, and installation costs - Some projects require a company to expand its working capital - Many projects require periodic outlays for repairs and maintenance and additional operating costs 10.1.2 Cash flows CASH INFLOW Most projects have at least three types of cash inflows: - A project will normally increase revenues or reduce costs - Cash inflows are also frequently realized from selling equipment for its salvage value when a project ends - Any working capital that was tied up in the project can be released for use elsewhere at the end of the project and should be treated as a cash inflow at that time 10.1.3 Time Value of Money There are types of cash flow: - Single cash flow: is the cash flow that happens in one period - Compound cash flow: is the cash flow that happens regularly 10.1.3 Time Value of Money The capital budgeting techniques that best recognize the time value of money are those that involve discounted cash flows Discounting cash flows is a method to translate the value of future cash flows to their present value 10.2 Methods in analyzing capital budgeting decisions • The Payback Period Method (PP) • The Net Present Value Method (NPV) • The Internal Rate of Return Method (IRR) • The Simple Rate of Return Method (SRR) 10.2.1 The Payback Method The payback period is the length of time that it takes for a project to recover its initial cost out of the cash receipts that it generates The payback period is expressed in years 10.2.2.The Net Present Value Method The net present value is the difference between the present value of the cash inflows and the present value of the cash outflows of an investment project There are steps to apply NPV method 10.2.2.The Net Present Value Method - Step 1: classify cash flows of the project: + Cash outflows include: Initial investment (including installation costs) Increased working capital needs Repair and maintenance Incremental operating costs + Cash inflows: Incremental revenues Reduction in cost Salvage value Release of working capital Refund VAT 10.2.2.The Net Present Value Method - Step 2: Choosing a discount rate Bases on cost of capital: It is the average rate of return the company must pay to its long term creditors, shareholders for using their funds - Step 3: Calculate Cash flow Present Value Present Value = Cash flow Value X Discount rate - Step 4: Calculate Net Present Value NPV = Total cash inflows PV – Total cash Outflows PV 10.2.2.The Net Present Value Method Step 5: Select projects: NPV < 0: not acceptable because its return is less than the required rate of return NPV = 0: acceptable NPV > 0: acceptable because its return is greater than the required rate of return 10.2.3 Internal Rate of Return Method • The internal rate of return is the rate of return promised by an investment project over its useful life • It is computed by finding the discount rate that will cause the net present value of a project to be zero 10.2.3 Internal Rate of Return Method When using the internal rate of return, the cost of capital acts as a hurdle rate that a project must clear for acceptance 10.2.4 The Simple Rate of Return The simple rate of return is the rate of the annual incremental net operating income generated by a project is divided by SRR = the initial investment in the project Annual Incremental net operating income Initial Investment ... time 10. 1.3 Time Value of Money There are types of cash flow: - Single cash flow: is the cash flow that happens in one period - Compound cash flow: is the cash flow that happens regularly 10. 1.3... project to be zero 10. 2.3 Internal Rate of Return Method When using the internal rate of return, the cost of capital acts as a hurdle rate that a project must clear for acceptance 10. 2.4 The Simple... of acceptance?  Preference decisions: Selecting from among several competing courses of action 10. 1.2 Cash flows CASH OUTFLOW Most projects have at least three types of cash outflows: - They