Financial and managerial accounting 2nd kimel kieso willey chapter 26

26-1 26 Planning for Capital Investments Learning Objectives 26-2 Describe capital budgeting inputs and apply the cash payback technique Use the net present value method Identify capital budgeting challenges and refinements Use the internal rate of return method Use the annual rate of return method LEARNING OBJECTIVE Describe capital budgeting inputs and apply the cash payback technique Corporate capital budget authorization process: 26-3 Proposals for projects are requested from each department Proposals are screened by a capital budget committee Officers determine which projects are worthy of funding Board of directors approves capital budget LO Authorization Process Many companies follow a carefully prescribed process in capital budgeting Illustration 26-1 Corporate capital budget authorization process 26-4 LO Cash Flow Information For purposes of capital budgeting, estimated cash inflows and outflows are the preferred inputs Why? Ultimately, the value of all financial investments is determined by the value of cash flows received and paid 26-5 LO Cash Flow Information Typical cash flows relating to capital budgeting decisions Cash Outflows Illustration 26-2 Initial investment Repairs and maintenance Increased operating costs Overhaul of equipment Cash Inflows Sale of old equipment Increased cash received from customers Reduced cash outflows related to operating costs Salvage value of equipment 26-6 LO Cash Flow Information Capital budgeting decisions depend on: 26-7 Availability of funds Relationships among proposed projects Company’s basic decision-making approach Risk associated with a particular project LO Illustrative Data Stewart Shipping Company is considering an investment of $130,000 in new equipment Illustration 26-3 26-8 LO Cash Payback Cash payback technique identifies the time period required to recover the cost of the capital investment from the net annual cash inflow produced by the investment Illustration 26-4 Cash payback period for Stewart is … $130,000 ÷ $24,000 = 5.42 years 26-9 LO Cash Payback Shorter payback period = More attractive the investment In the case of uneven net annual cash flows, the company determines the cash payback period when the: Cumulative net cash flows from the investment 26-10 = Cost of the investment LO DO IT! Solution Present value of annual cash flows Profitability Index Solar Wind $78,580 $168,450 Less: Initial investment 45,500 125,300 Net present value $33,080 $ 43,150 Profitability index 1.73* 1.34** *$78,580 ÷ $45,500 **168,450 ÷ 125,300 While the investment in wind power generates the higher net present value, it also requires a substantially higher initial investment The profitability index favors solar power, which suggests that the additional net present value of wind is outweighed by the cost of the initial investment The company should choose solar power 26-45 LO LEARNING OBJECTIVE  Use the internal rate of return method Differs from the net present value method in that it finds the interest yield of the potential investment  Internal rate of return (IRR) - interest rate that will cause the present value of the proposed capital expenditure to equal the present value of the expected net annual cash flows (NPV equal to zero)  26-46 How does one determine the internal rate of return? LO Internal Rate of Return Method Illustration: Stewart Shipping Company is considering the purchase of a new front-end loader at a cost of $244,371 Net annual cash flows from this loader are estimated to be $100,000 a year for three years Determine the internal rate of return on this front-end loader Illustration 26-21 Estimation of internal rate of return 26-47 LO Internal Rate of Return Method An easier approach to solving for the internal rate of return when net annual cash flows are equal Illustration 26-22 Applying the formula: $244,371 ÷ $100,000 = 2.44371 26-48 LO Internal Rate of Return Method Illustration 26-23 Internal rate of return decision criteria 26-49 LO Comparing Discounted Cash Flow Methods Illustration 26-24 Comparison of discounted cash flow methods Either method will provide management with relevant quantitative data for making capital budgeting decisions 26-50 LO DO IT! Internal Rate of Return Watertown Paper Corporation is considering adding another machine for the manufacture of corrugated cardboard The machine would cost $900,000 It would have an estimated life of years and no salvage value The company estimates that annual cash inflows would increase by $400,000 and that annual cash outflows would increase by $190,000 Management has a required rate of return of 9% Calculate the internal rate of return on this project and discuss whether it should be accepted 26-51 LO DO IT! Internal Rate of Return Calculate the internal rate of return Estimated annual cash inflows Estimated annual cash outflows Net annual cash flow $400,000 - 210,000 Machine cost Net annual cash flow 190,000 900,000 210,000 PV Factor ÷ 4.28571 Now, find the rate that corresponds to the present value factor 26-52 LO DO IT! Internal Rate of Return Find the rate that corresponds to the present value factor PV Factor 4.28571 Since the required rate of return is only 9%, the project should be accepted 26-53 LO LEARNING OBJECTIVE Use the annual rate of return method Indicates the profitability of a capital expenditure by dividing expected annual net income by the average investment Illustration 26-25 26-54 LO Annual Rate of Return Illustration: Reno Company is considering an investment of $130,000 in new equipment The new equipment is expected to last five years and have zero salvage value at the end of its useful life Reno uses the straight-line method of depreciation Illustration 26-26 Estimated annual net income from Reno Company’s capital expenditure 26-55 LO Annual Rate of Return Illustration 26-27 $130,000 + $0 = $65,000 Expected annual rate of return $13,000 = 20% $65,000 A project is acceptable if its rate of return is greater than management’s required rate of return 26-56 LO DO IT! Annual Rate of Return Watertown Paper Corporation is considering adding another machine for the manufacture of corrugated cardboard The machine would cost $900,000 It would have an estimated life of years and no salvage value The company estimates that annual revenues would increase by $400,000 and that annual expenses excluding depreciation would increase by $190,000 It uses the straight-line method to compute depreciation expense Management has a required rate of return of 9% Compute the annual rate of return 26-57 LO DO IT! Annual Rate of Return Compute the annual rate of return The proposed project is acceptable 26-58 LO Copyright Copyright © 2015 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 permission 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 26-59 ... years and lower in the later years 26- 19 LO Unequal Annual Cash Flows Illustration 26- 9 Computation of present value of unequal annual cash flows 26- 20 LO Unequal Annual Cash Flows Illustration 26- 10... Question Compute the net present value of a $260 ,000 investment with a 10-year life, annual cash inflows of $50,000 and a discount rate of 12% 26- 26 a $(9,062) b $22,511 c $9,062 d $(22,511)... Illustration 26- 12 Investment information for Best Taste Foods example 26- 27 LO Comprehensive Example Compute the net annual cash flow Illustration 26- 13 Computation of net annual cash flow 26- 28 LO