Accounting Principles Thirteenth Edition Weygandt Kimmel Kieso Chapter 27 Planning for Capital Investments Prepared by Coby Harmon University of California, Santa Barbara Westmont College Chapter Outline Learning Objectives LO Describe capital budgeting inputs and apply the cash payback technique LO Use the net present value method LO Identify capital budgeting challenges and refinements LO Use the internal rate of return method LO Use the annual rate of return method Copyright ©2018 John Wiley & Son, Inc Capital Budgeting and Cash Payback Corporate capital budget authorization process: Proposals for projects are requested from each department, plants, and authorized personnel Proposals are screened by a capital budget committee Officers determine which projects are worthy of funding Board of directors approves capital budget LO Copyright ©2018 John Wiley & Son, Inc Cost 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 LO Copyright ©2018 John Wiley & Son, Inc Cost Flow Information Cash Outflows Initial investment Repairs and maintenance Increased operating costs Overhaul of equipment ILLUSTRATION 27.2 Typical cash flows relating to capital budgeting decisions Cash Inflows Proceeds from sale of old equipment Increased cash received from customers Reduced cash outflows related to operating costs Salvage value of equipment LO Copyright ©2018 John Wiley & Son, Inc Cost Flow Information Capital budgeting decisions depend on: a Availability of funds b Relationships among proposed projects c Company’s basic decision-making approach d Risk associated with a particular project LO Copyright ©2018 John Wiley & Son, Inc Illustrative Data Stewart Shipping Company is considering an investment of $130,000 in new equipment Initial investment Estimated useful life Estimated salvage value Estimated annual cash flows Cash inflows from customers Cash outflows for operating costs Net annual cash flow $130,000 10 years -0$200,000 176,000 $ 24,000 ILLUSTRATION 27.3 Investment information for Stewart Shipping example LO Copyright ©2018 John Wiley & Son, Inc Cash Payback Cash payback technique identifies time period required to recover cost of capital investment from net annual cash inflow produced by investment Cash payback period for Stewart is … Cost of Capital ÷ Investment $130,000 LO ÷ ILLUSTRATION 27.4 Cash payback formula Net Annual Cash Flow = Cash Payback Period $24,000 = 5.42 years Copyright ©2018 John Wiley & Son, Inc Cash Payback Shorter payback period = More attractive investment In case of uneven net annual cash flows, company determines cash payback period when: Cumulative net cash flows from investment LO = Cost of investment Copyright ©2018 John Wiley & Son, Inc ILLUSTRATION 27.5 Computation of cash payback period— unequal cash flows Cash Payback Illustration: Chen Company proposes an investment in a new website that is estimated to cost $300,000 Year LO Investmen t $300,00 Net Annual Cash Flows $60,000 90,000 90,000 120,000 100,000 Cash payback period = 3.5 years Copyright ©2018 John Wiley & Son, Inc Cumulative Net Cash Flow $60,000 150,000 240,000 360,000 460,000 10 DO IT! Profitability Index (2 of 2) Solar Wind Present value of annual cash flows $78,580 Initial investment 45,500 125,300 Net present value$33,080 $ 43,150 Profitability index *$78,580 ÷ $45,500 $168,450 1.73* 1.34** **$168,450 ÷ $125,300 The investment in wind power generates higher net present value and 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 LO Copyright ©2018 John Wiley & Son, Inc 41 Internal Rate of Return Differs from net present value method in that it finds interest yield of potential investment Internal rate of return (IRR) - interest rate that will cause present value of proposed capital expenditure to equal present value of expected net annual cash flows (NPV equal to zero) How does one determine internal rate of return? LO Copyright ©2018 John Wiley & Son, Inc 42 Internal Rate of Return Stewart Shipping Company is considering the purchase of a new frontend 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 To determine the internal rate of return on this front-end loader, the company finds the discount rate that results in a net present value of zero Less: Initial investment Present Value 10% $ 90,909 82,645 75,132 248,686 244,371 Net present value $ 4,315 Year LO Net Annual Cash Flows $100,000 $100,000 $100,000 Discount Factor 10% 90909 82645 75132 ILLUSTRATION 27.21 Estimation of internal rate of return Discount Factor 11% 90090 81162 73119 Present Value 11% $ 90,090 81,162 73,119 244,371 244,371 $ Discount Factor 12% 89286 79719 71178 Copyright ©2018 John Wiley & Son, Inc Present Value 12% $ 89,286 79,719 71,178 240,183 244,371 $ (4,188) 43 Internal Rate of Return An easier approach to solving for internal rate of return when net annual cash flows are equal ILLUSTRATION 27.22 Formula for internal rate of return— even cash flows Capital Investment $244,371 ÷ Net Annual Cash Flow = Internal Rate of Return Factor ÷ $100,000 = 2.44371 Table Present Value of an Annuity of (n) Payments 4% 5% 6% 7% 8% 9% 10% 11% 2.77509 2.72325 2.67301 2.62432 2.57710 2.53130 2.48685 2.44371 LO Copyright ©2018 John Wiley & Son, Inc 44 Internal Rate of Return ILLUSTRATION 27.23 Internal rate of return decision criteria Internal Rate of Return If equal to or greater than: Accept Proposal LO Compared to Required Rate of Return (the Discount Rate) Copyright ©2018 John Wiley & Son, Inc If less than: Reject Proposal 45 Comparing Discounted Cash Flow Methods Net Present Value Internal Rate of Return Objective Compute net present value (a dollar amount) Compute internal rate of return (a percentage) Decision Rule If net present value is zero or positive, accept the proposal If net present value is negative, reject the proposal If internal rate of return is equal to or greater than the required rate of return, accept the proposal If internal rate of return is less than the required rate of return, reject the proposal ILLUSTRATION 27.24 Comparison of discounted cash flow methods LO Copyright ©2018 John Wiley & Son, Inc 46 DO IT! Internal Rate of Return (1 of 3) 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 LO Copyright ©2018 John Wiley & Son, Inc 47 DO IT! Internal Rate of Return (2 of 3) Calculate the internal rate of return on this project Estimated annual cash inflows Estimated annual cash outflows Net annual cash flow Machine cost Net annual cash flow Present value factor $400,000 190,000 $210,000 $900,000 ÷ $210,000 4.28571 Now, find the rate that corresponds to the present value factor LO Copyright ©2018 John Wiley & Son, Inc 48 DO IT! Internal Rate of Return (3 of 3) Find the rate that corresponds to the present value factor of 4.28571 for periods Period 4% 0.96154 1.88609 2.77509 3.62990 4.45182 5.24214 6.00205 TABLE Present Value of an Annuity of 5% 6% 7% 8% 9% 0.95238 0.94340 0.93458 0.92593 0.91743 1.85941 1.83339 1.80802 1.78326 1.75911 2.72325 2.67301 2.62432 2.57710 2.53129 3.54595 3.46511 3.38721 3.31213 3.23972 4.32948 4.21236 4.10020 3.99271 3.88965 5.07569 4.91732 4.76654 4.62288 4.48592 5.78637 5.58238 5.38929 5.20637 5.03295 10% 0.90909 1.73554 2.48685 3.16987 3.79079 4.35526 4.86842 11% 0.90090 1.71252 2.44371 3.10245 3.69590 4.23054 4.71220 Required rate of return is only 9%, project should be accepted LO Copyright ©2018 John Wiley & Son, Inc 49 Annual Rate of Return Indicates profitability of a capital expenditure by dividing expected annual net income by average investment Expected Annual Average ÷ Net Income Investment = Annual Rate of Return ILLUSTRATION 27.25 Annual rate of return formula LO Copyright ©2018 John Wiley & Son, Inc 50 Annual Rate of Return ILLUSTRATION 27.26 Estimated annual net income from Reno Company’s capital expenditure Illustration: Reno Company is considering an investment of $130,000 in new equipment The equipment is expected to last five years and have zero salvage value at the end of its useful life Reno uses straight-line depreciation Sales Less: Costs and expenses Manufacturing costs (exclusive of depreciation) Depreciation expense ($130,000 ÷ 5) Selling and administrative expenses Income before income taxes Income tax expense Net income LO Copyright ©2018 John Wiley & Son, Inc $200,000 $132,000 26,000 22,000 180,000 20,000 7,000 $ 13,000 51 Annual Rate of Return Original Investment + Value at End of Useful Life Expected annual rate of return $130,000 + $0 $13,000 $65,000 ILLUSTRATION 27.27 Formula for computing average investment = Average Investment = $65,000 = 20% A project is acceptable if its rate of return is greater than management’s required rate of return LO Copyright ©2018 John Wiley & Son, Inc 52 DO IT! Annual Rate of Return (1 of 2) 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 LO Copyright ©2018 John Wiley & Son, Inc 53 DO IT! Annual Rate of Return (2 of 2) Compute the annual rate of return Revenues Less: Expenses (excluding depreciation) Depreciation expense ($900,000 ÷ years) Annual net income $400,000 $190,000 150,000 340,000 $ 60,000 Average investment = ($900,000 + $0)/2 = $450,000 Annual rate of return = $60,000/$450,000 = 13.3% The proposed project is acceptable LO Copyright ©2018 John Wiley & Son, Inc 54 Copyright Copyright © 2018 John Wiley & Sons, Inc All rights reserved Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States 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 Copyright ©2018 John Wiley & Son, Inc 55