Topic 7 ENGLISH ACCOUNTING

Managerial accounting information for long-term Decisions Topic 13-2 What is capital budgeting? • Analysis of potential additions to fixed assets • Long-term decisions; involve large expenditures • Very important to firm’s future 13-3 Time Value of Money A dollar today is worth more than a dollar a year from now Therefore, investments that promise earlier returns are preferable to those that promise later returns 13-4 Typical Cash Outflows Repairs and maintenance Working capital Initial investment Incremental operating Costs (Out-of-pocket costs) 13-5 Typical Cash Inflows Salvage value Release of working capital Reduction of costs Incremental revenues 13-6 Net Present Value (NPV) To determine net present value we Calculate the present value of cash inflows, Calculate the present value of cash outflows, Subtract the present value of the outflows from the present value of the inflows 13-7 Net Present Value rule 13-8 Internal Rate of Return (IRR) • The internal rate of return is the rate of return promised by an investment project over its useful life • The internal rate of return is computed by finding the discount rate that will cause the net present value of a project to be zero 13-9 Internal Rate of Return rule If the Internal Rate of Return is Then the Project is Equal to or greater than the minimum required rate of return Acceptable Less than the minimum required rate of return Rejected When using the internal rate of return, the cost of capital acts as a hurdle rate that a project must clear for acceptance 13-10 Choosing a Discount Rate • The firm’s cost of capital is usually regarded as the minimum required rate of return • The cost of capital is the average rate of return the company must pay to its long-term creditors and stockholders for the use of their funds 13-11 Screening decisions vs Preference Decision Screening Decisions Preference Decisions Pertain to whether or not some proposed investment is acceptable; these decisions come first Attempt to rank acceptable alternatives from the most to least appealing 13-12 Ranking Investment Projects Project = profitability index Net present value of the project Investment required The The higher higher the the profitability profitability index, index, the the more more desirable desirable the the project project 13-13 Payback Period The length of time that it takes for a project to recover its initial cost out of the cash receipts that it generates Payback period = Investment required Annual net cash inflow Simple Rate of Return (Accrual Accounting Rate of return) 13-14 Does not focus on cash flows rather it focuses on accounting net operating income Simple rate Annual incremental net operating income = of return Initial investment 13-15 End of topic ... Annual net cash inflow Simple Rate of Return (Accrual Accounting Rate of return) 13-14 Does not focus on cash flows rather it focuses on accounting net operating income Simple rate Annual incremental... outflows, Subtract the present value of the outflows from the present value of the inflows 13 -7 Net Present Value rule 13-8 Internal Rate of Return (IRR) • The internal rate of return is the... Simple rate Annual incremental net operating income = of return Initial investment 13-15 End of topic