Transcript MANAGEMENT ACCOUNTING © Pearson Education Limited 2008 Cheryl S. McWatters, Jerold L.

MANAGEMENT ACCOUNTING
© Pearson Education Limited 2008
Cheryl S. McWatters, Jerold L. Zimmerman, Dale C. Morse
13-2
Management Accounting
Investment decisions (Planning)
Chapter 13
Management Accounting McWatters, Zimmerman, Morse
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Objectives
• Describe the steps of the capital-budgeting process.
• Identify the opportunity cost of capital
• Estimate the payback period of an investment and
identify weaknesses of the payback method in making
investment choices
• Calculate the accounting rate of return (ROI) and
identify weaknesses of ROI in making investment
decisions
• Calculate the net present value of cash flows
• Identify non-cash profit and loss accounts that should
be excluded in calculating the net present value
• Adjust cash flows to reflect the additional accounts
receivable and inventory required
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Objectives - cont
• Exclude financing charges when calculating the net
present value of an investment
• Estimate tax cash flows for capital budgeting
• Recognize the effect of risk on the discount rate
• Estimate the internal rate of return (IRR) of an
investment project
• Identify problems with using the IRR to evaluate
investment projects
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Long-Term Investment Decisions
Long-term investment decisions differ from
short-term decisions because long-term usually
Involve larger cash
outlays
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Have multi-year
cash flow
implications
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The Capital Budgeting Process
Start
Identification of an
investment proposal
Ratification of
the proposal
Check to determine
that cash flow
estimates and risks
are reasonably assessed
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The Capital Budgeting Process
Start
Identification of an
investment proposal
Cash and other resources
are invested and related
operations begin
Ratification of
the proposal
Implementation
of the proposal
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The Capital Budgeting Process
Evaluate whether
investment is
fulfilling expectations
Start
Identification of an
investment proposal
Monitoring
activity
Ratification of
the proposal
Implementation
of the proposal
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The Capital Budgeting Process
Start
Identification of an
investment proposal
Monitoring
activity
Ratification of
the proposal
Implementation
of the proposal
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Opportunity Cost of Capital
The opportunity cost of using a resource
depends on alternative uses of that resource
The opportunity cost of capital is a term used to
describe the forgone opportunity of using cash
The ability to compare cash flows over different
time periods is very important in evaluating
investment decisions
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Investment Criteria Ignoring the
Opportunity Cost of Capital
Some managers find the discounting of future
costs confusing or difficult
Alternatives to discounting method
Payback
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Accounting Rate
Of Return
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Payback
The number of years or months it takes for
cash flows from an investment to equal the
initial investment cost
When the net annual cash inflow is the same
every year, the following formula can be used
to compute the payback period
Payback period =
Management Accounting McWatters, Zimmerman, Morse
Investment required
Net annual cash inflow
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Payback
A £4,000,000 investment in a motel has expected net
cash flows of £1,000,000 in each of the next 5 years
What is the investment’s payback
What does the payback method ignore
The investment has a payback of 4 years but the
payback method ignores the cash flows in the
fifth year and the time value of money
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Shortcomings of Payback
Lacks an acceptance benchmark
Ignores the opportunity cost of capital
Ignores cash flows beyond the payback period
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Accounting Rate of Return
The accounting rate of return (ROI) does
not focus on cash flows, rather it focuses on
accounting income
Accounting rate of return is:
RO
=
I
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Profit
Investment
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Accounting Rate of Return
The choice of how to measure profit and investment
for ROI depends on how the ROI is to be used
ROI for performance measures should
reflect controllability
ROI for capital-budgeting decisions should make
comparisons with the opportunity cost of capital
A multi-period alternative of estimating ROI is:
RO
I
Average annual profit from the project
=
Average annual investment in the project
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Accounting Rate of Return
Average net income, average book value of
investment and annual ROI
Year
Net Profit (£)
Average book value of
investment (£)
ROI (%)
1
900,000
9,000,000
10
2
900,000
7,000,000
13
3
900,000
5,000,000
18
4
900,000
3,000,000
30
5
900,000
1,000,000
90
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Accounting Rate of Return
Numerical Example
An investment of €300,000 generates cash flows of
€150,000 during each of the next 3 years
The investment is fully depreciated using the straight line
method over the 3 years. The annual net income of the
investment is €150,000 - €100,000 (€50,000) . The average
investment is used as the denominator to calculate ROI
What is the ROI for each year. What is the multi-year ROI.
How would the sum-of-the-year’s digits method of depreciation
affect the calculation of ROI
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Accounting Rate of Return
Numerical Example
Straight-line depreciation method
Year
Profit (€)
Average investment (€)
ROI (%)
1
50,000
250,000
20
2
50,000
150,000
33
3
50,000
50,000
100
The multi year ROI is
€50,000/€150,000
(33%)
Sum of the years digits method
Year
Profit (€)
Average investment (€)
ROI (%)
1
0
225,000
0
2
50,000
100,00
50
3
100,000
25,000
400
Management Accounting McWatters, Zimmerman, Morse
The multi year ROI is
€50,000/€100,000
(50%)
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The Net Present Value of Cash Flows
Future cash flows should be discounted when
compared with present cash flows
The discount factor for a future cash flow is
1
(1 + r)n
Where: r = opportunity cost of capital
n = number of periods until cash flow occurs
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The Net Present Value of Cash
Flows Numerical Example
Carbon corporation has an opportunity cost of
capital of 10%. The company is considering an
investment project that should yield the following
cash flows
Year from now
Cash inflow (€)
1
44,000
2
50,000
3
20,000
What is the present value of these cash inflows
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The Net Present Value of Cash
Flows Numerical Example
Cash inflow (€)
Discount factor
Present value (€)
44,000
1/(1 + 0.1)1 = 0.90909
40,000
50,000
1/(1 + 0.1)2 = 0.82645
41,322
20,000
1/(1 + 0.1)3 = 0.75131
15,026
Total present value of cash flows
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96,348
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Estimating Cash Flows
• Discount cash flows not accounting
earnings
• Adjust cash flows to reflect the need for
additional accounts receivable and
inventory
• Include opportunity costs but not sunk
costs
• Exclude financing costs
• Taxes and depreciation tax shields
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Depreciation Tax Shields
The primary difference between cash flows and
income for tax purposes is depreciation
The reduction in cash tax payments due to
depreciation is called the depreciation tax shield
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Tax and Depreciation Tax Shields
The depreciation tax shield is a set of simple
algebraic equations
Where:
R = revenues
E = expenses except depreciation
D = depreciation allowed for tax purposes
t = tax rate
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Depreciation Tax Shields
Net income (NI) = (R - E - D) × (1 - t)
Taxes = (R - E - D) × t
Cash flow = (R - E - Taxes)
This is the
depreciation
tax shield
So . . .
Cash flow = (R - E) × (1 - t) + (D × t)
The sooner the depreciation is taken, the higher
the present value of the depreciation tax shield
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Depreciation Tax Shields
Numerical Example
An asset is purchased for €500,000. The asset
has a five-year lift and no salvage value. The
tax rate is 34% and the interest rate is 5%
What is the present value of the tax shields
under the straight line and double-declining
balance depreciation methods
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Depreciation Tax Shields
Numerical Example
Straight line depreciation
Double-declining-balance depreciation
Year
Depreciation
expense (€)
Tax
shield
(Dt) (€)
PV of tax
shield (€)
DDB
rate
Book value
at beginning
of year (€)
Depreciation
expense (€)
Tax
shield
(Dt)(€)
PV of tax
shield (€)
1
100,000
34,000
32,381
0.4
500,000
200,000
68,000
64,762
2
100,000
34,000
30,839
0.4
300,000
120,000
40,800
37,007
3
100,000
34,000
29,370
0.4
180,000
72,000
24,480
21,147
4
100,000
34,000
27,972
0.4
108,000
43,200
14,688
12,084
5
100,000
34,000
26,64
64,000
64,800
22,032
17,263
500,000
147,202
500,000
152,263
Double declining writes off the €500,000 original cost
faster than does straight line depreciation therefore it’s
tax shield has a higher present value than the straight
line method (€5,061)
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Adjusting the Discount Rate for Risk
• Risky projects should be discounted at a
higher interest rate than safe projects
• For any given risky cash flow stream, we
will assume that an equivalent risk-adjusted
interest rate exists
• Instead of discounting the highest/lowest
cash flow we discount the expected
(average) cash flow
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Internal Rate of Return (IRR)
The internal rate of return method finds the
interest rate that equates the initial investment
cost to the future discounted cash flows.
(Makes the NPV = £0)
It is easy to calculate is an initial cash outflow is
followed by a cash in flow in the same period
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Internal Rate of Return (IRR)
If you invest £1,000 in a project today and
receive £1,070 in a year
Investment cost = (Cash inflows in year one) ÷ (1 + IRR)
£1,000 =
£1,070
1 + IRR
IRR = .07 = 7%
If the cost of capital is 6%, this investment offers
a return in excess of its opportunity cost
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Internal Rate of Return (IRR)
If there is a 5% cost of capital, the net present value
of this investment opportunity is:
NPV = £1,070 - £1,000
1.05
= £1,019.05 - £1,000 = £19.05
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Internal Rate of Return (IRR)
General Rule
If the internal rate of return exceeds the
opportunity cost of capital, the investment
should be undertaken
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Comparing IRR and NPV of Two
Investments
• The IRR and NPV methods do not always
give consistent answers
• IRR and NPV may lead to different
investment decisions if investments are
mutually exclusive (only one investment
can be chosen from a group of
opportunities)
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Comparing IRR and NPV of Two
Investments Numerical Example
A company is considering an investment that requires
an initial cash outlay of €100,000 the investment is
expected to return €70,000 in the first year and
€55,000 in the second year. What is the IRR
-€100,000 + (€70,000/(1 + 0.17)) + (€55,000/(1 + 0.17)2) = 17
The NPV (at 17%) is very close to zero so the IRR
is approximately 17%
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Comparing IRR and NPV of Two
Investments
Net present value indicates how much cash in
today’s dollars an investment is worth, or the
magnitude of the investment’s return
Internal rate of return only indicates the relative
return on the investment
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Capital Budgeting Methods Used in
Practice
• The discounting of cash flows to make
capital decisions has become common
practice
• Cultural differences can affect the nature of
the capital-budgeting process
• Small organizations evaluate capitalbudgeting projects differently
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Capital Budgeting Methods Used in
Practice
The following are reasons for the continued
prevalence of discounting methods
1. Discounting methods are theoretically superior
2. They are the mainstay of business school
curricula
3. Computer technology can calculate NPVs and
IRRs quickly and easily
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Management Accounting
Investment decisions (Planning)
End of Chapter 13
Management Accounting McWatters, Zimmerman, Morse
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