CPAPrepChapter21 - CHAPTER 21 CAPITAL BUDGETING AND COST ANALYSIS 21-3 In essence the discounted cash-flow method calculates the expected cash

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Unformatted text preview: CHAPTER 21 CAPITAL BUDGETING AND COST ANALYSIS 21-3 In essence, the discounted cash-flow method calculates the expected cash inflows and outflows of a project as if they occurred at a single point in time so that they can be aggregated (added, subtracted, etc.) in an appropriate way. This enables comparison with cash flows from other projects that might occur over different time periods. 21-6 The payback method measures the time it will take to recoup, in the form of expected future net cash inflows, the net initial investment in a project. The payback method is simple and easy to understand. It is a handy method when screening many proposals and particularly when predicted cash flows in later years are highly uncertain. The main weaknesses of the payback method are its neglect of the time value of money and of the cash flows after the payback period. 21-15 These two rates of return differ in their elements: Real-rate of return Nominal rate of return 1. Risk-free element 1. Risk-free element 2. Business-risk element 2. Business-risk element 3. Inflation element The inflation element is the premium above the real rate of return that is demanded for the anticipated decline in the general purchasing power of the monetary unit. 21-16 Exercises in compound interest, no income taxes. The answers to these exercises are printed after the last problem, at the end of the chapter. 21-17 (22–25 min.) Capital budget methods, no income taxes. 1a. The table for the present value of annuities (Appendix B, Table 4) shows: 5 periods at 12% = 3.605 Net present value = $60,000 (3.605) – $160,000 = $216,300 – $160,000 = $56,300 1b. Payback period = $160,000 ÷ $60,000 = 2.67 years 1c. Internal rate of return: $160,000 = Present value of annuity of $60,000 at R% for 5 years, or what factor (F) in the table of present values of an annuity (Appendix B, Table 4) will satisfy the following equation. $160,000 = $60,000F 21- 1 F = 000 , 60 $ 000 , 160 $ = 2.667 21- 2 On the 5-year line in the table for the present value of annuities (Appendix B, Table 4), find the column closest to 2.667; it is between a rate of return of 24% and 26%. Interpolation is necessary: Present Value Factors 24% 2.745 2.745 IRR rate –– 2.667 26% 2.635 –– Difference 0.110 0.078 Internal rate of return = 24% + 110 . 078 . (2%) = 24% + (0.7091) (2%) = 25.42% 1d. Accrual accounting rate of return based on net initial investment: Net initial investment = $160,000 Estimated useful life = 5 years Annual straight-line depreciation = $160,000 ÷ 5 = $32,000 return of rate accounting Accrual = investment initial Net income operating annual average expected in Increase = 000 , 160 $ 000 , 32 $ 000 , 60 $- = 000 , 160 $ 000 , 28 $ = 17.5% Note how the accrual accounting rate of return, whichever way calculated, can produce results that differ markedly from the internal rate of return....
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This note was uploaded on 08/11/2009 for the course ACCT 612 taught by Professor Jamesswanson during the Spring '09 term at Univ. of Massachusetts Med. School.

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CPAPrepChapter21 - CHAPTER 21 CAPITAL BUDGETING AND COST ANALYSIS 21-3 In essence the discounted cash-flow method calculates the expected cash

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