Chapter12StudentSp2019.docx - Ch 12 Capital Investment Decisions and the Time Value of Money 12.1 Capital Budgeting process of making capital investment

# Chapter12StudentSp2019.docx - Ch 12 Capital Investment...

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Ch 12 - Capital Investment Decisions and the Time Value of Money 12.1 Capital Budgeting - process of making capital investment decisions Capital Investments Investing in capital assets (fixed assets) assets used for a long period of time equipment, buildings, vehicles, automating production, improving technology, etc. usually require large sums of money Analyzing Capital Investments Desirability of a capital asset depends on its ability to generate NET CASH INFLOWS o Cash inflows minus cash outflows Most methods use net cash inflow rather than accrual accounting operating income Cash flows include: Future cash net income (no depreciation, amortization, etc) Any future savings in ongoing cash operating costs Any future residual (salvage) value of the asset If you are given operating income, you must add back depreciation expense to get net cash inflows (Payback, NPV, IRR methods) Denver Company is considering purchasing machinery that costs \$130,000 and is expected to have a 6-year life. At the end of its expected life, it is estimated that the machinery can be sold for \$10,000. The machinery is expected to increase operating income by \$15,200 per year over the useful life. What is the expected annual cash inflow from the machinery? 1) 130,000 – 10,000/ 6yrs = 20,000 dpre expense 2) Net cash inflows = OI 15,200 + 20,000 = 35,200 Capital Budgeting Process Step 1 Identify potential capital investments Step 2 Estimate future net cash inflows Step 3 Analyze potential investments a) screen out undesirable investments using Payback or Accounting Rate of Return b) Further analyze using Net Present Value or Internal Rate of Return Step 4 If resources are limited, use capital rationing tools to choose among alternatives Step 5 Perform post-audits to evaluate if investments are going as planned and if estimated
cash inflows were reasonable 12.2 Payback Period Length of time it takes to recover the initial cost Generally, the shorter the payback period, the better Usually used as a screening tool Calculating: When the net cash inflows are equal each year : Payback Period = Amount invested Expected annual net cash inflows When periodic cash flows are unequal, you must accumulate net cash inflows until the amount invested is recovered Major Criticism: o focuses only on time, not on profitability o considers only those cash flows that occur during the payback period Kitchen Helpers is considering producing Air Fryers or Instant Pots. The products each require a specialized machine costing \$1,000,000. Each machine has a five-year life and no residual value. The expected cash inflows for each machine are as follows: Year Air Fryers Instant Pots 1 \$332,000 \$500,000 2 332,000 380,000 3 332,000 320,000 4 332,000 280,000 5 332,000 25,000 Total \$1,660,000 \$1,505,000 Average cash inflow for Instant Pots = 1,505,000 / 5 = 301,000 Kitchen Helpers must achieve a payback period of 3.5 years and an ARR of 8% for an investment to be acceptable.

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