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McGrawHill/Irwin 161 Chapter Sixteen Capital Expenditure Decisions Capital 162 DiscountedCashFlow Analysis
Plant expansion Equipment selection Equipment replacement Cost reduction Lease or buy McGrawHill/Irwin 163 NetPresentValue Method
Prepare a table showing cash flows for each Prepare year, year, Calculate the present value of each cash flow Calculate using a discount rate, using Compute net present value, If the net present value (NPV) is positive, If accept the investment proposal. Otherwise, reject it. reject McGrawHill/Irwin 164 NetPresentValue Method
Mattson Co. has been offered a five year contract to Mattson provide component parts for a large manufacturer. provide McGrawHill/Irwin 165 NetPresentValue Method
T At the end of five years the working capital At will be released and may be used elsewhere by Mattson. elsewhere T Mattson uses a discount rate of 10%. Should the contract be accepted? McGrawHill/Irwin 166 NetPresentValue Method
Annual net cash inflows from operations McGrawHill/Irwin 167 NetPresentValue Method McGrawHill/Irwin 168 NetPresentValue Method Present value of an annuity of $1 Present factor for 5 years at 10%. factor McGrawHill/Irwin 169 NetPresentValue Method Present value of $1 Present factor for 3 years at 10%. factor McGrawHill/Irwin 1610 NetPresentValue Method Present value of $1 Present factor for 5 years at 10%. factor McGrawHill/Irwin 1611 NetPresentValue Method Mattson should accept the contract because the present value of the cash inflows exceeds the present value of the cash outflows by $85,955. The project has a positive net present value. positive
McGrawHill/Irwin 1612 InternalRateofReturn Method
T The internal rate of return is the true The economic return earned by the asset over its life. its T The internal rate of return is computed by The finding the discount rate that will cause the net present value of a project to be zero. net McGrawHill/Irwin 1613 InternalRateofReturn Method
T Black Co. can purchase a new machine at Black a cost of $104,320 that will save $20,000 per year in cash operating costs. T The machine has a 10year life. McGrawHill/Irwin 1614 InternalRateofReturn Method
Future cash flows are the same every year Future in this example, so we can calculate the internal rate of return as follows: internal
Investment required Net annual cash flows Net $104, 320 $20,000 $20,000 = Present value factor Present = 5.216 5.216 McGrawHill/Irwin 1615 InternalRateofReturn Method
The present value factor (5.216) is located on the Table IV in the Appendix. Scan the 10period row and locate the value 5.216. Look at the top of the column and you find a rate of 14% which is the internal rate of return. which
$104, 320 $20,000 $20,000 = 5.216 McGrawHill/Irwin 1616 InternalRateofReturn Method Here’s the proof . . . McGrawHill/Irwin 1617 Comparing the NPV and IRR Methods
Net Present Value y The cost of capital is The used as the actual used discount rate. discount y Any project with a Any negative net present value is rejected. value McGrawHill/Irwin 1618 Comparing the NPV and IRR Methods
Net Present Value y The cost of capital is The used as the actual used discount rate. discount y Any project with a Any negative net present value is rejected. value Internal Rate of Return y The cost of capital is The compared to the internal rate of return on a project. rate y To be acceptable, a To project’s rate of return must be greater than the cost of capital. cost McGrawHill/Irwin 1619 Comparing the NPV and IRR Methods
The net present value method The has the following advantages over the internal rate of return method . . . method
Easier to use. Easier Easier to adjust for risk. Easier Provides more usable information. information. McGrawHill/Irwin Assumptions Underlying DiscountedCashFlow Analysis
All cash flows are treated as though they occur at year end. Assumes a perfect capital market. 1620 Cash flows are Cash treated as if treated they are known with certainty. Cash inflows are immediately reinvested at the required rate of return. McGrawHill/Irwin 1621 Managerial Accountant’s Role
Managerial accountants are often asked to predict Managerial cash flows related to operating cost savings, additional working capital requirements, and incremental costs and revenues. incremental When cash flow projections are very uncertain, the When accountant may . . . accountant increase the hurdle rate, use sensitivity analysis. McGrawHill/Irwin 1622 Postaudit of Investment Projects
A postaudit is a followup after the project postaudit has been approved to see whether or not expected results are actually realized. expected McGrawHill/Irwin Alternative Methods for Making Investment Decisions
Payback Method
Payback Initial investment = period Annual aftertax cash inflow Annual 1623 A company can purchase a machine for $20,000 that will provide annual cash inflows of $4,000 for 7 years. Payback = period
McGrawHill/Irwin $20,000 $4,000 $4,000 = 5 years 1624 Payback: Pro and Con
Fails to consider Fails the time value of money. money. Does not consider Does a project’s cash flows beyond the payback period. payback McGrawHill/Irwin 1625 Payback: Pro and Con
Provides a tool for Provides roughly screening investments. investments. For some firms, it For may be essential that an investment recoup its initial cash outflows as quickly as possible. quickly McGrawHill/Irwin 1626 AccountingRateofReturn Method
Discountedcashflow method focuses on Discountedcashflow cash flows and the time value of money. and Accountingrateofreturn method focuses on Accountingrateofreturn the incremental accounting income that results from a project. results McGrawHill/Irwin 1627 AccountingRateofReturn Method
The following formula is used to calculate The the accounting rate of return: the
Average Average incremental  incremental expenses, incremental revenues including depreciation revenues = Initial investment Accounting rate of return McGrawHill/Irwin 1628 AccountingRateofReturn Method
Meyers Company wants to install an espresso bar in Meyers its restaurant. its
The espresso bar: q Cost $140,000 and has a 10year life. q Will generate incremental revenues of $100,000 and Will incremental expenses of $80,000 including depreciation. depreciation. What is the accounting rate of return on the What investment project? investment
McGrawHill/Irwin 1629 AccountingRateofReturn Method
Accounting = rate of return $100,000  $80,000 $140,000 $140,000 = 14.3% 14.3% The accounting rate of return method is not recommended for a variety of reasons, the most important of which for is that it ignores the time value of money. is McGrawHill/Irwin 1630 Capital Budgeting Practices
Pe nt of m rce anage who be vee te rs lie ach chniqueis im portant. McGrawHill/Irwin Justification of Investments in Advanced Manufacturing Systems
Hurdle rates are too high Time horizons are too short Bias towards incremental projects 1631 Benefits difficult to quantify
McGrawHill/Irwin Greater cash flow uncertainty ...
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 Fall '07
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 Accounting, Net Present Value

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