ACCT 2020 1st Edition Lecture 19 Outline of Last Lecture I Decentralization in Organizations II Cost Profit Investment Centers III Return on Investment IV Residual Income V Delivery Performance Measures VI Balanced Scorecard Outline of Current Lecture I Capital Budgeting II Time Value of Money III Net Present Value IV Internal Rate of Return V Comparing Approaches Current Lecture I Capital Budgeting Common Decisions o Plant Expansion new product line would bring in new revenue is it worth it to us to spend that money right now to gain that revenue These notes represent a detailed interpretation of the professor s lecture GradeBuddy is best Used as a supplement to your own notes not as a substitute o Equipment Replacement o Equipment Selection o Lease or Buy pay all up front or pay a bit each year o Cost Reduction Invest in something that promises to reduce our costs Types of Decisions o Screening decision Does a proposed project meet some present standard of acceptance o Preference decisions selecting from several competing courses of action II Time Value of Money A dollar today is worth more than a dollar a year from now 100 now 100 in a year I would rather have that 100 now to earn interest through investment of my own Therefore projects that promise earlier returns are preferable to those that promise later returns o For example my minimum required return is 5 The cost of borrowing money and how much I can normally earn also needs to be considered Lets say I can always earn 5 interest on any investment and lets say that someone gives choice between 2 opportunities 1 Choice A receive 100 Today in one year will still be 100 2 Choice B Receive 100 in a year but will earn 5 interests 105 o For another example 1 Choice A receive 100 Today in one year will still be 105 2 Choice B Receive 100 Today 110 in a year III Net Present Value If the net present value is positive than it is an acceptable project If it s zero than it is also acceptable If it s negative it will not be accepted Net present value is all based on the cash we pay and cash we receive Depreciation not relevant Cash Outflows o Initial investment o Working capital cash tied up within the project o Repairs and maintenance o Incremental operating costs Cash Inflows o Salvage value o Release of working capital o Reduction of costs o Incremental revenues The longer you wait for the dollar to be paid to you the less it will be worth This can be seen by using a present value chart and the interest rate to find the value of the annuity At a 10 interest rate the 1 would be worth o Year 1 909 Year 2 826 Year 3 751 Year 4 683 o Add these up to get 3 17 o 3 17 is the value of a 1 annuity received for 4 years o If the question is 1000 at net present value x 3 17 you get 3170 witch is exactly the amount that meets our 10 minimum So Net present value is 0 o Example 1 Annual Net cash inflow from operations 750 000 400 000 270 000 80 000 Net present value method Investment in Equip Working Capital need Annual net cash flow Refining of equip Salvage value Equip Wrk capital released 160 000 100 000 303 280 80 000 x 3 791 PV annuity 80 000 5yrs 22530 30 000 x 751 PV of 30 000 3yrs 10 3105 5 000 x 621 PV of 5 000 5yrs 10 62 100 100 000 x 621 PV 100 000 5yrs 10 Net Present Value 85 955 o Example 2 Net present value method Investment in Equip Working Capital need Ann net cash inflow Refining of Equip Salvage value Equip Wrk capital released 250 000 20 000 349 680 120 000 x 2 914 PV annuity 120 000 4yr 14 69 210 90 000 x 769 PV of 90 000 2yrs 14 5 920 10 000 x 592 PV of 10 000 4yrs 14 11 840 20 000 x 592 PV 100 000 4yrs 14 Net Present Value 28 230 IV Internal Rate of Return Take the project as it is to calculate the rate of return Find the rate that requires the net present value to be zero If the cash flows are the same every year than it doesn t work quite as well We use this when we have an initial investment and the same cash inflows every Can compare the rate of return found to the required rate of return PV Factor for the Internal Rate of Return Investment Required Annual Net Cash Flows The internal rate of return is found by taking the factor and looking at the chart for the allotted years and find the correlating rate according to that PV Example o 79 310 22 000 3 605 For 5 years it can be found on the chart on the 5 th period line under the 12 interest rate mark So 12 is the rate V Comparing Approaches Net present value is often simpler to use and can consider more things Clear findings with the positive negative zero meanings There is a major flaw with Internal rate of return because we are assuming that all cash inflows are invested at the same rate To compare competing investment polices we can use 2 approaches o Total cost can compare the total costs using the annuity tables and net present values by comparing our answers By comparing NPV for both o Incremental cost instead the incremental changes can be compared and the NPV can be taken on only the incremental changes The same answer is found just more quickly