ACCTG 211 1st Edition Lecture 24 Outline of Last Lecture I Common Short Term Business Making Decisions a Accepting a special order from a customer b Pricing decisions c Dropping a product department or division d Determining the optimal product mix e Outsourcing make vs buy f Sell now or process further Outline of Current Lecture II Capital Investment and Time Value of Money III Capital Budget Approaches a Payback period b Accounting Rate of Return c Net Present Value d Weight Average Cost of Capital Current Lecture I II Capital Investment Decisions and Time Value of Money a Capital Budgeting is related to the purchase of property plant and equipment Typical Capital Budget Approaches a Payback Period i Payback the amount of time it takes to recover the initial capital investment ii Payback period Amount Invested Expected Annual CF iii Even cash flows example 1 A company wants to invest 240 000 in a capital project 2 Project should deliver 60 000 in cost savings per year iv Question how long in years will it take to recover the initial investment 1 4 years v For Uneven cash flow 1 Figure out atleast how many years and then figure out the portion of the final year that is needed by doing Amount remaining CF from year b Accounting Rate of Return 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 i ARR the average annual rate of return over an asset s life ii ARR Average Annual Operating Income Initial Investment 1 Average Annual Operating Income Annual project income accrual income minus any depreciation expense iii Even cash flows example 1 A company wants to invest 240 000 in a capital project 2 Project should deliver 60 000 in cost savings per year 3 Project is estimated to last 6 years 4 Project does not have a stated residual value iv Question what is the project s ARR 1 ARR Average Annual Operating Income Initial Investment 2 Average Annual Operating Income 60 000 40 000 20 000 a Depreciation Expense 240 000 0 6 years 40k 3 ARR 20 000 240 000 8 33 c Net Present Value i NPV net present value used in assisting with capital budgeting decisions among other things ii Net means include all positive and negative cash flows iii NPV analysis is typically associated with a series of positive and negative cash flows in a proposed project iv 2 types of cash flows 1 Lump Sum the receipt or payment of one dollar amount at a specific point in time Use PV 1 factor table 2 Annuity a recurring dollar amount i e the same dollar amount received or paid at predictable intervals of time for a predictable period of time Use PV Annuity 1 factor table v Treat any project residual values as being received at the end of the last year of the cash flow schedule vi NPV relies on the concept of discounted cash flows 1 Discount rate is applied to each cash flow 2 A company s weighted average cost of capital WACC is typically used as the discount rate in NPV analysis vii NPV Example 1 You are a manager considering an investment of 120 000 in a project that is estimated to return 50 000 at the end of each of three years Your company requires a minimum rate of return of 10 on all new projects a k a discount rate or hurdle rate for new projects Assume 1 compounding period per year a Present value rates are provided b NPV is positive so make the investment d Weighted Average Cost of Capital WACC i Weighted Capital Outstanding Capital Outstanding X Capital Cost ii WACC Total Weighted Capital Outstanding Total Capital Outstanding