Chapter 12-2AnnouncementsLearning ObjectivesThe Importance of Cash FlowsSources of Cash InflowSlide 6Review NPV AnalysisAccounting for Asset Acquisitions (Quick review and background)Depreciation (Quick review)Methods of DepreciationDepreciation ExampleSlide 12Recap: Sources of Cash FlowPowerPoint PresentationSlide 15Slide 16Net of Tax ExampleBack to Net Present ValueSlide 19Slide 20Slide 21Slide 22Back to Net Present Value E 12.17What Other Factors should be Considered? CT12.3Chapter 12-2Chapter 12-2 Planning Investments: Capital B Capital Budgeting udgeting Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin12-2AnnouncementsAnnouncements•There are 4 digital tutors on Chapter 12. Try them!•If you have an exam conflict, send me an email.•Learnsmart Assignment Chapter 12 due 1/30 at 5:00 PM.12-3Learning ObjectivesLearning Objectives•LO1 Explain the concept of and calculate a company cost of capital.•LO2 Use NPV analysis to make investment decisions.•LO3 Use NPV analysis to make investment decisions assuming uniform depreciation.•LO4 Use NPV analysis to make investment decisions assuming tax depreciation.12-4•Generally, cash inflows come in the form of increased revenues or decreased expenses.Increased revenues or decreased expenses increase net income and generally increase cash flows as wellOf course we know that net income is computed using the accrual basisaccrual basis of accounting, and net income net income  cash cash flow.flow.The Importance of Cash FlowsThe Importance of Cash Flows12-5Sources of Cash InflowSources of Cash Inflow•Two important things to remember regarding cash inflows.1.1.Increases in net income will Increases in net income will also result in increases in also result in increases in taxes. Thus, we use taxes. Thus, we use after-after-tax cash flowstax cash flows for NPV for NPV analysis to account for the analysis to account for the tax effect.tax effect.2.2.DepreciationDepreciation is the one big non-cash is the one big non-cash expense that we must account for. As we expense that we must account for. As we will see later, even though depreciation will see later, even though depreciation does not affect cash, does not affect cash, it doesit does generate tax generate tax savings.savings.12-6A company’s pre-tax cash flows for the year are $100,000 and its income tax rate is 35%. Sources of Cash InflowSources of Cash InflowIf you assume all net income is derived from cash, the company will pay $35,000 to the IRS [$100,000 x 35%] and its after-after-tax cash flowtax cash flow equals $65,000. [You can also compute after-tax cash flows by multiplying net income by 1 minus the tax rate1 minus the tax rate, or 1 – 35% = 65% in this example. $100,000 x 65% = $65,000].12-71. Estimate the timing and amount of all cash infl ows and outfl ows associated with a potential investment2. Calculate the present value of the expected f uture cash fl ows using the hurdle rate as the discount rate3. Compute the Net Present ValueNet Present ValuePV cash infl ows PV cash infl ows ––initial outfl owinitial outfl ow4. Make your decisiongivenReview NPV AnalysisReview NPV Analysis12-8•When an asset is initially acquired, we When an asset is initially acquired, we capitalize capitalize it (record it as as asset on the it (record it as as asset on the books). For example, if office furniture books). For example, if office furniture were acquired with cash, our entry would were acquired with cash, our entry would be:be:Dr Asset Dr Asset XX XXCr CashCr CashXXXXNOTE:NOTE: If you don’t remember your debits If you don’t remember your debits and credits from 2101 (Chapter 7), and credits from 2101 (Chapter 7), nownow is an excellent time to review is an excellent time to review them. them. Accounting for Asset Acquisitions(Quick review and background)Accounting for Asset Acquisitions(Quick review and background)12-9•Although capitalized assets will last for more than one period, they won’t last forever, suggesting that we are using them up over time.•Depreciation is the process of expensing the costs of an asset over the periods in which the asset was used to help produce revenues (accounting for the “using up” of the asset).•The periods that the asset helps generate revenues is known as the asset’s useful lifeuseful life..•Depreciation illustrates the concept of the matching principlematching principle, where under the accrual-basis of accounting, expenses are reported in the same period as the revenues they helped produce.Depreciation (Quick review)Depreciation (Quick review)12-10Straight-line method: spreads the asset’s depreciable cost evenly over useful life.Salvage value is what you expect to sell the asset for when you are finished using it.Useful LifeDepreciable Cost = Useful Life Cost - Salvage Value=AnnualDepreciationMethods of DepreciationMethods of DepreciationThe most straight-forward depreciation method is the straight-line method.12-11Depreciation ExampleDepreciation ExampleYear 1Year 1Year 2Year 2Year 3Year 3Year 4Year 4Annual DepreciationAnnual DepreciationA copier with a A copier with a cost of $57,000cost of $57,000 has an has an estimated salvage value estimated salvage value of $5,000of $5,000 and a and a useful life of 4 yearsuseful life of 4 years. . Compute depreciation Compute depreciation expense and carrying value for each of the four years.expense and carrying value for each of the four years. = $57,000 - $5,000 = $13,000 4 = AnnualDepreciationUseful LifeCost - Salvage Value12-12Depreciation ExampleDepreciation ExampleYear 1Year 1Year 2Year 2Year 3Year 3Year 4Year 4Annual DepreciationAnnual Depreciation$13,000$13,000$13,000$13,000$13,000$13,000$13,000$13,000A copier with a cost of $57,000 has an estimated salvage value A copier with a cost of $57,000 has an estimated salvage value of $5,000 and a useful life of 4 years. of $5,000 and a useful life of 4 years. Compute depreciation Compute depreciation expense and carrying value for each of the four years.expense and carrying value for each of the four years. Depreciation expense reduces the Depreciation expense reduces the companycompany’’s net income s net income AND ITS taxable AND ITS taxable incomeincome. When taxable income is lowered, . When taxable income is lowered, so too is the amount of taxes owed to the so too is the amount of taxes owed to the