Upload
nwcbenny337
View
225
Download
0
Embed Size (px)
Citation preview
8/8/2019 AFD W2 Lecture Power Point
1/40
1
Accounting for Decision Making
Week 2 Lecture
(2010)
8/8/2019 AFD W2 Lecture Power Point
2/40
2
CAPITAL EXPENDITURE
BUDGETING- Concernedwithdecision-makinginthefollowingareas:
-DeterminingHOW MUCH capitalexpenditurethe
businessshouldundertake
-DeterminingWHICH projects shouldbeundertake.
-DeterminingHOW theyshouldbefinanced
8/8/2019 AFD W2 Lecture Power Point
3/40
3
BUDGET PROCEDURE Proposalsusuallyanalysedunderthefollowingheadings:
Fixedassets/workingcapitalrequiredforEXPANSION (newproducts/markets)
REPLACEMENTfixedassets
FixedassetsrequiredforSTATUTORY reasons(noise,safetyetc)
RESEARCH & DEVELOPMENTfixedassets
FixedassetsrequiredforADMINISTRATION systems
enhancement
8/8/2019 AFD W2 Lecture Power Point
4/40
4
HOW MUCH CAPITAL
EXPENDITURE? Moneyforcapitalexpenditureisascarceresourceso HOW IS IT TO BE ALLOCATED?
PROBLEMS?
-M
anynew businessproposalswillbeinoutlineformonly - Someprojectsmay beemergencyreplacementsatlastmoment -Theremay beashortageofavailablefunds
SOLUTION? Allocateamaximum amounttoeach typeofexpenditureknown
asCapitalRationing
Appraisebyidentifying relevantcostsandrevenues, knownasCostv BenefitAnalysis
8/8/2019 AFD W2 Lecture Power Point
5/40
5
COST vBENEFIT ANALYSISSUMMARYOF RELEVANTCOSTS/INCOMEBY
TYPEOF PROJECTTypeofproject
Expansion
Replacement
Statutory
R & D
Adminsystems
Costs
Plant& machinery
Additionalworkingcapital
Plant& machinery
Plant& machinery
Plant& machinery
Computers,softwareetc
Benefits
Additionalnetcashinflowfromadditionalsales
Opportunityincomefrom
avoiding
lost
salesand/oraddlprodncosts
Opportunityincomefromavoidingpenalties/lostsalesthrough badpublicity
Additionalnetcashflowfromaddlsales(competitiveedge)
Additionalnetcashinflowfromcostsavings
8/8/2019 AFD W2 Lecture Power Point
6/40
6
METHODSOF APPRAISINGCAPITAL EXPENDITURE
PROJECTSACCOUNTING
RATE OF RETURNPAY-BACKMETHOD
DISCOUNTEDCASH FLOW
(DCF)
INTERNAL RATE OFRETURN
(IRR)
NET PRESENTVALUE METHOD
(NPV)
8/8/2019 AFD W2 Lecture Power Point
7/40
7
ACCOUNTING RATE OFRETURN
(ARR)
Average Annual profit (after depreciation)
Average investment + working capital= X 100
Accounting Rate of Return
Average investment (average book value)= Initial Investment (Annual Depreciation) x life / 2)
or
= (Initial Investment + Residual Value) / 2
8/8/2019 AFD W2 Lecture Power Point
8/40
8
Seminar Question
SuperCo. is considering a newproduct. The initialexpenditure on machinery is expected to be 200,000 formachinerywhich is estimated to have a life of fiveyears attheend ofwhich it will beexpected to realize 20,000 indisposal proceeds. Additional investment in working capital(stocks plus debtors, less creditors) is expected to be intheregion of 10,000. Annual profits afterdepreciation areexpected to be 18,000 perannum. The company's cost of
capital is 10%.
8/8/2019 AFD W2 Lecture Power Point
9/40
9
Seminar Question
1) What is the Annual Depreciation charge?
2) Calculate theAccounting Rate of Returnbyexpressing theaverage annual profit as a % of the average investment inmachinery and working capital?
8/8/2019 AFD W2 Lecture Power Point
10/40
10
ACCOUNTING RATE OF RETURN(ARR)
Advantages:
- Easy to understand (similarto return on capital employed)
- Allows comparison ofprojects with differing initial investment- Considers profit overentire life ofproject
Disadvantage:
- Ignores time value of money
8/8/2019 AFD W2 Lecture Power Point
11/40
11
PAY-BACK
STEP 1 Calculatetotalcostofproject
STEP 2 Calculatecashinflow
each year(profitbefore depreciation)
STEP 3 Calculatetimeittakesforcashinflow toequalorexceed
projectcost
8/8/2019 AFD W2 Lecture Power Point
12/40
12
Seminar Question
SuperCo. is considering a newproduct. The initialexpenditure on machinery is expected to be 200,000 formachinerywhich is estimated to have a life of fiveyears attheend ofwhich it will beexpected to realize 20,000 indisposal proceeds. Additional investment in working capital(stocks plus debtors, less creditors) is expected to be intheregion of 10,000. Annual profits afterdepreciation areexpected to be 18,000 perannum. The company's cost of
capital is 10%.
8/8/2019 AFD W2 Lecture Power Point
13/40
13
Seminar Question3) Ifprofits are 18,000 perannum, what is the annual cash flow
resulting from trading?
4) Assuming that the initial expenditure on machinery and theinvestment in working capital takes place in Year0 (before the
start of Year1) and that the machinery is sold for20,000 andtheworking capital disinvested at theend of Year5, calculate theannual cash flows:
Year0 ............................Year1 ............................Year2 ............................
Year3 ............................Year4 ............................Year5 ............................
5) How long does it take before theproject will Pay-backthe initial
investment?
8/8/2019 AFD W2 Lecture Power Point
14/40
14
PAY-BACK Advantages
- Easy to understand
- Lowrisk as projects chosen are those
with quickest pay-back
Disadvantages
- Ignores timing ofreceipts
- Ignores receipts after pay-backperiod - Ignores profitability
8/8/2019 AFD W2 Lecture Power Point
15/40
15
DISCOUNTEDCASH FLOW
(DCF) Based on principle that 1 receivedtoday is worthmore than 1 receivedtomorrow time value of money
Can be measured by two methods:
- Net Present Value (NPV)
- Internal Rate of Return (IRR)
8/8/2019 AFD W2 Lecture Power Point
16/40
16
Interest and the Time Value of
Money TheThepresent valuepresent value of any sum to bereceived in theof any sum to bereceived in thefuture can be computed by solving forP:future can be computed by solving forP:
TheThepresent valuepresent value of any sum to bereceived in theof any sum to bereceived in thefuture can be computed by solving forP:future can be computed by solving forP:
-
!nn
rFP
)1(
1
P= present valueFn= future cash flow at theend of n periodr= required rate ofreturn ordiscount rate
8/8/2019 AFD W2 Lecture Power Point
17/40
17
Interest and the Time Value of
Money A bond will pay $100 in two years. What is thepresent value of the $100 if an investorcan earn areturn of 12% on investments?
P ! $1001
210.12
-
P = $100 (0.7972)P = $79.7$79.722
8/8/2019 AFD W2 Lecture Power Point
18/40
18
Interest and the Time Value of
Money A bond will pay $100 in two years. What isthepresent value of the $100 if an investorcan
earn a return of 12% on investments?
Present Value = $79.72
What does this mean?If $79.72 is invested by the investor today, it willbeworth $100 in two years. In that sense, $79.72
today is equivalent to $100 in two years.
8/8/2019 AFD W2 Lecture Power Point
19/40
19
Bank Balance Year 1 Year 2
Beginning balance 79.70$ 89.26$
Interest earned @ 12% 9.56 10.71Ending balance 89.26$ 99.97$
Interest and the Time Value of
Money Lets verify that ifwe invest the $79.70 today at 12%
interest that it would grow to $100 at theend of twoyears.
Bank Balance Year 1 Year 2
Beginning balance $79.72 $89.29
Interest earned @ 12% $9.57 $10.71Ending balance $89.29 $100.00
We can also determine the present value
using present value tables.
8/8/2019 AFD W2 Lecture Power Point
20/40
20
Interest and the Time Value of
Money
RatePeriods 10% 12% 14%
1 0.909 0.893 0.877
2 0.826 0.797 0.769
3 0.751 0.712 0.675
4 0.683 0.636 0.592
5 0.621 0.567 0.519
Excerpt from Discount cash flow Table
Present
va
lue
factor o
f
$1
for 2
periods at 12%.Prese
nt
va
lue
factor o
f
$1
for 2
periods at 12%.
8/8/2019 AFD W2 Lecture Power Point
21/40
21
Quick Check
How muchwouldyou have to put in the banktoday to have $100 at the end of five yearsif the interest rate is 10%?
a. $62.10b. $56.70
c. $90.90
d. $51.90
8/8/2019 AFD W2 Lecture Power Point
22/40
22
Net Present Value Method
To determine net present valuewe . . .To determine net present valuewe . . .
Calculate thepresent value of cash inflows,Calculate thepresent value of cash inflows,
Calculate thepresent value of cash outflows,Calculate thepresent value of cash outflows,
Subtract thepresent value of the outflows from theSubtract thepresent value of the outflows from thepresent value of the inflows.present value of the inflows.
8/8/2019 AFD W2 Lecture Power Point
23/40
23
Net Present Value Method
General decision rule ...General decision rule ...If the Net Present
Value is . . . Then the Project is . . .
Positive . . .Acceptable, since it promises a
return greater than the required
rate of return.
Zero . . .
Acceptable, since it promises a
return equal to the required rate
of return.
Negative . . .
Not acceptable, since it promises
a return less than the required
rate of return.
8/8/2019 AFD W2 Lecture Power Point
24/40
24
Net Present Value Method
Carver Hospital is considering the purchase of an attachment forits X-ray machine.
No investments are to be made unless theyhave an annual returnof at least 10%.
Cost $3,169Life 4 yearsSalvage value zeroIncrease in annual cash inflows 1,000
8/8/2019 AFD W2 Lecture Power Point
25/40
25
Net Present Value Method
It m Y (s)
Amount of
C sh Flow
10%
Facto
sent
Value of
Cash
FlowsIn t al investment(outflow) Now (3,170) 1.000 (3,170)
Item Year(s)
Amountof
Cash Flow
Present
Value of
Cash
FlowsInitial investment(outflow) Now (3,169) (3,169)
Annual cash inflows 1-4 1,000$ 3,169$
Netpresentvalue $ -0-
$1,000 x (0.909 + 0.826 + 0.751 + 0.683) = $3,169$1,000 x 3.169 = $3,169
8/8/2019 AFD W2 Lecture Power Point
26/40
26
Net Present Value Method
Item Year(s)
Amountof
Cash Flow
10%
Factor
Present
Value of
Cash
FlowsInitial investment(outflow) Now (3,170) 1.000 (3,170)
Item Year(s)
Amountof
Cash Flow
Present
Value of
Cash
FlowsInitial investment(outflow) Now (3,169) (3,169)
Annual cash inflows 1-4 1,000$ 3,169$
Netpresentvalue $ -0-
$1000 x (0.909 + 0.826 + 0.751 + 0.683) = $3,169
Because the net present value is equal to zero,the investment in the attachment for the X-ray
machineprovides exactly a 10% return.
8/8/2019 AFD W2 Lecture Power Point
27/40
27
Quick Check
Suppose that the investment in the attachment forthe X-ray machine had cost $4,000 and generated anincrease in annual cash inflows of $1,200. What is the
net present value of the investment?a. $ 800
b. $ 197
c. $(197)
d. $(800)
8/8/2019 AFD W2 Lecture Power Point
28/40
28
Seminar Question
Year0
Year1
Year2
Year3
Year4
Year5
200,000 + 10,000
54,000+10,000+20,000=
(210,000)
54,000
54,000
54,000
54,000
84,000
6) Calculate theNet Present Value (NPV) by applying the
10% discount factors (see tables on Page 58) to the cashflows calculated in 4) above.
Annual cash flows
8/8/2019 AFD W2 Lecture Power Point
29/40
29
Net Present Value Method
OTHER THINGSTOCONSIDER
Includeanyadditionalworkingcapitalrequiredininitialinvestment
Includedisinvestmentofworkingcapitalandproceedsofsaleoffixedassetsatendofproject
Minimumrateofreturnrequiredcalculatedbyreferencetominimumrequiredby variousfinanceproviders(weighted
averagecostofcapital)ormarginalcostofcapital(costofadditionalcapitalrequired)
8/8/2019 AFD W2 Lecture Power Point
30/40
30
Net Present Value Method
Whatfactorscouldthecompany havetakenintoconsiderationwhendecidingonthecostofcapital (thediscountrate)?
Theweightedaveragecostofcapital (theaverageofthereturnsrequiredbythe
variousprovidersofcapital)orthemarginalcostofcapital ietheactualcostofthecapitalsumrequiredtofinancetheprojectinthemarketatthetime.
8/8/2019 AFD W2 Lecture Power Point
31/40
31
Internal Rate of Return (IRR)
The interest rate that makes . . .
Presentvalue ofcash inflows
Presentvalue ofcash outflows
=
The net present valueequal zero.
8/8/2019 AFD W2 Lecture Power Point
32/40
32
Projects with even annual cash flows
Project life = 3 years
Initial cost = $675Cash inflow at year 3 = $1,000
Determine the IRR for this project.
Internal Rate of Return (IRR)
8/8/2019 AFD W2 Lecture Power Point
33/40
33
Projects with even annual cash flows
Project life = 3 years
Initial cost = $675Cash inflow at year 3 = $1,000
Determine the IRR for this project.
Internal Rate of Return (IRR)
1. Compute present value factor.$675 $1,000 per year = 0.675
2. Using discounted cash flow table: 14%
8/8/2019 AFD W2 Lecture Power Point
34/40
34
- It can be used either to screen or torank projects
- Anyproject whose IRR is less than
the required return is rejected.- The higher the IRR of a project, the
more desirable it is considered to be.
Using Internal Rate of Return
8/8/2019 AFD W2 Lecture Power Point
35/40
35
- Sophisticated business calculators and electronicspreadsheets can beused to easily solve theseproblems.
Internal Rate of Return (IRR)
8/8/2019 AFD W2 Lecture Power Point
36/40
36
Net Present Value Methodvs
Internal Rate of Return (IRR)
Disadvantages of IRR:
- Multiple or missing IRR.
- NPV method assumes that intermediate cash flows are
reinvested at a rate equal to the required rate of return, TheIRR method assumes that intermediate cash flows can bereinvested at the projects IRR while an identical project maynot be available in the future.
While the IRR method may have intuitive appeal tomanagers (accepting project if the IRR is higher than therequired return). It has the following main disadvantages.
8/8/2019 AFD W2 Lecture Power Point
37/40
37
CAPITAL APPRAISAL INPRACTICE
More than one method is used when appraising projects
Managers are re-assured by QUICK PAYBACK!
Divisional performance often measured by ROCE (Return on capitalemployed) which requires that rate of return is maintained and short-
life projects continually replaced There are Potential conflict between DCF methods (NPV & IRR) in
the case ofmutually exclusive projects When two or moreprojects are considered, a firm can select only one. (NPV of projectA is higher than NPV of projectB, while IRR of project A is lowerthan IRR of projectB).
In this case, the NPV methods should be chosen. The amount ofpositive NPV represents value added to a business.
8/8/2019 AFD W2 Lecture Power Point
38/40
38
CAPITAL APPRAISAL INPRACTICE
Sensitivity (what if.?) andprobabilitymodelling can be used to
minimise inaccuracy of forecasts
Some form ofpost-auditcarried out to check on accuracy of figures
used in appraisal
8/8/2019 AFD W2 Lecture Power Point
39/40
39
Seminar 3: Questions 1 4
Students are required to hand in
handwritten solutions to the assigned
exercises at the beginning of the
tutorial sessions.
Tutorial Exercise
8/8/2019 AFD W2 Lecture Power Point
40/40
40
End of
Week 2
Lecture