Kế toán, kiểm toán - Chapter sixteen: Planning for capital investments

Chapter SixteenPlanning for Capital Investments© 2015 McGraw-Hill Education.Capital Investment DecisionsPurchases of long-term operational assets are capital investments. Once a company purchases operational assets, it is committed to these investments for an extended period of time. Understanding the time value of money concept will help you make rational capital investment decisions. 16-2Time Value of MoneyThis concept recognizes that the value of a dollar received in the future is less than today’s dollar. The further into the future the receipt is expected to occur, the smaller its present value.When a company invests in capital assets, it sacrifices present dollars in exchange for the opportunity to receive future dollars. 16-3Minimum Rate of ReturnMost companies consider the cost of capital to be the minimum expected return on investment opportunities. Creditors expect interest payments; in most companies, owners expect dividends and increased stock value. The blend of creditor and owner costs is considered the cost of capital for an organization. 16-4Converting Future Cash Inflows to Their Equivalent Present ValuesEZ Rentals wants to add LCD projectors to its product line. If EZ invests $178,571 on January 1 and requires a rate of return of 12%, the company will expect a $200,000 cash inflow at the end of the first year.Investment + (0.12 × Investment) = Future cash inflow1.12 (Investment) = $200,000Investment = $178,571 16-5Present Value Table for Single-Amount Cash InflowsTable 1 in the Appendix$200,000 × 0.892857 = $178,571 (rounded) 16-6Present Value Table for AnnuitiesLet’s assume that EZ Rentals is going to receive $200,000 at the end of each of the next 4 years. The company uses an interest rate for present value calculations of 12%.An annuity is a series of equal periodic payments. Rent on your apartment or home, or insurance on your automobile is probably paid in the form an equal periodic payment.How do we determine the present value when faced with a series of payments? 16-7Present Value Table for AnnuitiesInvesting $607,470 today at a 12% return is equivalent to receiving $200,000 each year for the next four years. Table 1 in the Appendix 16-8Present Value Table for AnnuitiesAn annuity must meet three criteria: (1) equal payment amounts, (2) equal time intervals between payments, and (3) a constant rate of return.$200,000 × 3.037349 = $607,470 (rounded) 16-9Ordinary Annuity AssumptionAn ordinary annuity is a series of equal payments made at the end of each period.Capital investment decisions often involve uncertainties about future cash inflows and outflows. The assumptions inherent in ordinary annuities simplify the calculation process.$100$100$100$100$100$100 16-10Reinvestment AssumptionIn the first example of using Excel to calculate present value, we determine that the present value of the investment was $607,470 at a 12% rate of return. This calculation assumes that the periodic cash inflows, in our case $200,000, will be reinvested at the desired rate of return, or 12%. Here is the proof. 16-11Check YourselfTo increase productivity, Wald Corporation is considering the purchase of a new machine that costs $50,000. The machine is expected to provide annual net cash inflows of $12,500 for each of the next five years. Wald desires a minimum annual rate of return of 10%. Would you recommend that Wald invest in the new machine?PV of cash inflows = $12,500 × 3.790787 = $47,385Wald should not purchase the new machine. 16-12Internal Rate of ReturnThe internal rate of return is the rate at which the present value of cash inflows equals cash outflows.An investment cost $582,742, and will return $200,000 at the end of each of the next 4 years. What is the IRR?$582,742 ÷ $200,000 = 2.91371 16-13Measuring Investment Cash InflowsCash InflowsIncrementalRevenuesCostSavingsSalvageValueRelease ofWorking Capital 16-14Measuring Investment Cash OutflowsCash OutflowsIncrease in WorkingCapitalCommitmentsIncreases inOperatingExpensesInitialInvestment 16-15PV IndexPV index =PV of cash inflowsPV of cash outflowsAlternative 1 == 1.108$86,414$78,000Alternative 2 == 1.048$255,061$243,358Alternative 1 yields a higher return than Alternative 2. 16-16Relevance and theTime Value of MoneyYou have an opportunity to invest in one of the two projects shown below. Both require an investment of $6,000, and return total cash inflows of $8,000.If you have a desired rate of return of 10%, in which project would you invest? 16-17Relevance and theTime Value of MoneyProject 1 is clearly preferable to Project 2. 16-18Techniques That Ignorethe Time Value of MoneyPayback MethodThis is a simple and easy approach to looking at the recovery of an investment.Paybackperiod=Net cost of investmentAnnual net cash inflows 16-19Payback MethodWinston Cleaners can purchase a piece of equipment for $100,000 that will reduce labor costs by $40,000 per year over a four-year useful life. Let’s calculate the payback period.Paybackperiod=Net cost of investmentAnnual net cash inflowsPaybackperiod=$100,000$40,000= 2.5 yearsGenerally, the shorter the payback period, the better. 16-20Unequal Cash FlowsThe payback method requires adjustment when cash flows are unequal. Let’s assume a company purchases a machine for $6,000, with the cash inflows shown below: 16-21Unequal Cash FlowsAnother approach is to calculate the average annual cash inflows to compute the payback period.Paybackperiod=$6,000$1,500= 4 years 16-22Unadjusted Rate of ReturnInvestment cash flows are not adjusted to reflect the time value of money. The return is computed as follows:Unadjustedrate of return=Average incremental increase in annual net incomeNet cost of original investmentTo avoid distortions caused by the failure to recognize the recovery of invested capital, the unadjusted rate of return should be based on the average investment when working with investments in depreciable assets. 16-23PostauditsA postaudit is conducted at the completion of a capital investment project, using the same analytical technique that was used to justify the original investment. The focus should be on continuous improvement in the capital expenditure process. 16-24End of Chapter Sixteen 16-25