management accounting

© Pearson Education Limited 2008

MANAGEMENT ACCOUNTINGMANAGEMENT ACCOUNTING

Cheryl S. McWatters, Jerold L. Zimmerman, Dale C. Morse Cheryl S. McWatters, Jerold L. Zimmerman, Dale C. Morse

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© Pearson Education Limited 2008Management Accounting McWatters, Zimmerman, Morse

Management Accounting Management Accounting

Investment decisions (Planning) Investment decisions (Planning)

Chapter 13

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ObjectivesObjectives• Describe the steps of the capital-budgeting process.• Identify the opportunity cost of capital• Estimate the payback period of an investment and

identify weaknesses of the payback method in making investment choices

• Calculate the accounting rate of return (ROI) and identify weaknesses of ROI in making investment decisions

• Calculate the net present value of cash flows• Identify non-cash profit and loss accounts that should be

excluded in calculating the net present value• Adjust cash flows to reflect the additional accounts

receivable and inventory required

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Objectives - contObjectives - cont

• Exclude financing charges when calculating the net present value of an investment

• Estimate tax cash flows for capital budgeting• Recognize the effect of risk on the discount rate• Estimate the internal rate of return (IRR) of an

investment project• Identify problems with using the IRR to evaluate

investment projects

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Long-Term Investment DecisionsLong-Term Investment Decisions

Long-term investment decisions differ from short-term decisions because long-term usually Long-term investment decisions differ from

short-term decisions because long-term usually

Involve larger cash outlays

Involve larger cash outlays

Have multi-year cash flow

implications

Have multi-year cash flow

implications

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The Capital Budgeting ProcessThe Capital Budgeting Process

Check to determinethat cash flow

estimates and risks are reasonably assessed

Check to determinethat cash flow

estimates and risks are reasonably assessed

Identification of aninvestment proposalIdentification of aninvestment proposal

Ratification ofthe proposal


Start

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Cash and other resourcesare invested and related

operations begin

Cash and other resourcesare invested and related

operations begin




Implementationof the proposal


Start

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Evaluate whetherinvestment is

fulfilling expectations

Evaluate whetherinvestment is

fulfilling expectations






Monitoringactivity

Monitoringactivity

Start

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Monitoringactivity

Monitoringactivity

Start

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Opportunity Cost of CapitalOpportunity Cost of Capital

The opportunity cost of using a resource depends on alternative uses of that resource The opportunity cost of using a resource depends on alternative uses of that resource

The opportunity cost of capital is a term used to describe the forgone opportunity of using cash

The opportunity cost of capital is a term used to describe the forgone opportunity of using cash

The ability to compare cash flows over different time periods is very important in evaluating

investment decisions

The ability to compare cash flows over different time periods is very important in evaluating

investment decisions

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Investment Criteria Ignoring the Investment Criteria Ignoring the Opportunity Cost of CapitalOpportunity Cost of Capital

Payback Payback

Some managers find the discounting of future costs confusing or difficult

Some managers find the discounting of future costs confusing or difficult

Accounting Rate Of Return

Accounting Rate Of Return

Alternatives to discounting methodAlternatives to discounting method

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PaybackPayback

The number of years or months it takes for cash flows from an investment to equal the

initial investment cost

The number of years or months it takes for cash flows from an investment to equal the

initial investment cost

When the net annual cash inflow is the same every year, the following formula can be used

to compute the payback period

When the net annual cash inflow is the same every year, the following formula can be used

to compute the payback period

Payback period = Investment required Net annual cash inflow

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PaybackPayback

A £4,000,000 investment in a motel has expected net cash flows of £1,000,000 in each of the next 5 years

A £4,000,000 investment in a motel has expected net cash flows of £1,000,000 in each of the next 5 years

What is the investment’s payback

What does the payback method ignore

What is the investment’s payback

What does the payback method ignore

The investment has a payback of 4 years but the payback method ignores the cash flows in the

fifth year and the time value of money

The investment has a payback of 4 years but the payback method ignores the cash flows in the

fifth year and the time value of money

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Shortcomings of PaybackShortcomings of Payback

Ignores the opportunity cost of capitalIgnores the opportunity cost of capital

Ignores cash flows beyond the payback periodIgnores cash flows beyond the payback period

Lacks an acceptance benchmarkLacks an acceptance benchmark

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Accounting Rate of ReturnAccounting Rate of Return

ROI =Profit

Investment

The accounting rate of return (ROI) does not focus on cash flows, rather it focuses on

accounting income

The accounting rate of return (ROI) does not focus on cash flows, rather it focuses on

accounting income

Accounting rate of return is:Accounting rate of return is:

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ROI =

Average annual profit from the project

Average annual investment in the project

ROI for capital-budgeting decisions should make comparisons with the opportunity cost of capital ROI for capital-budgeting decisions should make comparisons with the opportunity cost of capital

The choice of how to measure profit and investment for ROI depends on how the ROI is to be used

The choice of how to measure profit and investment for ROI depends on how the ROI is to be used

ROI for performance measures should reflect controllability

ROI for performance measures should reflect controllability

A multi-period alternative of estimating ROI is: A multi-period alternative of estimating ROI is:

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Average net income, average book value of investment and annual ROI

Average net income, average book value of investment and annual ROI

Year Net Profit (£) Average book value of investment (£)

ROI (%)

1 900,000 9,000,000 10

2 900,000 7,000,000 13

3 900,000 5,000,000 18

4 900,000 3,000,000 30

5 900,000 1,000,000 90

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Accounting Rate of ReturnAccounting Rate of ReturnNumerical ExampleNumerical Example

What is the ROI for each year. What is the multi-year ROI. How would the sum-of-the-year’s digits method of depreciation

affect the calculation of ROI

What is the ROI for each year. What is the multi-year ROI. How would the sum-of-the-year’s digits method of depreciation

affect the calculation of ROI

An investment of €300,000 generates cash flows of €150,000 during each of the next 3 years

An investment of €300,000 generates cash flows of €150,000 during each of the next 3 years

The investment is fully depreciated using the straight line method over the 3 years. The annual net income of the

investment is €150,000 - €100,000 (€50,000) . The average investment is used as the denominator to calculate ROI

The investment is fully depreciated using the straight line method over the 3 years. The annual net income of the

investment is €150,000 - €100,000 (€50,000) . The average investment is used as the denominator to calculate ROI

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Accounting Rate of ReturnAccounting Rate of ReturnNumerical ExampleNumerical Example

Year Profit (€) Average investment (€) ROI (%)

1 0 225,000 0

2 50,000 100,00 50

3 100,000 25,000 400

The multi year ROI is €50,000/€100,000

(50%)


(50%)


(33%)


(33%)

Sum of the years digits methodSum of the years digits method

Year Profit (€) Average investment (€) ROI (%)

1 50,000 250,000 20

2 50,000 150,000 33

3 50,000 50,000 100

Straight-line depreciation methodStraight-line depreciation method

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The Net Present Value of Cash The Net Present Value of Cash FlowsFlows

Future cash flows should be discounted when compared with present cash flows

Future cash flows should be discounted when compared with present cash flows

The discount factor for a future cash flow isThe discount factor for a future cash flow is

1 (1 + r)n

Where: r = opportunity cost of capital n = number of periods until cash flow occurs

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The Net Present Value of Cash The Net Present Value of Cash Flows Flows Numerical ExampleNumerical Example

Carbon corporation has an opportunity cost of capital of 10%. The company is considering an

investment project that should yield the following cash flows

Carbon corporation has an opportunity cost of capital of 10%. The company is considering an

investment project that should yield the following cash flows

What is the present value of these cash inflowsWhat is the present value of these cash inflows

Year from now Cash inflow (€)

1 44,000

2 50,000

3 20,000

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The Net Present Value of Cash The Net Present Value of Cash FlowsFlows Numerical ExampleNumerical Example

Cash inflow (€) Discount factor Present value (€)

44,000 1/(1 + 0.1)1 = 0.90909 40,000

50,000 1/(1 + 0.1)2 = 0.82645 41,322

20,000 1/(1 + 0.1)3 = 0.75131 15,026

Total present value of cash flows 96,348

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Estimating Cash FlowsEstimating Cash Flows

• Discount cash flows not accounting earnings

• Adjust cash flows to reflect the need for additional accounts receivable and inventory

• Include opportunity costs but not sunk costs

• Exclude financing costs• Taxes and depreciation tax shields

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Depreciation Tax ShieldsDepreciation Tax Shields

The primary difference between cash flows and income for tax purposes is depreciation

The primary difference between cash flows and income for tax purposes is depreciation

The reduction in cash tax payments due to depreciation is called the depreciation tax shield

The reduction in cash tax payments due to depreciation is called the depreciation tax shield

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Tax and Depreciation Tax ShieldsTax and Depreciation Tax Shields

The depreciation tax shield is a set of simple algebraic equations

The depreciation tax shield is a set of simple algebraic equations

Where: R = revenues

E = expenses except depreciationD = depreciation allowed for tax purposest = tax rate

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Depreciation Tax ShieldsDepreciation Tax Shields

Taxes = (R - E - D) × t

Cash flow = (R - E - Taxes)

Net income (NI) = (R - E - D) × (1 - t)

Cash flow = (R - E) × (1 - t) + (D × t)

So . . .

This is thedepreciation

tax shield

This is thedepreciation

tax shield

The sooner the depreciation is taken, the higher the present value of the depreciation tax shield

The sooner the depreciation is taken, the higher the present value of the depreciation tax shield

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Depreciation Tax ShieldsDepreciation Tax ShieldsNumerical ExampleNumerical Example

An asset is purchased for €500,000. The asset has a five-year lift and no salvage value. The

tax rate is 34% and the interest rate is 5%

An asset is purchased for €500,000. The asset has a five-year lift and no salvage value. The

tax rate is 34% and the interest rate is 5%

What is the present value of the tax shields under the straight line and double-declining

balance depreciation methods

What is the present value of the tax shields under the straight line and double-declining

balance depreciation methods

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Depreciation Tax ShieldsDepreciation Tax ShieldsNumerical ExampleNumerical Example

Straight line depreciation

Year Depreciation expense (€)

Tax shield (Dt) (€)

PV of tax shield (€)

DDB rate

1 100,000 34,000 32,381 0.4

2 100,000 34,000 30,839 0.4

3 100,000 34,000 29,370 0.4

4 100,000 34,000 27,972 0.4

5 100,000 34,000 26,64

500,000 147,202

Double-declining-balance depreciation

Book value at beginning of year (€)

Depreciation expense (€)

Tax shield (Dt)(€)

PV of tax shield (€)

500,000 200,000 68,000 64,762

300,000 120,000 40,800 37,007

180,000 72,000 24,480 21,147

108,000 43,200 14,688 12,084

64,000 64,800 22,032 17,263

500,000 152,263

Double declining writes off the €500,000 original cost faster than does straight line depreciation therefore

it’s tax shield has a higher present value than the straight line method (€5,061)

Double declining writes off the €500,000 original cost faster than does straight line depreciation therefore

it’s tax shield has a higher present value than the straight line method (€5,061)

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Adjusting the Discount Rate for RiskAdjusting the Discount Rate for Risk

• Risky projects should be discounted at a higher interest rate than safe projects

• For any given risky cash flow stream, we will assume that an equivalent risk-adjusted interest rate exists

• Instead of discounting the highest/lowest cash flow we discount the expected (average) cash flow

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Internal Rate of Return (IRR)Internal Rate of Return (IRR)

The internal rate of return method finds the interest rate that equates the initial investment

cost to the future discounted cash flows. (Makes the NPV = £0)

The internal rate of return method finds the interest rate that equates the initial investment

cost to the future discounted cash flows. (Makes the NPV = £0)

It is easy to calculate is an initial cash outflow is followed by a cash in flow in the same period

It is easy to calculate is an initial cash outflow is followed by a cash in flow in the same period

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Investment cost = (Cash inflows in year one) ÷ (1 + IRR)Investment cost = (Cash inflows in year one) ÷ (1 + IRR)

If you invest £1,000 in a project today and receive £1,070 in a year

If you invest £1,000 in a project today and receive £1,070 in a year

£1,000 = £1,070 1 + IRR

IRR = .07 = 7%IRR = .07 = 7%

If the cost of capital is 6%, this investment offersa return in excess of its opportunity cost

If the cost of capital is 6%, this investment offersa return in excess of its opportunity cost

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NPV = £1,070 1.05

- £1,000

= £1,019.05 - £1,000 = £19.05

If there is a 5% cost of capital, the net present value of this investment opportunity is:

If there is a 5% cost of capital, the net present value of this investment opportunity is:

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General Rule

If the internal rate of return exceeds the opportunity cost of capital, the investment

should be undertaken

General Rule

If the internal rate of return exceeds the opportunity cost of capital, the investment

should be undertaken

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Comparing IRR and NPV of Two Comparing IRR and NPV of Two InvestmentsInvestments

• The IRR and NPV methods do not always give consistent answers

• IRR and NPV may lead to different investment decisions if investments are mutually exclusive (only one investment can be chosen from a group of opportunities)

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Comparing IRR and NPV of Two Comparing IRR and NPV of Two InvestmentsInvestments Numerical ExampleNumerical Example

A company is considering an investment that requires an initial cash outlay of €100,000 the investment is

expected to return €70,000 in the first year and €55,000 in the second year. What is the IRR

A company is considering an investment that requires an initial cash outlay of €100,000 the investment is

expected to return €70,000 in the first year and €55,000 in the second year. What is the IRR

The NPV (at 17%) is very close to zero so the IRR is approximately 17%

The NPV (at 17%) is very close to zero so the IRR is approximately 17%

-€100,000 + (€70,000/(1 + 0.17)) + (€55,000/(1 + 0.17)2) = 17

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Comparing IRR and NPV of Two Comparing IRR and NPV of Two InvestmentsInvestments

Net present value indicates how much cash in today’s dollars an investment is worth, or the

magnitude of the investment’s return

Net present value indicates how much cash in today’s dollars an investment is worth, or the

magnitude of the investment’s return

Internal rate of return only indicates the relative return on the investment

Internal rate of return only indicates the relative return on the investment

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Capital Budgeting Methods Used in Capital Budgeting Methods Used in PracticePractice

• The discounting of cash flows to make capital decisions has become common practice

• Cultural differences can affect the nature of the capital-budgeting process

• Small organizations evaluate capital-budgeting projects differently

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Capital Budgeting Methods Used in Capital Budgeting Methods Used in PracticePractice

The following are reasons for the continued prevalence of discounting methods

1. Discounting methods are theoretically superior

2. They are the mainstay of business school curricula

3. Computer technology can calculate NPVs and IRRs quickly and easily

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Management Accounting Management Accounting

Investment decisions (Planning) Investment decisions (Planning)

End of Chapter 13

management accounting

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