ACCT 102 Management Accounting Lecture 17

1. ACCT 102Management AccountingLecture 17

2. 2 Introduction

3. 3

4. 4 Money has time value if it can invested be at some positive return Amounts of money received at different periods of time must be converted to their value on a common date to be compared, added or subtracted

5. 5 Future value It is the amount a current sum of money earning a stated rate of interest will accumulate to at the end of the future period FV = PV (1 + r)n where r: compound rate Present value It is the current worth of a specified amount of money to be received at some future date at some interest rate. PV = FV / (1 + r)n where r: discount rate It is very useful to draw a time line in calculations that involve the time value of money

6. 6 Annuities An annuity is a stream of equal cash flows that occur at equal intervals over a given period of time 2 types of annuity Ordinary annuity: Cash flows occur at the end of each year Formula: PVOA = (a / r) x [1 � 1/(1 + r)n] Refer to annuity table PVOA = Ordinary Annuity Factor (n, r) x Annuity Annuity due: Cash flows occur at the beginning of each period Formula: PVOAD = (a / r) x [1 � 1/(1 + r)n-1] + a Refer to annuity table. PVOAD = Ordinary Annuity Factor (n -1, r) x Annuity + Annuity

7. 7 Practice questions on time value of money Determine the answers to each of the following situations: The future value in 2 years of $1,000 deposited today in a savings account with interest compounded annually at 8%. The present value of $9,000 to be received in five years, discounted at 12%. The present value of an annuity of $2,000 per year for five years discounted at 16%. A proposed investment of $32,010 is to be retuned in eight equal annual payments. Determine the amount of each payment if the interest rate is 10%. A proposed investment will provide cash flows of $20,000; $8,000; and $6,000 at the end of Years 1, 2 and 3 respectively. Using a discount rate of 20%, determine the present value of these cash flows. Find the present value of an investment that will pay $5,000 at the end of Years 10, 11 and 12. Use a discount rate of 14%.

8. 8 Case Study

9. 9

10. 10

11. 11

12. 12 Capital Budgeting

13. 13 Net Present Value

14. 14

15. 15

16. 16

17. 17 Internal Rate of Return (IRR)

18. 18

19. 19

20. 20 When discounting models are used to evaluate capital expenditure proposals, management must determine the discount rate Uses of the discount rate Used to compute a proposal�s NPV Used as the standard for evaluating a proposal�s IRR An organization�s cost of capital is often used as this discount rate.

21. 21 Differences Between Net Present Value and the Internal Rate of Return Models The net present value model gives explicit consideration to investment size. The internal rate of return does not. The net present value model assumes all net cash inflows are reinvested at the discount rate. The internal rate of return model assumes all net cash inflows are reinvested at the project�s internal rate of return.

22. 22 The cost of capital is the average cost of obtaining the resources to make investments. This average rate takes into account such items as: Effective interest rate on notes or bonds Effective dividend rate of preferred stock Discount rate that that equates the PV of all dividends expected on common stock over the life of the organization to the current market value of the organization�s common stock

23. 23 The cost of capital is the minimum return that is acceptable for investment purposes Any investment proposal not expected to yield this minimum rate should normally be rejected However, because of the difficulties in determining the cost of capital, many organizations adopt a discount rate or a target rate of return without complicated mathematical calculations

24. 24 Techniques Developed to Assist in the Analysis of Capital Budgeting Risks The discount rate for individual projects may be adjusted based on management�s perception of the risk associated with the project. Several internal rates of return/or net present values may be computed for a project. A capital expenditure proposal may be subject to sensitivity analysis.

25. 25 Payback Period

26. 26

27. 27

28. 28

29. 29 Accounting Rate of Return

30. 30

31. 31

32. 32

33. 33 Evaluating Capital Budgeting Models

34. 34

35. 35

36. 36 Evaluating Capital Budgeting Proposals Capital budgeting models do not make investment decisions. They only help managers separate capital expenditure proposal that meet certain criteria from those that do not Multiple Investment Criteria Management may use a single capital budgeting model or they may use multiple models, including those that have not been discussed

37. 37 Evaluating Capital Budgeting Proposals For example, to be accepted, a proposal must meet the following criteria: Proposal must be in line with the organization�s long-range goals and business strategy Maximum payback period of 3 years Have a net positive NPV when discounted at 14 percent Have an initial investment of less than $500,000 If many of the criteria suggest the project should be taken, the chance is greater that the project is desirable

38. 38 Ranking Capital Budgeting Proposals

39. 39 Ranking Capital Budgeting Proposals

40. 40

41. 41

42. 42

43. 43

44. 44 Present Value Index

45. 45

46. 46

47. 47