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ACTG 2120

ACTG 2120. Chapter 25 – Capital Budgeting and Managerial Decisions. Capital Investment Decisions. Nature of decision Long-term Large amounts Financial considerations Nonfinancial considerations Satisfy regulations Good for community Others. Payback Period.

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ACTG 2120

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  1. ACTG 2120 Chapter 25 – Capital Budgeting and Managerial Decisions

  2. Capital Investment Decisions • Nature of decision • Long-term • Large amounts • Financial considerations • Nonfinancial considerations • Satisfy regulations • Good for community • Others

  3. Payback Period • Period of time it takes to recover cash investment • Based exclusively on cash flows • Cash flows = net income + depreciation Initial investment Annual cash flows = Payback period • Ex.: $300,000/ $100,000 = 3 years • Lower payback period, the better • Problems: 1 - Ignores time value of money • 2- Disregards cash flows after payback

  4. Accounting Rate of Return • Return on average investment • Net Income/ Average investment = ROI • Average investment = (Cost + Salvage value) / 2 • Ex.: $25,000/(($300,000 + 0)/2) • $25,000/15,000 = 16.7% • The higher the rate, the better • Problems: Ignores time value of money

  5. Net Present Value Method • 1 - Using present value tables at a chosen “discount” rate, compute the present value of net cash flows • 2 - Compare (1) to investment • 3 - Value in (2) should be positive in order to consider investment further • Problems - NPV varies based on discount rate chosen

  6. Net Present Value • Profitability index: • NPV/Initial investment • Allows different size projects to be compared • Highest NPV index would be chosen

  7. Internal Rate of Return • n • SPeriodic cash flow for period t • t=0 (1 + internal rate of return) • Interest rate computed such that the net present value of the investment is zero. • IRR assumes that the cash flows will be reinvested at the internal rate of return. • Often not as reliable as net present value • End product is a percentage that can be compared to minimum rate of return.

  8. Additional Factors • Income taxes • Unequal proposal lives • Uncertainty • Inflation • Qualitative considerations • Uneven cash flows • Comparison – Exhibit 25.10, page 1047

  9. Break-even Time • Variation of the payback method that includes the time value of money • Tells us how long it takes to recover the initial investment based on the PRESENT VALUE of the cash flows.

  10. Managerial Decisions • Decision Making • Relevant Costs • Data must differ between alternatives • Must be future revenues or future costs • Not past or “sunk” costs • Opportunity costs • Qualitative information

  11. Managerial Decisions • Accepting additional business • Often price charged is lower than usual • Consider relevant costs of special order only • If relevant costs < special order price, consider accepting the special order • Check on capacity restraints • Consider long-run implications of short-run decisions

  12. Managerial Decisions • Make or buy decisions • Compare costs of outside bid to relevant costs to make a part or product • Lowest cost alternative appears to be the best choice • Consider opportunity costs • Consider nonfinancial considerations such as effects on employment, quality of products made elsewhere, supply of additional units, reliable delivery of units

  13. Managerial Decisions • Scrap or rework a product • Only consider future costs of rework • Past costs are not considered • If additional costs of rework < revenue from selling scrap, consider reworking.

  14. Managerial Decisions • Sell or Process Further • Consider the additional revenue and the additional costs from further processing the products • Disregard costs incurred to date • If additional revenue > additional costs, consider processing further

  15. Managerial Decisions • Sales mix selection if demand is unlimited: • Determine the contribution margin (CM) per product • The product with the highest CM should be promoted • Sales mix selection if demand is limited: • Divide the contribution margin per unit by the scarce resource (i.e., time, machine hours, shelf capacity, etc.) • The product with the highest contribution margin per scarce resource is the best selection.

  16. Managerial Decisions • Discontinuing an unprofitable segment • Often a division or product line has a negative net income • If trying to decide whether to drop the line, one needs to consider relevant costs of dropping the line only • Would we still have the costs if we dropped the line? • If so, those are not relevant • Consider the impact of dropping the line would have on the sales of the other products • Could we add another product that contributes more to profits?

  17. Managerial Decisions • Keep or Replace Equipment • Compare cost of running new equipment to cost of running old equipment • Consider additional sales of new equipment • Consider cost of new equipment • Do not consider the cost of the old equipment (sunk cost); be do consider the salvage value (future revenue) • Consider opportunity costs

  18. Homework • Problems 25-2B*, 25-4B*, 25-6B* • DUE WITH EXAM, FRIDAY, MAY 30

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