ACCT 2302 Fundamentals of Accounting II Spring 2011 Lecture 20 Professor Jeff Yu
Review: Sell or Process Further? Decision Rule: process further only when the incremental revenue from such processing exceeds the incremental processing cost incurred after the split-off point. Joint costs are irrelevant to the decision.
Review: Present Values Present Value of a future dollar amount: If $C will be received in n years and annual interest rate is r, then its present value = C * the PV factor from the table of Exhibit 14B-1. Present Value of an Annuity: If $C will be received at the end of each period for n years and annual interest rate is r, then the present value of this annuity = C * the PV of an annuity factor from the table of Exhibit 14B-2.
Review: DCF Analysis • Net Present Value (NPV) Method • Compare PV of all cash inflows with PV of all cash outflows that are associated with the project. • If NPV >= 0, accept the project. Otherwise, reject it. • Internal Rate of Return (IRR) Method • Calculate IRR: the discount ratethat sets NPV = 0. • Accept the project if IRR >= the required rate of return (cost of capital). Otherwise, reject it.
Both consider time value of money. NPV is often simpler to use. Different assumptions: IRR method assumes cash inflows are reinvested at the internal rate of return, which is unrealistic especially when IRR is high. NPV method assumes cash inflows are reinvested at a rate of return equal to the company’s cost of capital, which is more realistic, because such a rate of return can be realized by paying off the creditors and buying back stocks with cash flows from the project. Review: NPV versus IRR
Expanding the NPV Method NPV method could be expanded to compare two alternative (competing) projects. Two Approaches: • Total-cost: All cash inflows and outflows are included in DCF analysis (the most flexible method). • Incremental cost: only those cash flows that differ between 2 alternatives are considered (simpler method using the relevant cost concept).
Example White Co. uses a discount rate of 10% and is considering two alternatives: (1) remodel an old car wash (no salvage value); (2) remove it & install a new one. For simplicity, assume both alternatives have a 10-year life. Q: Which alternative will yield a higher NPV? By how much?
The Total-Cost Approach If we install the new washer, the investment will yield a positive NPV of $83,202.
The Total-Cost Approach If we remodel the existing washer, we will produce a positive net present value of $56,405.
The Incremental-Cost Approach Under incremental-cost approach, only those cash flows that differs between alternatives are considered.
Consider the following two competing projects. Each project would last for five years. Project AProject B Initial investment $80,000 $60,000 Annual net cash inflows 20,000 16,000 Salvage value at year 5 10,000 8,000 The company uses a discount rate of 14% to evaluate projects. Which of the following statements is true? A. NPV of Project A > NPV of Project B by $5,230 B. NPV of Project B > NPV of Project A by $5,230 C. NPV of Project A > NPV of Project B by $2,000 D. NPV of Project B > NPV of Project A by $2,000 Practice Problem
Investment required Net annual cash inflow Payback period = The Payback Method • The payback periodis the length of time that it takes for a project to recover its initial cost out of the cash receipts that it generates. • When the net annual cash inflow is the same each year, the following formula can be used to compute the payback period:
Practice Problem • Management at The Daily Grind wants to install an espresso bar in its restaurant. A payback period of 5 years or less is required on all investments. • The espresso bar: • costs $140,000 and has a 10-year life. • will generate net annual cash inflows of $35,000. Q: What is the payback period for the espresso bar?
$1,000 $0 $2,000 $1,000 $500 1 2 3 4 5 Payback and Uneven Cash Flows When the cash flows associated with an investment project change from year to year, the payback formula introduced earlier cannot be used. Instead, the un-recovered investment must be tracked year by year. For example, if a project requires an initial investment of $4,000 and provides uneven net cash inflows in years 1-5 as shown, the investment would be fully recovered in year 4.
Ignores the time value of money. Ignores cash flows after the payback period. Evaluation of the Payback Method Short-comings of the Payback Period.
Serves as screening tool. Identifies investments that recoup cash investments quickly. Identifies products that recoup initial investment quickly. Strengths of the payback period. Evaluation of the Payback Method
Simple Rate of Return Method • Does not focus on cash flows -- rather it focuses on net operating income. Annual Incremental NOI Simple rate of return = Initial investment Notes: (1) Annual incremental NOI = annual incremental revenue (cost savings) – annual incremental expenses; (2) Annual depreciation expense should be included in the calculation of annual incremental expenses; (3) Initial investment should be reduced by any salvage value from the sale of the old equipment.
Practice Problem Management of The Daily Grind wants to install an espresso bar in its restaurant. The espresso bar: Cost $140,000 and has a 10-year life. Will generate incremental revenues of $100,000 and incremental expenses of $65,000 including depreciation expense of $5,000. Q: What is the simple rate of return on the project?
Ignores the time value of money. The same project may appear desirable in some years and undesirable in other years. Criticism of the Simple Rate of Return Short-comings of the simple rate of return.
Preference Decisions Screening Decisions Preference Decisions whether or not some proposed investment is acceptable. Rankacceptable alternatives from the most to least appealing.
Preference decision using IRR method When using the IRR method to rank competing investment projects, the preference rule is: The higher IRR, the more desirable the project.
Profitability NPV of the project index Investment required = Preference decision using NPV method When funds are constrained and the initial investment of competing projects are NOT equal, then all else equal, the project with higher profitability index is more desirable.
For Next Class • Tax effects in capital budgeting (Appendix 14C) • Attempt the assigned homework problems.
Homework Problem 1 Neal Co. has a discount rate of 12% and is considering a project that requires a $2,400,000 investment in equipment and has an 8-year life. At the end of year 8, the equipment has no salvage value. Each year, the project will generate the following data: Sales (all in cash): $3,000,000 Variable expenses: $1,800,000 Fixed expenses: Depreciation: $300,000 Other fixed expenses: $700,000 Q: Assume depreciation is the only non-cash expense. Compute the project’s (1) NPV (2) IRR (3)Payback period (4) Simple rate of return.
Homework Problem 2 Perit Co. is choosing between the following two alternatives: Both projects have a life of 6 years, and the working capital needed for Project B will be released at the end of 6 years for investment elsewhere. Perit Co.’s discount rate is 14%. Q: Which investment alternative would you choose?