Principles of Managerial Accounting

Chapter 14

Time Value of Money A dollar today is worth more than a

dollar received in the future.

Future amount of $1 Table 14C-1 page 702 If you invest $1,000 for 10 years at

10%, how much will you be able to withdraw from your investment?

1,000 x 2.594 = 2,594

Future amount of annuity Table 14C-2 page 703 How much would an investment of

$1,000 made at the end of each year for 10 years at 10% accumulate to?

1,000 x 15.938 = 15,938

Present value of $1 Table 14C-3 page 703 What is the present value of being

able to receive $1,000, 10 years from today, if the relevant interest rate is 10%?

1,000 x .386 = 386

Present value of an annuity Table 14C-4 page 704 How much would you need to

invest today to receive $1,000 at the end of each year for the next 10 years with a relevant interest rate of 10%?

1,000 x 6.145 = 6,145

Capital budgeting Planning and financing capital

outlays for purchase of new machines, introduction of new products, and modernization of facilities.

A commitment of funds now in order to receive cash flows in the future.

Typical capital budgeting decisions Screening decisions – proposed

project must meet some preset standard of acceptance Eg. Investment must generate at

least 20% return. Preference decisions – selecting

from several competing courses of action.

Discounted Cash Flows-Net present value method The present value of a project is the

difference between the present value of all cash inflows and the present value of all cash outflows.

If the net present value is positive, the investment project is acceptable.

The discount rate is typically the minimum required rate of return of investment projects.

Cost of capital The overall cost to an organization

of obtaining investment funds including the cost of both debt and equity sources.

Discounted cash flows – Internal rate of return method Internal rate of return is the rate of

return on an investment over its useful life

Rate on any investment is compared to whatever rate of return the organization requires on its investment projects. If internal rate of return is equal to or

greater than the required rate of return, the project is acceptable.

Investments in automated equipment Cost of automated equipment is

generally greater than conventional equipment

Front end costs are greater—engineering, software, training

Benefits – reduced labor costs, more reliable, more consistent, faster, fewer defects, higher quality, less scrap

Payback Period Method Length of time that it takes for an

investment project to recoup its initial cost out of the cash inflows that it generates

Payback period = Investment required / Net annual cash inflow

Disadvantage of this method – ignores time value of money

Simple rate of return Also known as the accounting rate

of return Simple rate of return =

Incremental revenues – Incremental expenses/ Initial investment

Disadvantage – does not use cash flow, includes depreciation, ignores time value of money

Assignment Exercises 1, 6 Problem 13