Week 9 Lecture Capital Budgeting and Cost Analysis (1)

Slide 1Copyright ©2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442504653/Horngren/Cost Accounting/1st Edition
ACCG301 Organisational Planning and Control
WEEK 9
[Custom Pub.: Ch.18]
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Copyright ©2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442504653/Horngren/Cost Accounting/1st Edition
Lecture Outline
Use and evaluate various capital budgeting methods.
Behavioural issues when making capital expenditure decisions.
Strategic Considerations
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Two Dimension of Cost Analysis
Project-by-project dimension: one project spans multiple accounting periods
Period-by-period dimension: one period contains multiple projects
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Introduction to Capital Budgeting
Exhibit 18-1 pg 706
Dimensions of cost analysis
Making long-run (term) planning decisions for investing in projects
Decision-making and control tool spanning multiple years
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Five Stages in Capital Budgeting
Identification stage
Obtain Information stage
Types of Capital investments
Outsourcing of certain components
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Make predictions (Forecast) Stage
- substantial initial outlays
- use capital budgeting methods
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Implement decision, evaluate performance and learn
- divide into two phases
- internally generated cashflow
- debt and equity securities in capital market
(ii) track realised cash flows, compare against initial plans, revise plans (if applicable)
- based on predictions in stage 3
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Capital Budgeting Methods
Payback period
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Discounted cash flow (DCF)
Methods measure all expected future cash inflows and outflows of a project, discounted back to the present
Required rate of return (RRR)
Min. acceptable annual return on investment
Reflects risk
Time value of money
Dollar received today is worth more than a dollar received in the future (Table 2 on page 914)
Capital Budgeting Methods
Set by upper management
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Net Present Value (NPV) Method
Calculates the expected monetary gain or loss from a project
How? Discounting all expected future cash inflows and outflows to the present point in time using the required rate of return
Focus on financial factors only
Projects with a zero or positive NPV are acceptable
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NPV Method Illustrated
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Class Activity: Exercise 18.18 on page 731
St. Luke’s Hospital, a not-for-profit organisation, estimates that it can save $22,000 a year is cash operating costs for the next 10 years if it buys a special purpose eye-testing machine at a cost of $100,000. No terminal disposal value is expected. The hospitals’ required rate of return is 16%. Assume all cash flows occur at year-end except for initial investment amounts.
Calculate the NPV for eye-test machine
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Calculates the discount rate where present value of cash inflows = cash outflows.
Calculator or computer program used to provide the IRR
Project accepted if IRR> or = to RRR
Trial and error approach:
Use a discount rate and calculate the project’s NPV. Goal: find the discount rate for which NPV = 0
If the calculated NPV is greater than zero, use a higher discount rate
If the calculated NPV is less than zero, use a lower discount rate
Continue until NPV = 0
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IRR Method
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Calculate the IRR for eye-test machine
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Comparing NPV and IRR Methods
NPV is the preferred method Why?
Expresses results in dollars not %
Sum NPVs’ of individual projects or a portfolio for evaluation
NPV computed and expressed as a unique number (size and sign).
Accurate assessment of financial consequences of accepting/rejecting project
Can be used when the RRR varies over the life of a project.
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Comparing NPV and IRR Methods
Disadvantages of IRR
Individual projects cannot be added only averaged, representing a portfolio of projects.
Size and length of projects must be the same
More than one IRR may exist for a project
When RRR varies over life of project – no single RRR that the IRR can be compared to.
Prone to indicating erroneous decisions
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Payback Method
Payback measures the time it will take to recoup the net initial investment ina project
in the form of expected future cash flows
Future cash flows are not discounted
Shorter payback period are preferable
Helps to manage risk
Managers choose a cut-off period for the project.
Projects with payback period less than the cut-off = acceptable
Industries with rapidly changing technologies need a shorter payback.
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With uniform cash flows:
Add cash flows period-by-period until the initial investment is recovered;
count the number of periods included for payback period
Payback Method
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Calculate the Payback Period for the eye-test machine
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Payback Method
Useful measure when:
Screening cap. Investment proposals
Interest rates are high
Expected cash flows in later years of the project are highly uncertain.
Disadvantages:
Does not consider cash flows after the payback period.
Long-run positive NPV-positive projects may be rejected.
Industries with rapidly changing technologies need a shorter payback.
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Accrual Accounting Rate of Return Method (AARR)
Also called the accounting rate of return
Average Annual Income / Investment
Projects whose AARR (%) exceeds a specified hurdle rate are acceptable.
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Calculate the AARR (assume straightline depreciation)
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AARR Method
Does not track cash flows
Does not consider time value of money
Advantages of AARR:
Easy to understand
Use numbers reported in the financial statements
Considers how the accounting numbers reported in the future will be affected by the project.
Critical Thinking Question
AARR – uses operating profit numbers after accruals and tax
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Relevant Cash Flows in DCF Analysis
Relevant cash flows are the differences in expected future cash flows as a result of making an investment
Categories of cash flows:
After-tax cash flow from operations
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Net Initial Investment:
E.g. price of machine, transportation, handling, installation costs
Initial working capital investment
Gain or loss on disposal
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After-tax cash flow from operations:
After-tax inflows (excluding depreciation)
Savings in operating costs
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Cash flow from current disposal of an asset:
End of useful life of asset
After-tax cash flow from terminal disposal or salvage value of asset (investment)
After-tax cash flow from recovery of working capital
Liquidating receivables and inventory once needed to support the project
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Relevant Cash Flows in DCF Analysis – An Illustration
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Now assume that St Luke’s Hospital is a tax-paying entity. The income tax rate is 30% for all transactions that affect income taxes.
Required:
Remember:
Both methods calculate a rate-of-return percentage
AARR – uses operating profit numbers after accruals and tax
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Evaluating Managers and Goal-Congruence issues
Using different capital budgeting methods may give conflicting results
Firms use a different method for evaluating performance
Managers may make capital budgeting decisions based on how their performance is evaluated.
Not in the best interests of the organisation
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Strategic Considerations in
Capital Budgeting
A company’s strategy (Lecture 4) is the source of its strategic capital budgeting decisions.
Constraints Management (Lecture 8)
Investment in Research and Development
Outcomes very uncertain
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What to expect in Tutorials in Week 10
Further discussions and activities to understand:
Understand the five stages of capital budgeting, recognising its multiyear focus.
Use and evaluate various capital budgeting methods:
Accrual Accounting Rate of Return, Payback, Discounted Cash Flow, Net Present Value, Internal Rate of Return.
Identify and explain relevant behavioural issues when making capital expenditure decisions.
Understand strategic considerations in capital budgeting.
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What we expect from you in the tutorials in Week 10
Attend and participate in the tutorial in which you are officially registered
Bring with you your hand-written answers to pre-set tutorial questions (in Unit Outline pp.18-19).
Will randomly collect assignments
Bring your Textbook

Week 9 Lecture Capital Budgeting and Cost Analysis (1)

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