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© Pearson Education Limited 2008 MANAGEMENT ACCOUNTING Cheryl S. McWatters, Jerold L. Zimmerman, Dale C. Morse Cheryl S. McWatters, Jerold L. Zimmerman, Dale C. Morse

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13-2 © Pearson Education Limited 2008 Management Accounting McWatters, Zimmerman, Morse Management Accounting Investment decisions (Planning) Chapter 13

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13-3 © Pearson Education Limited 2008 Management Accounting McWatters, Zimmerman, Morse Objectives Describe the steps of the capital-budgeting process. Identify the opportunity cost of capital Estimate the payback period of an investment and identify weaknesses of the payback method in making investment choices Calculate the accounting rate of return (ROI) and identify weaknesses of ROI in making investment decisions Calculate the net present value of cash flows Identify non-cash profit and loss accounts that should be excluded in calculating the net present value Adjust cash flows to reflect the additional accounts receivable and inventory required

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13-4 © Pearson Education Limited 2008 Management Accounting McWatters, Zimmerman, Morse Objectives - cont Exclude financing charges when calculating the net present value of an investment Estimate tax cash flows for capital budgeting Recognize the effect of risk on the discount rate Estimate the internal rate of return (IRR) of an investment project Identify problems with using the IRR to evaluate investment projects

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13-5 © Pearson Education Limited 2008 Management Accounting McWatters, Zimmerman, Morse Long-Term Investment Decisions Long-term investment decisions differ from short-term decisions because long-term usually Involve larger cash outlays Have multi-year cash flow implications

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13-6 © Pearson Education Limited 2008 Management Accounting McWatters, Zimmerman, Morse The Capital Budgeting Process Check to determine that cash flow estimates and risks are reasonably assessed Check to determine that cash flow estimates and risks are reasonably assessed Identification of an investment proposal Identification of an investment proposal Ratification of the proposal Ratification of the proposal Start

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13-7 © Pearson Education Limited 2008 Management Accounting McWatters, Zimmerman, Morse The Capital Budgeting Process Cash and other resources are invested and related operations begin Cash and other resources are invested and related operations begin Identification of an investment proposal Identification of an investment proposal Ratification of the proposal Ratification of the proposal Implementation of the proposal Implementation of the proposal Start

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13-8 © Pearson Education Limited 2008 Management Accounting McWatters, Zimmerman, Morse The Capital Budgeting Process Evaluate whether investment is fulfilling expectations Evaluate whether investment is fulfilling expectations Identification of an investment proposal Identification of an investment proposal Ratification of the proposal Ratification of the proposal Implementation of the proposal Implementation of the proposal Monitoring activity Monitoring activity Start

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13-9 © Pearson Education Limited 2008 Management Accounting McWatters, Zimmerman, Morse The Capital Budgeting Process Identification of an investment proposal Identification of an investment proposal Ratification of the proposal Ratification of the proposal Implementation of the proposal Implementation of the proposal Monitoring activity Monitoring activity Start

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13-10 © Pearson Education Limited 2008 Management Accounting McWatters, Zimmerman, Morse Opportunity Cost of Capital The opportunity cost of using a resource depends on alternative uses of that resource The opportunity cost of capital is a term used to describe the forgone opportunity of using cash The ability to compare cash flows over different time periods is very important in evaluating investment decisions

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13-11 © Pearson Education Limited 2008 Management Accounting McWatters, Zimmerman, Morse Investment Criteria Ignoring the Opportunity Cost of Capital Payback Some managers find the discounting of future costs confusing or difficult Accounting Rate Of Return Alternatives to discounting method

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13-12 © Pearson Education Limited 2008 Management Accounting McWatters, Zimmerman, Morse Payback The number of years or months it takes for cash flows from an investment to equal the initial investment cost When the net annual cash inflow is the same every year, the following formula can be used to compute the payback period Payback period = Investment required Net annual cash inflow

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13-13 © Pearson Education Limited 2008 Management Accounting McWatters, Zimmerman, Morse Payback A £4,000,000 investment in a motel has expected net cash flows of £1,000,000 in each of the next 5 years What is the investment’s payback What does the payback method ignore What is the investment’s payback What does the payback method ignore The investment has a payback of 4 years but the payback method ignores the cash flows in the fifth year and the time value of money

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13-14 © Pearson Education Limited 2008 Management Accounting McWatters, Zimmerman, Morse Shortcomings of Payback Ignores the opportunity cost of capital Ignores cash flows beyond the payback period Lacks an acceptance benchmark

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13-15 © Pearson Education Limited 2008 Management Accounting McWatters, Zimmerman, Morse Accounting Rate of Return RO I = Profit Investment The accounting rate of return (ROI) does not focus on cash flows, rather it focuses on accounting income Accounting rate of return is:

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13-16 © Pearson Education Limited 2008 Management Accounting McWatters, Zimmerman, Morse Accounting Rate of Return RO I = Average annual profit from the project Average annual investment in the project ROI for capital-budgeting decisions should make comparisons with the opportunity cost of capital The choice of how to measure profit and investment for ROI depends on how the ROI is to be used ROI for performance measures should reflect controllability A multi-period alternative of estimating ROI is:

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13-17 © Pearson Education Limited 2008 Management Accounting McWatters, Zimmerman, Morse Accounting Rate of Return Average net income, average book value of investment and annual ROI YearNet Profit (£)Average book value of investment (£) ROI (%) 1900,0009,000,00010 2900,0007,000,00013 3900,0005,000,00018 4900,0003,000,00030 5900,0001,000,00090

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13-18 © Pearson Education Limited 2008 Management Accounting McWatters, Zimmerman, Morse Accounting Rate of Return Numerical Example What is the ROI for each year. What is the multi-year ROI. How would the sum-of-the-year’s digits method of depreciation affect the calculation of ROI An investment of €300,000 generates cash flows of €150,000 during each of the next 3 years The investment is fully depreciated using the straight line method over the 3 years. The annual net income of the investment is €150,000 - €100,000 (€50,000). The average investment is used as the denominator to calculate ROI

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13-19 © Pearson Education Limited 2008 Management Accounting McWatters, Zimmerman, Morse Accounting Rate of Return Numerical Example YearProfit (€)Average investment (€)ROI (%) 10225,0000 250,000100,0050 3100,00025,000400 The multi year ROI is €50,000/€100,000 (50%) The multi year ROI is €50,000/€150,000 (33%) Sum of the years digits method YearProfit (€)Average investment (€)ROI (%) 150,000250,00020 250,000150,00033 350,000 100 Straight-line depreciation method

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13-20 © Pearson Education Limited 2008 Management Accounting McWatters, Zimmerman, Morse The Net Present Value of Cash Flows Future cash flows should be discounted when compared with present cash flows The discount factor for a future cash flow is 1 (1 + r) n Where: r = opportunity cost of capital n = number of periods until cash flow occurs

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13-21 © Pearson Education Limited 2008 Management Accounting McWatters, Zimmerman, Morse The Net Present Value of Cash Flows Numerical Example Carbon corporation has an opportunity cost of capital of 10%. The company is considering an investment project that should yield the following cash flows What is the present value of these cash inflows Year from nowCash inflow (€) 144,000 250,000 320,000

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13-22 © Pearson Education Limited 2008 Management Accounting McWatters, Zimmerman, Morse The Net Present Value of Cash Flows Numerical Example Cash inflow (€)Discount factorPresent value (€) 44,0001/(1 + 0.1) 1 = 0.9090940,000 50,0001/(1 + 0.1) 2 = 0.8264541,322 20,0001/(1 + 0.1) 3 = 0.7513115,026 Total present value of cash flows96,348

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13-23 © Pearson Education Limited 2008 Management Accounting McWatters, Zimmerman, Morse Estimating Cash Flows Discount cash flows not accounting earnings Adjust cash flows to reflect the need for additional accounts receivable and inventory Include opportunity costs but not sunk costs Exclude financing costs Taxes and depreciation tax shields

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13-24 © Pearson Education Limited 2008 Management Accounting McWatters, Zimmerman, Morse Depreciation Tax Shields The primary difference between cash flows and income for tax purposes is depreciation The reduction in cash tax payments due to depreciation is called the depreciation tax shield

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13-25 © Pearson Education Limited 2008 Management Accounting McWatters, Zimmerman, Morse Tax and Depreciation Tax Shields The depreciation tax shield is a set of simple algebraic equations

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13-26 © Pearson Education Limited 2008 Management Accounting McWatters, Zimmerman, Morse Depreciation Tax Shields Taxes = (R - E - D) × t Cash flow = (R - E - Taxes) Net income (NI) = (R - E - D) × (1 - t) Cash flow = (R - E) × (1 - t) + (D × t) So... This is the depreciation tax shield This is the depreciation tax shield The sooner the depreciation is taken, the higher the present value of the depreciation tax shield

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13-27 © Pearson Education Limited 2008 Management Accounting McWatters, Zimmerman, Morse Depreciation Tax Shields Numerical Example An asset is purchased for €500,000. The asset has a five-year lift and no salvage value. The tax rate is 34% and the interest rate is 5% What is the present value of the tax shields under the straight line and double-declining balance depreciation methods

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13-28 © Pearson Education Limited 2008 Management Accounting McWatters, Zimmerman, Morse Depreciation Tax Shields Numerical Example Straight line depreciation YearDepreciation expense (€) Tax shield (Dt) (€) PV of tax shield (€) DDB rate 1100,00034,00032,3810.4 2100,00034,00030,8390.4 3100,00034,00029,3700.4 4100,00034,00027,9720.4 5100,00034,00026,64 500,000147,202 Double-declining-balance depreciation Book value at beginning of year (€) Depreciation expense (€) Tax shield (Dt)(€) PV of tax shield (€) 500,000200,00068,00064,762 300,000120,00040,80037,007 180,00072,00024,48021,147 108,00043,20014,68812,084 64,00064,80022,03217,263 500,000152,263 Double declining writes off the €500,000 original cost faster than does straight line depreciation therefore it’s tax shield has a higher present value than the straight line method (€5,061)

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13-29 © Pearson Education Limited 2008 Management Accounting McWatters, Zimmerman, Morse Adjusting the Discount Rate for Risk Risky projects should be discounted at a higher interest rate than safe projects For any given risky cash flow stream, we will assume that an equivalent risk-adjusted interest rate exists Instead of discounting the highest/lowest cash flow we discount the expected (average) cash flow

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13-30 © Pearson Education Limited 2008 Management Accounting McWatters, Zimmerman, Morse Internal Rate of Return (IRR) The internal rate of return method finds the interest rate that equates the initial investment cost to the future discounted cash flows. (Makes the NPV = £0) It is easy to calculate is an initial cash outflow is followed by a cash in flow in the same period

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13-31 © Pearson Education Limited 2008 Management Accounting McWatters, Zimmerman, Morse Internal Rate of Return (IRR) Investment cost = (Cash inflows in year one) ÷ (1 + IRR) If you invest £1,000 in a project today and receive £1,070 in a year £1,000 = £1,070 1 + IRR IRR =.07 = 7% If the cost of capital is 6%, this investment offers a return in excess of its opportunity cost If the cost of capital is 6%, this investment offers a return in excess of its opportunity cost

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13-32 © Pearson Education Limited 2008 Management Accounting McWatters, Zimmerman, Morse Internal Rate of Return (IRR) NPV = £1,070 1.05 - £1,000 = £1,019.05 - £1,000 = £19.05 If there is a 5% cost of capital, the net present value of this investment opportunity is:

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13-33 © Pearson Education Limited 2008 Management Accounting McWatters, Zimmerman, Morse Internal Rate of Return (IRR) General Rule If the internal rate of return exceeds the opportunity cost of capital, the investment should be undertaken General Rule If the internal rate of return exceeds the opportunity cost of capital, the investment should be undertaken

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13-34 © Pearson Education Limited 2008 Management Accounting McWatters, Zimmerman, Morse Comparing IRR and NPV of Two Investments The IRR and NPV methods do not always give consistent answers IRR and NPV may lead to different investment decisions if investments are mutually exclusive (only one investment can be chosen from a group of opportunities)

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13-35 © Pearson Education Limited 2008 Management Accounting McWatters, Zimmerman, Morse Comparing IRR and NPV of Two Investments Numerical Example A company is considering an investment that requires an initial cash outlay of €100,000 the investment is expected to return €70,000 in the first year and €55,000 in the second year. What is the IRR The NPV (at 17%) is very close to zero so the IRR is approximately 17% -€100,000 + (€70,000/(1 + 0.17)) + (€55,000/(1 + 0.17) 2 ) = 17

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13-36 © Pearson Education Limited 2008 Management Accounting McWatters, Zimmerman, Morse Comparing IRR and NPV of Two Investments Net present value indicates how much cash in today’s dollars an investment is worth, or the magnitude of the investment’s return Internal rate of return only indicates the relative return on the investment

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13-37 © Pearson Education Limited 2008 Management Accounting McWatters, Zimmerman, Morse Capital Budgeting Methods Used in Practice The discounting of cash flows to make capital decisions has become common practice Cultural differences can affect the nature of the capital-budgeting process Small organizations evaluate capital- budgeting projects differently

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13-38 © Pearson Education Limited 2008 Management Accounting McWatters, Zimmerman, Morse Capital Budgeting Methods Used in Practice The following are reasons for the continued prevalence of discounting methods 1.Discounting methods are theoretically superior 2.They are the mainstay of business school curricula 3.Computer technology can calculate NPVs and IRRs quickly and easily

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13-39 © Pearson Education Limited 2008 Management Accounting McWatters, Zimmerman, Morse Management Accounting Investment decisions (Planning) End of Chapter 13

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