AFD W2 Lecture Power Point

8/8/2019 AFD W2 Lecture Power Point

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Accounting for Decision Making

Week 2 Lecture

(2010)


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CAPITAL EXPENDITURE

BUDGETING- Concernedwithdecision-makinginthefollowingareas:

-DeterminingHOW MUCH capitalexpenditurethe

businessshouldundertake

-DeterminingWHICH projects shouldbeundertake.

-DeterminingHOW theyshouldbefinanced


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BUDGET PROCEDURE Proposalsusuallyanalysedunderthefollowingheadings:

Fixedassets/workingcapitalrequiredforEXPANSION (newproducts/markets)

REPLACEMENTfixedassets

FixedassetsrequiredforSTATUTORY reasons(noise,safetyetc)

RESEARCH & DEVELOPMENTfixedassets

FixedassetsrequiredforADMINISTRATION systems

enhancement


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HOW MUCH CAPITAL

EXPENDITURE? Moneyforcapitalexpenditureisascarceresourceso HOW IS IT TO BE ALLOCATED?

PROBLEMS?

-M

anynew businessproposalswillbeinoutlineformonly - Someprojectsmay beemergencyreplacementsatlastmoment -Theremay beashortageofavailablefunds

SOLUTION? Allocateamaximum amounttoeach typeofexpenditureknown

asCapitalRationing

Appraisebyidentifying relevantcostsandrevenues, knownasCostv BenefitAnalysis


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COST vBENEFIT ANALYSISSUMMARYOF RELEVANTCOSTS/INCOMEBY

TYPEOF PROJECTTypeofproject

Expansion

Replacement

Statutory

R & D

Adminsystems

Costs

Plant& machinery

Additionalworkingcapital

Plant& machinery

Plant& machinery

Plant& machinery

Computers,softwareetc

Benefits

Additionalnetcashinflowfromadditionalsales

Opportunityincomefrom

avoiding

lost

salesand/oraddlprodncosts

Opportunityincomefromavoidingpenalties/lostsalesthrough badpublicity

Additionalnetcashflowfromaddlsales(competitiveedge)

Additionalnetcashinflowfromcostsavings


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METHODSOF APPRAISINGCAPITAL EXPENDITURE

PROJECTSACCOUNTING

RATE OF RETURNPAY-BACKMETHOD

DISCOUNTEDCASH FLOW

(DCF)

INTERNAL RATE OFRETURN

(IRR)

NET PRESENTVALUE METHOD

(NPV)


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ACCOUNTING RATE OFRETURN

(ARR)

Average Annual profit (after depreciation)

Average investment + working capital= X 100

Accounting Rate of Return

Average investment (average book value)= Initial Investment (Annual Depreciation) x life / 2)

or

= (Initial Investment + Residual Value) / 2


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Seminar Question

SuperCo. is considering a newproduct. The initialexpenditure on machinery is expected to be 200,000 formachinerywhich is estimated to have a life of fiveyears attheend ofwhich it will beexpected to realize 20,000 indisposal proceeds. Additional investment in working capital(stocks plus debtors, less creditors) is expected to be intheregion of 10,000. Annual profits afterdepreciation areexpected to be 18,000 perannum. The company's cost of

capital is 10%.


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Seminar Question

1) What is the Annual Depreciation charge?

2) Calculate theAccounting Rate of Returnbyexpressing theaverage annual profit as a % of the average investment inmachinery and working capital?


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ACCOUNTING RATE OF RETURN(ARR)

Advantages:

- Easy to understand (similarto return on capital employed)

- Allows comparison ofprojects with differing initial investment- Considers profit overentire life ofproject

Disadvantage:

- Ignores time value of money


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PAY-BACK

STEP 1 Calculatetotalcostofproject

STEP 2 Calculatecashinflow

each year(profitbefore depreciation)

STEP 3 Calculatetimeittakesforcashinflow toequalorexceed

projectcost


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Seminar Question

SuperCo. is considering a newproduct. The initialexpenditure on machinery is expected to be 200,000 formachinerywhich is estimated to have a life of fiveyears attheend ofwhich it will beexpected to realize 20,000 indisposal proceeds. Additional investment in working capital(stocks plus debtors, less creditors) is expected to be intheregion of 10,000. Annual profits afterdepreciation areexpected to be 18,000 perannum. The company's cost of

capital is 10%.


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Seminar Question3) Ifprofits are 18,000 perannum, what is the annual cash flow

resulting from trading?

4) Assuming that the initial expenditure on machinery and theinvestment in working capital takes place in Year0 (before the

start of Year1) and that the machinery is sold for20,000 andtheworking capital disinvested at theend of Year5, calculate theannual cash flows:

Year0 ............................Year1 ............................Year2 ............................

Year3 ............................Year4 ............................Year5 ............................

5) How long does it take before theproject will Pay-backthe initial

investment?


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PAY-BACK Advantages

- Easy to understand

- Lowrisk as projects chosen are those

with quickest pay-back

Disadvantages

- Ignores timing ofreceipts

- Ignores receipts after pay-backperiod - Ignores profitability


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DISCOUNTEDCASH FLOW

(DCF) Based on principle that 1 receivedtoday is worthmore than 1 receivedtomorrow time value of money

Can be measured by two methods:

- Net Present Value (NPV)

- Internal Rate of Return (IRR)


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Interest and the Time Value of

Money TheThepresent valuepresent value of any sum to bereceived in theof any sum to bereceived in thefuture can be computed by solving forP:future can be computed by solving forP:

TheThepresent valuepresent value of any sum to bereceived in theof any sum to bereceived in thefuture can be computed by solving forP:future can be computed by solving forP:

-

!nn

rFP

)1(

1

P= present valueFn= future cash flow at theend of n periodr= required rate ofreturn ordiscount rate


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Money A bond will pay $100 in two years. What is thepresent value of the $100 if an investorcan earn areturn of 12% on investments?

P ! $1001

210.12

-

P = $100 (0.7972)P = $79.7$79.722


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Money A bond will pay $100 in two years. What isthepresent value of the $100 if an investorcan

earn a return of 12% on investments?

Present Value = $79.72

What does this mean?If $79.72 is invested by the investor today, it willbeworth $100 in two years. In that sense, $79.72

today is equivalent to $100 in two years.


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Bank Balance Year 1 Year 2

Beginning balance 79.70$ 89.26$

Interest earned @ 12% 9.56 10.71Ending balance 89.26$ 99.97$


Money Lets verify that ifwe invest the $79.70 today at 12%

interest that it would grow to $100 at theend of twoyears.

Bank Balance Year 1 Year 2

Beginning balance $79.72 $89.29

Interest earned @ 12% $9.57 $10.71Ending balance $89.29 $100.00

We can also determine the present value

using present value tables.


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Money

RatePeriods 10% 12% 14%

1 0.909 0.893 0.877

2 0.826 0.797 0.769

3 0.751 0.712 0.675

4 0.683 0.636 0.592

5 0.621 0.567 0.519

Excerpt from Discount cash flow Table

Present

va

lue

factor o

f

$1

for 2

periods at 12%.Prese

nt

va

lue

factor o

f

$1

for 2

periods at 12%.


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Quick Check

How muchwouldyou have to put in the banktoday to have $100 at the end of five yearsif the interest rate is 10%?

a. $62.10b. $56.70

c. $90.90

d. $51.90


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Net Present Value Method

To determine net present valuewe . . .To determine net present valuewe . . .

Calculate thepresent value of cash inflows,Calculate thepresent value of cash inflows,

Calculate thepresent value of cash outflows,Calculate thepresent value of cash outflows,

Subtract thepresent value of the outflows from theSubtract thepresent value of the outflows from thepresent value of the inflows.present value of the inflows.


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General decision rule ...General decision rule ...If the Net Present

Value is . . . Then the Project is . . .

Positive . . .Acceptable, since it promises a

return greater than the required

rate of return.

Zero . . .

Acceptable, since it promises a

return equal to the required rate

of return.

Negative . . .

Not acceptable, since it promises

a return less than the required

rate of return.


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Carver Hospital is considering the purchase of an attachment forits X-ray machine.

No investments are to be made unless theyhave an annual returnof at least 10%.

Cost $3,169Life 4 yearsSalvage value zeroIncrease in annual cash inflows 1,000


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It m Y (s)

Amount of

C sh Flow

10%

Facto

sent

Value of

Cash

FlowsIn t al investment(outflow) Now (3,170) 1.000 (3,170)

Item Year(s)

Amountof

Cash Flow

Present

Value of

Cash

FlowsInitial investment(outflow) Now (3,169) (3,169)

Annual cash inflows 1-4 1,000$ 3,169$

Netpresentvalue $ -0-

$1,000 x (0.909 + 0.826 + 0.751 + 0.683) = $3,169$1,000 x 3.169 = $3,169


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Item Year(s)

Amountof

Cash Flow

10%

Factor

Present

Value of

Cash

FlowsInitial investment(outflow) Now (3,170) 1.000 (3,170)

Item Year(s)

Amountof

Cash Flow

Present

Value of

Cash

FlowsInitial investment(outflow) Now (3,169) (3,169)

Annual cash inflows 1-4 1,000$ 3,169$

Netpresentvalue $ -0-

$1000 x (0.909 + 0.826 + 0.751 + 0.683) = $3,169

Because the net present value is equal to zero,the investment in the attachment for the X-ray

machineprovides exactly a 10% return.


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Quick Check

Suppose that the investment in the attachment forthe X-ray machine had cost $4,000 and generated anincrease in annual cash inflows of $1,200. What is the

net present value of the investment?a. $ 800

b. $ 197

c. $(197)

d. $(800)


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Seminar Question

Year0

Year1

Year2

Year3

Year4

Year5

200,000 + 10,000

54,000+10,000+20,000=

(210,000)

54,000

54,000

54,000

54,000

84,000

6) Calculate theNet Present Value (NPV) by applying the

10% discount factors (see tables on Page 58) to the cashflows calculated in 4) above.

Annual cash flows


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OTHER THINGSTOCONSIDER

Includeanyadditionalworkingcapitalrequiredininitialinvestment

Includedisinvestmentofworkingcapitalandproceedsofsaleoffixedassetsatendofproject

Minimumrateofreturnrequiredcalculatedbyreferencetominimumrequiredby variousfinanceproviders(weighted

averagecostofcapital)ormarginalcostofcapital(costofadditionalcapitalrequired)


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Whatfactorscouldthecompany havetakenintoconsiderationwhendecidingonthecostofcapital (thediscountrate)?

Theweightedaveragecostofcapital (theaverageofthereturnsrequiredbythe

variousprovidersofcapital)orthemarginalcostofcapital ietheactualcostofthecapitalsumrequiredtofinancetheprojectinthemarketatthetime.


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Internal Rate of Return (IRR)

The interest rate that makes . . .

Presentvalue ofcash inflows

Presentvalue ofcash outflows

=

The net present valueequal zero.


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Projects with even annual cash flows

Project life = 3 years

Initial cost = $675Cash inflow at year 3 = $1,000

Determine the IRR for this project.



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Projects with even annual cash flows

Project life = 3 years

Initial cost = $675Cash inflow at year 3 = $1,000

Determine the IRR for this project.


1. Compute present value factor.$675 $1,000 per year = 0.675

2. Using discounted cash flow table: 14%


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- It can be used either to screen or torank projects

- Anyproject whose IRR is less than

the required return is rejected.- The higher the IRR of a project, the

more desirable it is considered to be.

Using Internal Rate of Return


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- Sophisticated business calculators and electronicspreadsheets can beused to easily solve theseproblems.



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Net Present Value Methodvs


Disadvantages of IRR:

- Multiple or missing IRR.

- NPV method assumes that intermediate cash flows are

reinvested at a rate equal to the required rate of return, TheIRR method assumes that intermediate cash flows can bereinvested at the projects IRR while an identical project maynot be available in the future.

While the IRR method may have intuitive appeal tomanagers (accepting project if the IRR is higher than therequired return). It has the following main disadvantages.


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CAPITAL APPRAISAL INPRACTICE

More than one method is used when appraising projects

Managers are re-assured by QUICK PAYBACK!

Divisional performance often measured by ROCE (Return on capitalemployed) which requires that rate of return is maintained and short-

life projects continually replaced There are Potential conflict between DCF methods (NPV & IRR) in

the case ofmutually exclusive projects When two or moreprojects are considered, a firm can select only one. (NPV of projectA is higher than NPV of projectB, while IRR of project A is lowerthan IRR of projectB).

In this case, the NPV methods should be chosen. The amount ofpositive NPV represents value added to a business.


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CAPITAL APPRAISAL INPRACTICE

Sensitivity (what if.?) andprobabilitymodelling can be used to

minimise inaccuracy of forecasts

Some form ofpost-auditcarried out to check on accuracy of figures

used in appraisal


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Seminar 3: Questions 1 4

Students are required to hand in

handwritten solutions to the assigned

exercises at the beginning of the

tutorial sessions.

Tutorial Exercise


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End of

Week 2

Lecture

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