Horngren Cost8Ce ISM Ch20 PDF

Preview

Summary

Solutions...

Description

CHAPTER 20 CAPITAL BUDGETING: METHODS OF INVESTMENT ANALYSIS The Short-Answer Questions, Exercises, and Problems marked with can be found on MyLab: Accounting. Students can practise them as often as they want, and most feature step-by-step guided instructions to help find the right answer. Items marked with have Excel templates available on MyLab for students to use.

20-1 No. Capital budgeting focuses on an individual investment project throughout its life, recognizing the time value of money. The life of a project is often longer than a year. Accrual accounting focuses on a particular accounting period, often a year, with an emphasis on income determination. 20-2 The six parts in the capital budgeting decision process are: 1. An identification stage to distinguish the types of capital expenditure projects that will accomplish strategic goals for the organization. 2. A stage to establish assumptions that are common for exploring several potential capital expenditure investments that will achieve organization objectives. 3. An information-acquisition stage to consider the predicted costs and consequences of alternative capital investments through an analysis of the present value of future cash inflows and outflows and relevant qualitative factors. 4. A selection stage to decide on the projects to execute, timing of implementation, and performance criteria. 5. A financing stage to obtain project financing. 6. An implementation and control stage to put the projects in motion and monitor their performance throughout the investment life. 20-3 In essence, the discounted cash-flow method calculates the expected cash inflows and outflows of a project as if they occurred at a single point in time so that they can be aggregated (added, subtracted, etc.) in an appropriate way. This enables comparison with cash flows from other projects that might occur over different time periods. d f i b

20-4 No. Only quantitative outcomes are formally analyzed in capital budgeting cisions. Many effects of capital budgeting decisions, however, are difficult to quantify in ancial terms. These nonfinancial or qualitative factors (for example, the number of accidents a manufacturing plant or employee morale) are important to consider in making capital dgeting decisions.

20-5 Sensitivity analysis can be incorporated into DCF analysis by examining how the DCF of each project changes with changes in the inputs used. These could include changes in revenue assumptions, cost assumptions, tax rate assumptions, and discount rates.

Copyright © 2019 Pearson Canada Inc. 20-1

Instructor’s Solutions Manual for Cost Accounting, Eighth Canadian Edition

20-6 The payback method measures the time it will take to recoup, in the form of expected future net cash inflows, the net initial investment in a project. The payback method is simple and easy to understand. It is a handy method when screening many proposals and particularly when predicted cash flows in later years are highly uncertain. The main weaknesses of the payback method are its neglect of the time value of money and of the cash flows after the payback period. 20-7 The accrual accounting rate of return (AARR) method divides an accrual accounting measure of average annual income of a project by an accrual accounting measure of investment. The strengths of the accrual accounting rate of return method are that it is simple, easy to understand, and considers profitability. Its weaknesses are that it ignores the time value of money and does not consider the cash flows for a project. 20-8 No. The discounted cash-flow techniques implicitly consider depreciation in rate of r urn computations; the compound interest tables automatically allow for recovery of i vestment. The net initial investment of an asset is usually regarded as a lump-sum outflow at t me zero. Where taxes are included in the DCF analysis, depreciation costs are included in the c mputation of the taxable income number that is used to compute the tax payment cash flow. 20-9 A point of agreement is that an exclusive attachment to the mechanisms of any single method examining only quantitative data is likely to result in overlooking important aspects of a decision. Two points of disagreement are (1) DCF can incorporate those strategic considerations that can be expressed in financial terms, and (2) “Practical considerations of strategy” not expressed in financial terms can be incorporated into decisions after DCF analysis. 20-10 No. If managers are evaluated on the accrual accounting rate of return, they may not use the NPV method for capital budgeting decisions. Instead, managers will choose investments that maximize the accrual accounting rate of return. 20-11 All overhead costs are not relevant in NPV analysis. Overhead costs are relevant only if the capital investment results in a change in total overhead cash flows. Overhead costs are not relevant if total overhead cash flows remain the same but the overhead allocated to the particular capital investment changes. 20-12 Capital investment projects typically have five major categories of cash flows: 1. Initial investment in machine and working capital: outflows made for purchasing plant, equipment, and machines that occur in the early periods of the project’s life and include cash outflows for transporting and installing the item. Investments in plant, equipment, machines and sales promotions for product lines are invariably accompanied by incremental investments in working capital. These investments take the form of current assets, such as receivables and inventories, minus current liabilities, such as accounts payable. Working capital investments are similar to machine investments. In each case, available cash is tied up. Copyright © 2019 Pearson Canada Inc. 20-2

Chapter 20: Capital Budgeting: Methods of Investment Analysis

2. Cash flow from current disposal of the old machine: any cash received from disposal of the old machine is a relevant cash inflow. 3. Recurring operating cash flows: these inflows may result from producing and selling additional goods or services or from operating cost savings. 4. Cash flow from terminal disposal of machine and recovery of working capital: the disposal of the investment at the date of termination of a project generally increases cash inflow in the year of disposal. The initial investment in working capital is usually fully recouped when the project is terminated. At that time, inventories and receivables necessary to support the project are no longer needed. 5. Income tax impacts on cash flows: to be discussed in Chapter 22.

20-13 Four critical success factors that managers focus on when controlling job projects are ( scope, (b) quality, (c) time schedule, and (d) costs. 20-14 The Division Y manager should consider why the Division X project was accepted and the Division Y project rejected by the president. Possible explanations are: a. The president considers qualitative factors not incorporated into the IRR computation and this leads to the acceptance of the X project and rejection of the Y project. b. The president believes that Division Y has a history of overstating cash inflows and understating cash outflows. c. The president has a preference for the manager of Division X over the manager of Division Y—this is a corporate politics issue. Factor (a) means qualitative factors should be emphasized more in proposals. Factor (b) means Division Y needs to document whether its past projections have been relatively accurate. Factor (c) means the manager of Division Y has to play the corporate politics game better.

Copyright © 2019 Pearson Canada Inc. 20-3

Instructor’s Solutions Manual for Cost Accounting, Eighth Canadian Edition

EXERCISES 20-15 (10 min.) Terminology. The goal of capital budgeting is to provide capacity in a planned and orderly manner that will match the predicted demand growth of the company and achieve a targeted rate of return (ROR) on these investments. The determination of the ROR links closely to the operating income or profit on sales. That is why investments affect the balance sheet, the income statement, and the statement of cash flows. Capital budgeting requires a careful analysis of the amount and timing of cash outflows and cash inflows. There are four methods from which a management team can choose: net present value (NPV), internal rate of return (IRR), payback method, and accrual accounting rate of return (AARR) (or return on investment (ROI)). The first two methods require the calculation of discounted cash flow. The NPV method requires that the management team determine what its required rate of return (RRR) must be (also called the discount rate, hurdle rate, or opportunity cost of capital). This discount rate is the return the team could expect from investing in a different project of similar risk. In contrast the IRR (sometimes called the adjusted rate of return) is fully determined by cash inflow and outflow. It is the rate at which the discounted net cash flow is zero. The payback method is based on nominal, not discounted, cash flow. It is simply the total investment divided by cash inflow to determine the time it takes to recover the cost of the investment. The accrual accounting rate of return (AARR) is calculated by dividing the increase in an accrual, expected average operating income, by the cost of the initial investment.

20-16 Exercises in compound interest, no income taxes. The general approach to these exercises centres on a key question: Which of the four basic tables in Appendix A should be used? No computations should be made until this basic question has been answered with confidence. 1. From Table 1. The $5,000 is the present value P of your winnings. Their future value S in 10 years will be: S = P (1 + r )n n The conversion factor, (1 + r) , is on line 10 of Table 1. Substituting at 6%: S = 5,000(1.791) = $8,955 Substituting at 14%: S = 5,000(3.707) = $18,535 2. From Table 2. The $89,550 is a future value. You want the present value of that amount. P = S , (1 + r)n . The conversion factor, 1 , (1 + r)n , is on line 10 of Table 2. Substituting, P = $89,550(0.558) = $49,969

Copyright © 2019 Pearson Canada Inc. 20-4

Chapter 20: Capital Budgeting: Methods of Investment Analysis

3. From Table 3. The $89,550 is a future value. You are seeking the uniform amount (annuity) to set aside annually. Note that $1 invested each year for 10 years at 6% has a future value of $13.181 after 10 years, from line 10 of Table 3. S n = Annual deposit (F) $89,550 = Annual deposit (13.181) $89,550  $6,794 Annual deposit = 13.181

4. From Table 3. You need to find the future value of an annuity of $5,000 per year. Note that $1 invested each year for 10 years at 12% has a future value of $17.549 after 10 years. S n = $5,000 F, where F is the conversion factor S n = $5,000(17.549) = $87,745

5. From Table 4. When you reach age 65, you will get $200,000, a present value at that time. You need to find the annuity that will exactly exhaust the invested principal in 10 years. To pay yourself $1 each year for 10 years when the interest rate is 6% requires you to have $7.360 today, from line 10 of Table 4. P n = Annual withdrawal (F) $200,000 = Annual withdrawal (7.360) $200,000  $27,174 Annual withdrawal = 7.360 6. From Table 4. You need to find the present value of an annuity for 10 years. At 6%: Pn = Annual withdrawal (F ) Pn = $50,000 (7.360) Pn = $368,000 At 20%: P n = $50,000 (4.192) P n = $209,600, a much lower figure 7. Plan B is preferable. The NPV of plan B exceeds that of plan A by $980 ($3,126 – $2,146): Even though plans A and B have the same total cash inflows over the five years, plan B is preferred because it has greater cash inflows occurring earlier.

Year 0 1 2 3 4 5

PV Factor At 6% 1.000 0.943 0.890 0.840 0.792 0.747

Cash Inflows $(10,000) 1,000 2,000 3,000 4,000 5,000

Plan A PV of Cash Inflows $(10,000) 973 1,780 2,520 3,168 3,735 $2,146

Plan B Cash PV of Cash Inflows Inflows $(10,000) $(10,000) 5,000 4,715 4,000 3,560 3,000 2,520 2,000 1,584 1,000 747 $3,126

Copyright © 2019 Pearson Canada Inc. 20-5

Instructor’s Solutions Manual for Cost Accounting, Eighth Canadian Edition

20-17 1a.

(22–25 min.) Capital budget methods, no income taxes.

The table for the present value of annuities (Appendix A, Table 4) shows: 5 periods at 12% = 3.605 Net present value

= $60,000 (3.605) – $180,000 = $216,300 – $180,000 = $36,300

1b. Payback period 1c.

= $180,000 ÷ $60,000 = 3 years

Internal rate of return: $180,000 = Present value of annuity of $60,000 at R% for 5 years, or what factor (F) in the table of present values of an annuity (Appendix A, Table 4) will satisfy the following equation. $180,000 = $60,000F 180,000 ÷ $60,000 F=3

On the 5-year line in the table for the present value of annuities (Appendix A, Table 4), find the column closest to 2.667; it is between a rate of return of 24% and 26%. Interpolation is necessary: 24% IRR rate 26% Difference Internal rate of return

Present Value Factors 2.745 2.745 –– 2.667 2.635 –– 0.110 0.078

 0.078  (2%) = 24% +   0.110  = 24% + (0.7091) (2%) = 25.42%

1d.

Accrual accounting rate of return based on net initial investment: Net initial investment = $180,000 Estimated useful life = 5 years Annual straight-line depreciation = $180,000 ÷ 5 = $36,000

Accrualaccounting = Increase in expected average annual operating income rate of return Net initial investment = (60,000 – 36,000) / 180,000 = 24,000 / 180,000 = 13.3% Note how the accrual accounting rate of return, whichever way calculated, can produce results that differ markedly from the internal rate of return.

Copyright © 2019 Pearson Canada Inc. 20-6

Chapter 20: Capital Budgeting: Methods of Investment Analysis

2.

Other than the NPV, rate of return, and the payback period on the new computer system, factors that Lethbridge should consider are:  Issues related to the financing the project, and the availability of capital to pay for the system.  The effect of the system on employee morale, particularly those displaced by the system. Salesperson expertise and real-time help from experienced employees is key to the success of a hardware store.  The benefits of the new system for customers (faster checkout, fewer errors).  The upheaval of installing a new computer system. Its useful life is estimated to be five years. This means that Lethbridge could face this upheaval again in five years. Also ensure that the costs of training and other “hidden” start-up costs are included in the estimated $160,000 cost of the new computer system.

20-18 (25 min.) Capital budgeting methods, no income taxes. The table for the present value of annuities (Appendix A, Table 4) shows: 10 periods at 14% = 5.216 1a.

Net present value

b. Payback period c.

= $28,000 (5.216) – $110,000 = $146,048 – $110,000 = $36,048 =

$110,000 = 3.93 years $28,000

For a $110,000 initial outflow, the project generates $28,000 in cash flows at the end of each of years one through ten. Using either a calculator or Excel, the internal rate of return for this stream of cash flows is found to be 21.96%.

d. Accrual accounting rate of return based on net initial investment: Net initial investment = $110,000 Estimated useful life = 10 years Annual straight-line depreciation = $110,000 ÷ 10 = $11,000 $28,000  $11,000 Accrual accounting rate of return = $110,000 $17,000 = = 15.45% $110,000

Copyright © 2019 Pearson Canada Inc. 20-7

Instructor’s Solutions Manual for Cost Accounting, Eighth Canadian Edition

e.

Accrual accounting rate of return based on average investment: Average investment = ($110,000 + $0) / 2 = $55,000 Accrual accounting rate of return

=

$28,000  $11,000 = 30.91% . $55,000

2. Factors City Hospital should consider include: a. Quantitative financial aspects. b. Qualitative factors, such as the benefits to its customers of a better eye-testing machine and the employee-morale advantages of having up-to-date equipment. c. Financing factors, such as the availability of cash to purchase the new equipment.

20-19

(20 min.)

New equipment purchase.

1. The cash inflow per year is $31,250. a. Solution Exhibit 20-19a shows the NPV computation. NPV= $32,656 An alternative approach: Present value of 5-year annuity of $31,250 at 12% $31,250  3.605 $ 112,656 Present value of cash outlays, $80,000  1.000 80,000 Net present value $ 32,656 EXHIBIT 20-19a Total Present Value

Present Value Discount Factors At 12%

1a. Initial equipment investment $(80,000) 1.000 1b. Initial working capital investment 0 1.000 2a. Annual cash flow from operations (excl. depr.) Year 1 27,906 0.893 Year 2 24,906 0.797 Year 3 22,250 0.712 Year 4 19,875 0.636 Year 5 17,719 0.567 3 a. Terminal disposal of equipment 0 0.567 3 b. Recovery of working capital 0 0.567 Net present value if new equipment is purchased $ 32,656

Sketch of Relevant Cash Flows 0 1 2 3

4

5

$(80,000) $

0 $31,25 0

Copyright © 2019 Pearson Canada Inc. 20-8

$31,250 $31,250 $31,250 $31,250 $0 $0

Chapter 20: Capital Budgeting: Methods of Investment Analysis

b.

Payback = $80,000 ÷ $31,250 = 2.56 years

c.

Let F = Present value factor for an annuity of $1 for 5 years in Appendix A, Table 4

F = $80,000 ÷ $31,250 = 2.56 The internal rate of return can be calculated by interpolation:

26% IRR 28% Difference

Present Value Factors for Annuity of $1 for 5 years 2.635 2.635 2.560  2.532  0.103 0.075

 0.075  Internal rate of return = 26% +   (2%) = 27.46%.  0.103  2.

Both the net present value and internal rate of return methods use the discounted cash flow approach in which all expected future cash inflows and outflows of a project are measured as if they occurred at a single point in time. The net present value approach computes the surplus generated by the project in today’s dollars, while the internal rate of return attempts to measure its effective return on investment earned by the project. The payback method, by contrast, considers nominal cash flows (without discounting) and measures the time at which the project’s expected future cash inflows recoup the net initial investment in a project. The payback method thus ignores the profitability of the project’s entire stream of future cash flows.

3.

The adjustment in discount rate made by the controller in headquarters will only change the net present value, while IRR and payback period will remain the same. Present value of 5-year annuity of $31,250 at 20% $31,250  2.991 Present value of cash outlays, $80,000  1.000 Net present value

$ 93,469 80,000 $ 13,469

The project will be approved by Innovation Inc. because its NPV is positive at a 20% required rate of return. The same conclusion can be achieved if the required rate of return (20%) is compared with the internal rate of return of the project (27.46%)

Copyright © 2019 Pearson Canada Inc. 20-9

Instructor’s Solutions Manual for Cost Accounting, Eighth Canadian Edition

20-20 (30 min.)

Payback methods, even and uneven cash flows.

Payback problem:

1. Annual revenue Annual costs Fixed Variable Net annual cash inflow

$140,000 $80,000 7,000

87,000 $ 53,000

Payback period = Investment/Net cash inflows = $159,000/$53,000 = 3 years Discounted Payback Period with even cash flows: Fixed Variable Net Disc Year Cash Discounted Cumulative Unrecov...