University:
California State University, Northridge
Course:
ACCT 220 | Introduction to Financial Accounting
Academic year:

2024
Views:

49

Pages:

22
Author:

Leilani Contreras

Chapter 12 Capital Budgeting Decisions Part 2 12-44 Learning Objective 2 Rank investment projects in order of preference. 12-45 Preference Decision – The Ranking of Investment Projects Screening Decisions Preference Decisions Pertain to whether or not some proposed investment is acceptable; these decisions come first. Attempt to rank acceptable alternatives from the most to least appealing. 12-46 Net Present Value Method The net present value of one project cannot be directly compared to the net present value of another project unless the investments are equal. 12-47 Ranking Investment Projects Project = Profitability Index Net present value of project Investment required Investment Net present value of project Investment required Project profitability index A $1,000 80,000 1% B $1,000 5,000 20% The higher the project profitability index, the more desirable the project. 12-48 Internal Rate of Return Method When using the internal rate of return method to rank competing investment projects, the preference rule is: The higher the internal rate of return, the more desirable the project. 12-49 Other Approaches to Capital Budgeting Decisions Other methods of making capital budgeting decisions include . . . The Payback Method. Simple Rate of Return. 12-50 Learning Objective 3 Determine the payback period for an investment. 12-51 The Payback Method The payback period is the length of time that it takes for a project to recover its initial cost out of the cash receipts that it generates. When the net annual cash inflow is the same each year, this formula can be used to compute the payback period: Payback period = Investment required Net annual cash inflow 12-52 The Payback Method Management at The Daily Grind wants to install an espresso bar in its restaurant. The espresso bar: 1. Costs $140,000 and has a 10-year life. 2. Will generate annual net cash inflows of $35,000. Management requires a payback period of 5 years or less on all investments. What is the payback period for the espresso bar? 12-53 The Payback Method Investment required Payback period = Net annual cash inflow Payback period = Payback period = $140,000 $35,000 4.0 years The payback period is 4.0 years. Therefore, management would choose to invest in the bar. 12-54 Quick Check  Consider the following two investments: Project X Project Y Initial investment $100,000 $100,000 Year 1 cash inflow $60,000 $60,000 Year 2 cash inflow $40,000 $35,000 Year 3-10 cash inflows $0 $25,000 Which project has the shortest payback period? a. Project X b. Project Y c. Cannot be determined 12-55 Quick Check  Consider the following two investments: Project X Project Y Initial investment $100,000 $100,000 Year 1 cash inflow $60,000 $60,000 Year 2 cash inflow $40,000 $35,000 Year 3-10 cash inflows $0 $25,000 Which project has the shortest payback period? a. Project X b. X Project Y • Project has a payback period of 2 years. c. Y Cannot be determined • Project has a payback period of slightly more than 2 years. • Which project do you think is better? 12-56 Evaluation of the Payback Method Ignores the time value of money. Criticisms of the payback period. Ignores cash flows after the payback period. 12-57 Evaluation of the Payback Method Serves as screening tool. Strengths of the payback method. Identifies investments that recoup cash investments quickly. If products become obsolete, It will help focus on short payback period projects. 12-58 Payback and Uneven Cash Flows When the cash flows associated with an investment project change from year to year, the payback formula introduced earlier cannot be used. Instead, the un-recovered investment must be tracked year by year. $1,000 1 $0 $2,000 $1,000 2 3 4 $500 5 12-59 Payback and Uneven Cash Flows For example, if a project requires an initial investment of $4,000 and provides uneven net cash inflows in years 1-5, as shown, the investment would be fully recovered in year 4. $1,000 1 $0 $2,000 $1,000 2 3 4 $500 5 12-60 Learning Objective 4 Compute the simple rate of return for an investment. 12-61 Simple Rate of Return Method • Does not focus on cash flows -- rather it focuses on accounting net operating income. • The following formula is used to calculate the simple rate of return: Simple rate of return = Annual Incremental Net Operating Income Initial investment* *Should be reduced by any salvage from the sale of the old equipment 12-62 Simple Rate of Return Method Management of The Daily Grind wants to install an espresso bar in its restaurant. The espresso bar: 1. Cost $140,000 and has a 10-year life. 2. Will generate incremental revenues of $100,000 and incremental expenses of $65,000, including depreciation. What is the simple rate of return on the investment project? 12-63 Simple Rate of Return Method Simple rate = of return $100,000 - $65,000 $140,000 = 25% The simple rate of return method is not recommended because it ignores the time value of money and the simple rate of return can fluctuate from year to year. 12-64 Postaudit of Investment Projects A postaudit is a follow-up after the project has been completed to see whether or not expected results were actually realized.