copyright 1998 dekker, ltd. 1. 2 capital budgeting understand capital budgeting as a tool to...

opyrig

r, Ltd.

Capital BudgetingCapital Budgeting

• understand capital budgeting as a tool to evaluate investment proposals and the related concepts of payback, accounting rate of return, net present value, return on investment, and added economic value

• Understand the effect of taxes on investment decisions

• identify the role and nature of what-if and sensitivity analysis in capital budgeting

• understand capital budgeting as a tool to evaluate investment proposals and the related concepts of payback, accounting rate of return, net present value, return on investment, and added economic value

• Understand the effect of taxes on investment decisions

• identify the role and nature of what-if and sensitivity analysis in capital budgeting

opyrig

r, Ltd.

The collection of tools planners use

to evaluate the desirability of the

acquisition of long-term assets

ReturnThe increased cash flows in the future

resulting from the assets acquired

opyrig

r, Ltd.Time Value of MoneyTime Value of Money

Because money can earn a return,

its value depends on the time period

in which it is received

Because money can earn a return,

its value depends on the time period

in which it is received

$1.0000

Year 5

$1.2763

Value of $1.00 today Value 5 years from today

opyrig

r, Ltd.

Number of PeriodsNumber of Periods

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

In this case, n = 5

10-21 1996 Prentice Hall Business Publishing Management Accounting, 2nd ed., Atkinson, Banker, Kaplan, and Young

The number of periods considered in the investment analysis.

Common period lengths are a month, a quarter, or a year.

opyrig

r, Ltd.

Rate of ReturnRate of Return

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

5% 5% 5% 5% 5%

Rate of Return expected from the investment each YEAR

opyrig

r, Ltd.

Future ValueFuture Value

5%Year 0

$1.0000

5%Year 1

5%Year 2

5%Year 3

5%Year 4 Year 5

$1.2763

The Future Value of $1.00

5 years from now at a 5% annual rate of return

opyrig

r, Ltd.Compound Growth

of InvestmentCompound Growth

of Investment

5%Year 0

$1.0000

5%Year 1

5%Year 2

5%Year 3

5%Year 4 Year 5

$1.2763$1.0500 $1.1025 $1.1576 $1.2155

AND THIS IS HOW IT

WOULD GET THERE!!

AND THIS IS HOW IT

WOULD GET THERE!!

opyrig

r, Ltd.Compound Growth

of Future ValueCompound Growth

of Future Value

1 5 9 13 17

Periods

opyrig

r, Ltd.Present Value

The current monetary worth of an amount to be paid in the future under stated conditions of

interest and compounding

Present Value The current monetary worth of an amount to

be paid in the future under stated conditions of interest and compounding

5%Year 0

$0.7835

5%Year 1

5%Year 2

5%Year 3

5%Year 4 Year 5

$1.000

The Present Value of $1.00 in 5 years at a 5% annual rate of return

opyrig

r, Ltd.

opyrig

r, Ltd.Future Value of an Annuity Future Value of an Annuity

5%Year 0

$0.7835

5%Year 1

5%Year 2

5%Year 3

5%Year 4 Year 5

$1.000

The Future Value of an Annuity is the sum of payments plus accumulated interest

$1.000$1.000

$1.000

$1.2151.1571.1031.0501.000

$5.525

opyrig

r, Ltd.Present Value

of an Annuity

Present Valueof an Annuity

The Present Value of an Annuity is the value today of a series of future payments or receipts

5%Year 0

5%Year 1

5%Year 2

5%Year 3

5%Year 4 Year 5

$0.7835$1.000

$1.000$1.000

$1.000

$0.783.823.864.907.952

$4.329

$1.000

opyrig

r, Ltd.Required Rate of Return ®

The interest rate used to compute present values. It is also known as

the Discount Rate.

Required Rate of Return ®The interest rate used to compute

present values. It is also known as the Discount Rate.

Cost of CapitalThe minimum return that the organization

must earn on its investments to meetits investors’ return requirements

Cost of CapitalThe minimum return that the organization

must earn on its investments to meetits investors’ return requirements

opyrig

r, Ltd.

Payback CriterionPayback Criterion

Year 0

-$70,000

$70,000

Year 1 Year 2 Year 3 Year 4 Year 5

Cash Flow

Remaining to be Recovered

$20,000

-$30,000

$20,000

-$10,000

$20,000

$10,000

$20,000

$30,000

$20,000

$50,000

opyrig

r, Ltd.Accounting Rate of ReturnAccounting Rate of Return

Average IncomeAverage Investment

$8,000$30,000=

26.67%

Average IncomeAverage Investment

$8,000$30,000=

26.67%

Accounting Rate of Return =

opyrig

r, Ltd.Net Present ValueNet Present Value

Net Present Value = PV Cash Inflows - PV Cash Outflows

This model is the most widely recommended approach to capital

budgeting since it specifically considers the time value of money and provides a

basis for valuing the firm

This model is the most widely recommended approach to capital

budgeting since it specifically considers the time value of money and provides a

basis for valuing the firm

(where is ‘the sum of’)(where is ‘the sum of’)

opyrig

r, Ltd.

Steps in Computing NPVSteps in Computing NPV

Choose the period lengthIdentify the firm’s cost of capitalIdentify the incremental cash flows for

each periodCompute the present value of each period’s

cash flowsSum the project’s cash inflows and outflows

and determine the NPVIf the NPV is positive, then the project is

acceptable from an economic perspective

Choose the period lengthIdentify the firm’s cost of capitalIdentify the incremental cash flows for

each periodCompute the present value of each period’s

cash flowsSum the project’s cash inflows and outflows

and determine the NPVIf the NPV is positive, then the project is

acceptable from an economic perspective

opyrig

r, Ltd.Net Present Value

ExampleNet Present Value

ExampleCost of Capital 10%

Time Amount PV Factor PV0 (70,000)$ 1.0000 (70,000.00)$ 1 20,000 0.9091 18,181.822 20,000 0.8264 16,528.933 20,000 0.7513 15,026.304 20,000 0.6830 13,660.275 30,000 0.6209 18,627.64

12,024.95$ Net Present Value

See Exhibit 10-4, P. 467See Exhibit 10-4, P. 467

opyrig

r, Ltd.Return on Investment (ROI)Return on Investment (ROI)

The discount rate that makes a project’snet present value equal zero.

Also called the Internal Rate of Return

The discount rate that makes a project’snet present value equal zero.

Also called the Internal Rate of Return

Return on Investment 16.14%

Time Amount PV Factor PV0 (70,000)$ 1.0000 (70,000.00)$ 1 20,000 0.8610 17,220.602 20,000 0.7414 14,827.453 20,000 0.6383 12,766.874 20,000 0.5496 10,992.665 30,000 0.4733 14,197.51

5.08$ NET PRESENT VALUE

opyrig

r, Ltd.Applying the ConceptsApplying the Concepts

Exercise #1

Turn to page 494 and work Problem 10-47.

Exercise #1

Tax Effects of Capital InvestmentsTax Effects of Capital Investments

• Organizations must pay taxes on net benefits (taxable income)

• The allocation of the cost of a capital investment through depreciation can offset some taxes

• Taxable income, the tax rate, and tax depreciation method are determined by legislation

• Organizations must pay taxes on net benefits (taxable income)

• The allocation of the cost of a capital investment through depreciation can offset some taxes

• Taxable income, the tax rate, and tax depreciation method are determined by legislation

opyrig

r, Ltd.

NPV with Taxes

Time Cash Flow Depreciation Tax Income Tax @ 40% Net Cash Flow PV Factor PV

0 (70,000) (70,000) 1.0000 ($70,000)1 20,000 12,000 8,000 3,200 16,800 0.9346 $15,7012 20,000 12,000 8,000 3,200 16,800 0.8734 $14,6743 20,000 12,000 8,000 3,200 16,800 0.8163 $13,7144 20,000 12,000 8,000 3,200 16,800 0.7629 $12,8175 20,000 12,000 8,000 3,200 16,800 0.7130 $11,9785 10,000 0 0 0 10,000 0.7130 $7,130

Total $6,013

Tax Reduces Cash Flow by Amount of

Assumed Tax Rate 40%

What-if and SensitivityAnalysis

• What-if Analysis is the process of varying the assumptions underlying a forecasting model to determine the effects of those assumptions on the forecasted amounts

• Sensitivity Analysis is the process of varying the assumptions underlying a decision to determine the decision’s sensitivity to those assumptions

• What-if Analysis is the process of varying the assumptions underlying a forecasting model to determine the effects of those assumptions on the forecasted amounts

• Sensitivity Analysis is the process of varying the assumptions underlying a decision to determine the decision’s sensitivity to those assumptions

opyrig

r, Ltd.What-if and Sensitivity

Analysis

What-if and sensitivity analysis are important tools because they provide decision-makers

with the opportunity to estimate the opportunity cost of the imperfect information upon which decisions are based.

Spreadsheets are excellent forWhat-if analysis.

What-if and sensitivity analysis are important tools because they provide decision-makers

with the opportunity to estimate the opportunity cost of the imperfect information upon which decisions are based.

Spreadsheets are excellent forWhat-if analysis.

opyrig

r, Ltd.What-if and Sensitivity

Analysis

ONE MORE POINT!!A Very Detailed Analysis is

required because it provides fora post implementation audit which

is an opportunity to re-evaluatea past decision to purchase along-term asset by comparingexpected and actual inflows

and outflows

ONE MORE POINT!!A Very Detailed Analysis is

required because it provides fora post implementation audit which

is an opportunity to re-evaluatea past decision to purchase along-term asset by comparingexpected and actual inflows

and outflows

opyrig

Exercise #2

Contemporary Management Accounting

• describe the total life cycle costing approach to managing product costs in a comprehensive manner

• explain the method of target costing - a management accounting method used to reduce product costs before the manufacturing cycle begins

• understand the importance and process of controlling the costs of nonconformance of products to established quality standards

• understand a model for benchmarking the best practices of other organizations

• describe the total life cycle costing approach to managing product costs in a comprehensive manner

• explain the method of target costing - a management accounting method used to reduce product costs before the manufacturing cycle begins

• understand the importance and process of controlling the costs of nonconformance of products to established quality standards

• understand a model for benchmarking the best practices of other organizations

opyrig

r, Ltd.Recent Innovations in

Management AccountingLife Cycle Concepts and Contemporary

Management Accounting MethodsLife Cycle Concepts and Contemporary

Management Accounting Methods

ManufacturingCycle

Post-Sale Serviceand

DisposalCycle

Research,Development and Engineering

opyrig

r, Ltd.

Research, Developmentand Engineering Cycle

1. Idea generation for new products

2. Product design

3. Product development

1. Idea generation for new products

2. Product design

3. Product development

opyrig

r, Ltd.

Manufacturing Cycle Costs

Costs incurred in the

production of the product.

Usually little ability to engineer change product costs.

opyrig

r, Ltd.Post-Sale Service

and Disposal CyclePost-Sale Service

and Disposal Cycle

Begins when the first unit produced is in the hands of the customer

Three Stages:Rapid growthTransitionMaturity

opyrig

r, Ltd.

Target CostingTarget Costing

A cost planning method used during the RD&E cycle that focuses on reducing costs for products that require discrete manufacturing processes and reasonably short product life cycles

opyrig

r, Ltd.

A Target Costing ExampleA Target Costing Example

Target Sales (100,000 units) $2,000,000

Less: Target Profit (25%) 500,000

Target Cost $1,500,000

Unit Cost $1,500,000/100,000 = $ 15.00

Target Sales (100,000 units) $2,000,000

Less: Target Profit (25%) 500,000

Target Cost $1,500,000

Unit Cost $1,500,000/100,000 = $ 15.00

opyrig

r, Ltd.

Concerns About Target Costing

• Conflicts between parties involved in the target costing process

• Burnout due to pressure

• Increase in development time

• Conflicts between parties involved in the target costing process

• Burnout due to pressure

• Increase in development time

opyrig

Exercise #3

Nonconformance(Quality)

• If products and services to not meet quality standards, the resultant cost is known as the cost of nonconformance (CONC)

• Factors Which Determine Quality • a. satisfying customer

expectations regarding the attributes and performance of the product, such as its functionality and features

b. Ensuring that the technical aspects of the product’s design and performance conform to standards from the perspective of the manufacturer

• If products and services to not meet quality standards, the resultant cost is known as the cost of nonconformance (CONC)

• Factors Which Determine Quality • a. satisfying customer

expectations regarding the attributes and performance of the product, such as its functionality and features

b. Ensuring that the technical aspects of the product’s design and performance conform to standards from the perspective of the manufacturer

opyrig

r, Ltd.International Quality

StandardsInternational Quality

Standards

ISO 9000 series of standards

Quality standards developed by the International

Organization for Standardization (ISO)

ISO 9000 series of standards

Quality standards developed by the International

Organization for Standardization (ISO)

opyrig

r, Ltd.Those who become ISO

9000 registeredThose who become ISO

9000 registered

Comply with external regulatory agencies

Meet or exceed customer requirements

Implement a quality-improvement program to remain competitive

Comply with external regulatory agencies

Meet or exceed customer requirements

Implement a quality-improvement program to remain competitive

opyrig

r, Ltd.Industrial Standard

Z8101-1981Industrial Standard

Z8101-1981

Q Series of Quality StandardsQ Series of Quality Standards

Sets Japanese standards for quality management

• Set of quality standards developed by the American Quality Control Society

opyrig

r, Ltd.

Cost of Quality CategoriesCost of Quality Categories

1. Prevention Costs

2. Appraisal Costs

3. Internal-Failure Costs

4. External-Failure Costs

1. Prevention Costs

2. Appraisal Costs

3. Internal-Failure Costs

4. External-Failure Costs

opyrig

r, Ltd.Examples of Quality-

Related CostsExamples of Quality-

Related Costs

Prevention Costs

Quality EngineeringQuality Training

Statistical Process ControlSupplier Certification

research of Customer Needs

opyrig

Related Costs

Appraisal Costs

Inspection of Incoming MaterialsMaintenance of test equipmentProcessing-Control Monitoring

Product Quality Audits

opyrig

Related Costs

Internal Failure Costs

Overtime Due DefectsWaste

Net Cost of ScrapRework Costs

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Related Costs

External Related Costs

Product Liability LawsuitsRepair Costs in the Field

Returned ProductsProduct Liability Recalls

Service CallsWarranty Claims

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Related Costs

External Related Costs

Worst of All

Permanent Loss of Customers

MANAGEMENT ACCOUNTING AND CONTROL SYSTEM DESIGN

• Understand the managerial approaches to motivation and, in particular, the Human Resources Model

• Concepts of motivation, ethics, control and performance and the design of management accounting and control systems (MACS)

• Identify the human factors to consider when changing and implementing a new MACS

• Understand the managerial approaches to motivation and, in particular, the Human Resources Model

• Concepts of motivation, ethics, control and performance and the design of management accounting and control systems (MACS)

• Identify the human factors to consider when changing and implementing a new MACS

opyrig

r, Ltd.

Goals of a MACSGoals of a MACS

Planning for the futureMonitoring events

Measuring & recording results of activities

Motivating individuals and groups

Evaluating the performance

of individuals and groups

opyrig

r, Ltd.Human Resources Model

Most Recent Model

Human Resources ModelMost Recent Model

• People do not find work objectionable• People want to participate in developing

objectives and obtaining goals• People have a great deal of informational

knowledge to contribute to the organization• People are creative• People are responsible• People desire opportunities to affect

change

• People do not find work objectionable• People want to participate in developing

objectives and obtaining goals• People have a great deal of informational

knowledge to contribute to the organization• People are creative• People are responsible• People desire opportunities to affect

change

opyrig

r, Ltd.Human Resources Model

Most Recent Model

Human Resources ModelMost Recent Model

Managers usually focus on three key aspects of employee motivation

DirectionIntensity

Persistence

Managers usually focus on three key aspects of employee motivation

DirectionIntensity

Persistence

opyrig

r, Ltd.A well-designed MACS

should include:A well-designed MACS

should include:

Multiple perspectives approach to management accounting systems

design

Incorporation of ethical responsibilities for all firm

employees

Multiple perspectives approach to management accounting systems

design

Incorporation of ethical responsibilities for all firm

employees

opyrig

r, Ltd.A well designed MACS

should include:A well designed MACS

should include:

The development and use of both quantitative and qualitative

information in a timely fashion for control, motivation, and

performance evaluation

The development and use of both quantitative and qualitative

information in a timely fashion for control, motivation, and

performance evaluation

opyrig

should include:

Participation and empowerment of employees in system design and improvements, and continuous

education of employees in understanding how the system

functions and how the information can be interpreted meaningfully

Participation and empowerment of employees in system design and improvements, and continuous

education of employees in understanding how the system

functions and how the information can be interpreted meaningfully

opyrig

should include:

An appropriate reward system to foster goal congruence between employees and the organization

and to reduce dysfunctional behavior

An appropriate reward system to foster goal congruence between employees and the organization

and to reduce dysfunctional behavior

opyrig

r, Ltd.Behavioral Consequences of Poorly

Designed Measurement SystemsBehavioral Consequences of Poorly

Designed Measurement Systems

Lack of Goal Congruence.

Smoothing .

Gaming .

Data Falsification

Lack of Goal Congruence.

Smoothing .

Gaming .

Data Falsification

opyrig

r, Ltd.

Exercise #4

copyright 1998 dekker, ltd. 1. 2 capital budgeting understand capital budgeting as a tool to...

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