Cost Management: Hansen & Mowen

Cost Management
ACCOUNTING AND CONTROL
HANSEN & MOWEN
20-1
20
Capital Investment
20-2
Capital Investment Decisions 1
Capital investment decisions are

concerned with the process of planning,
setting goals and priorities, arranging
financing, and using certain criteria to
select long-term assets.
20-3
Capital Investment Decisions 1
Capital budgeting is the process of making capital investment

decisions.
Two types of capital budgeting projects:
Projects that, if accepted or

Independent rejected, will not affect the
Projects cash flows of another
project.
Mutually Projects that, if accepted,

Exclusive preclude the acceptance of
Projects competing projects.
20-4
Payback and Accounting Rate of Return:
Nondiscounting Methods 2
Payback Analysis
*At the beginning of Year 3, $60,000 is needed to

recover the investment. Since a net cash inflow of
$100,000 is expected, only 0.6 year
($60,000/$100,000) is needed to recover the
$60,000. Thus, the payback period is 2.6 years (2
+ 0.6).
20-5
The payback period provides information to managers that
can be used as follows:
 To help control the risks associated with the uncertainty of

future cash flows.
 To help minimize the impact of an investment on a firm’s
liquidity problems.
 To help control the risk of obsolescence.
 To help control the effect of the investment on performance
measures.
Deficiencies of the payback period:

 Ignores the time value of money
 Ignores the performance of the investment beyond the
payback period
20-6
Accounting Rate Of Return (ARR)
ARR = Average income ÷ Original investment or

Average investment
Average annual net

cash flows, less Average investment =
average depreciation (I + S)/2
I = the original investment

S = salvage value
Assume that the investment
is uniformly consumed
20-7
Accounting Rate Of Return (ARR)
The major deficiency of the accounting rate of
return is that it ignores the time value of money.
20-8
The Net Present Value Method 3
Net present value is the difference between the
present value of the cash inflows and outflows
associated with a project.
NPV = P – I
where:
P = the present value of the project’s future
cash inflows
I = the present value of the project’s cost
(usually the initial outlay)
20-9
Polson Company has developed a new

cell phone that is expected to generate
an annual revenue of $750,000.
Necessary production equipment would
cost $800,000 and can be sold in five
years for $100,000.
In addition, working capital is expected

to increase by $100,000 and is
expected to be recovered at the end of
five years. Annual operating expenses
are expected to be $450,000. The
required rate of return is 12 percent.
20-10
Step 1. Cash Flow Identification

Year Item Cash Flow
0 Equipment $-800,000
Working capital -100,000
Total $-900,000
1-4 Revenues $ 750,000

Operating expenses -450,000
Total $ 300,000
5 Revenues $ 750,000
Operating expenses -450,000
Salvage 100,000
Recovery of working capital 100,000
Total $ 500,000
20-11
Step 2A. NPV Analysis
Year Cash Flow Discount Factor Present Value
0 $-900,000 1.000 $-900,000
Present Value
1 300,000 of $1 0.893 267,900
2 300,000 0.797 239,100
3 300,000 0.712 213,600
4 300,000 0.636 190,800
5 500,000 0.567 283,500
Net present value $ 294,900
Step 2B. NPV Analysis

Year Cash Flow Discount Factor Present Value
0 $-900,000 1.000 $-900,000
Present Value of
1-4 300,000
an Annuity of Value
$1
3.307 911,100
Present
5 500,000 of $1 0.567 283,500
Net present value $ 294,600
20-12
Decision Criteria for NPV
If NPV > 0, this indicates:

1. The initial investment has been
recovered
2. The required rate of return has
been recovered
Thus, Polson should manufacture the cell
phones.
20-13
Reinvestment Assumption
The NVP model assumes that all cash flows generated
by a project are immediately reinvested to earn the
required rate of return throughout the life of the project.
20-14
Internal Rate of Return 4
The internal rate of return (IRR) is the interest rate

that sets the project’s NPV at zero. Thus, P = I for the
IRR.
Example: A project requires a $240,000

investment and will return $99,900 at
the end of each of the next three
years. What is the IRR?
$240,000 = $99,900(df)
$240,000 / $99,400 = 2.402
i = 12%
20-15
Internal Rate of Return 4
Decision Criteria:
If the IRR > Cost of Capital, the project should be
accepted.
If the IRR = Cost of Capital, acceptance or
rejection is equal.
If the IRR < Cost of Capital, the project should be
rejected.
20-16
NPV versus IRR: Mutually
Exclusive Projects 5
There are two major differences between net

present value and the internal rate of return:
 NPV assumes cash inflows are reinvested
at the required rate of return, whereas the
IRR method assumes that the inflows are
reinvested at the internal rate of return.
 NPV measures the profitability of a project
in absolute dollars, whereas the IRR
method measures it as a percentage.
20-17
NPV and IRR: Conflicting Signals
20-18
Modified Comparison of Projects A and B
*1.08($686,342) + $686,342.
Modified Cash Flows with Additional Opportunity
a$1,440,000 + [(1.20 x $686,342) - (1.08 x $686,342)]. This last term is what is needed to repay the capital and its cost
at the end of Year 2.
b$686,342 + (1.20 x $686,342).
20-19
Milagro Travel Agency Example

Standard Custom
T2 Travel
Annual revenues $240,000 $300,000

Annual operating costs 120,000 160,000
System investment 360,000 420,000
Project life 5 years 5 years
The cost of capital is 12 percent
20-20
Cash Flow Pattern, NPV and IRR Analysis:
Standard T2 versus Custom Travel
20-21
20-22
aFrom Exhibit 20B-2.

bFrom Exhibit 20B-2, df = 3.0 implies that IRR =20%.
20-23
Computing After-Tax Cash Flows 6
The cost of capital is composed of two

elements:
1. The real rate
2. The inflationary element
20-24
The Effects of Inflation on Capital Investment
aFrom Exhibit 20B-2.

b6,670,000 bolivares = 1.15 x 5,800,000 bolivares (adjustment for one year of inflation)
7,670,500 bolivares = 1.15 x 1.15 x 5,800,000 bolivares (adjustment for two years of inflation).
cFrom Exhibit 20B-1.
20-25
Disposition of Old Machine

Book Value Sale Price
M1 $ 600,000 $ 780,000
M2 1,500,000 1,200,000
Acquisition of Flexible System

Purchase cost $7,500,000
Freight 60,000
Installation 600,000
Additional working capital 540,000
Total $8,700,000
20-26
Tax Effects of the Sale of M1 and M2
aSale price minus book value is $780,000 - $600,000.

bSale price minus book value is $1,200,000 - $1,500,000.
20-27
The two machines are sold:

Sales price, M1 $ 780,000
Sales price, M2 1,200,000
Tax savings 48,000
Net proceeds $2,028,000
The net investment is:

Total cost of flexible system $8,700,000
Less: Net proceeds 2,028,000
Net investment (cash outflow) $6,672,000
20-28
After-Tax Operating Cash Flows: Life of the Project
A company plans to make a new product that requires new

equipment costing $1,600,000. The new product is
expected to increase the firm’s annual revenue by
$1,200,000. Materials, labor, etc. will be $500,000 per year.
The income statement for the project is as follows:
Revenues $1,200,000
Less: Cash operating expenses -500,000
Depreciation (straight-line) -400,000
Income before income taxes $ 300,000
Less: Income taxes (@ 40%) 120,000
Net income $ 180,000
20-29
After-Tax Operating Cash Flows: Life of the Project
Cash flow = [(1– Tax rate) x Revenues] – [(1– Tax rate) x Cash expenses]
+ (Tax rate x Noncash expenses)
After-tax revenues $720,000
After-tax cash expenses -300,000
Depreciation tax shield 160,000
Operating cash flow $580,000
Computation of Operating Cash Flows:

Decomposition Terms
20-30
MACRS Depreciation Rates
The tax laws classify most assets into the following three
classes (class = allowable years):
Class Types of Assets
3 Most small tools
5 Cars, light trucks, computer equipment
7 Machinery, office equipment
Assets in any of the three classes can be depreciated using
either straight-line or MACRS (Modified Accelerated Cost
Recovery System) with a half-year convention.
20-31
 Half the depreciation for the first year can be claimed
regardless of when the asset is actually placed in
service.
 The other half year of depreciation is claimed in the year
following the end of the asset’s class life.
 If the asset is disposed of before the end of its class life,
only half of the depreciation for that year can be claimed.
20-32
Value of Accelerated Methods Illustrated
20-33
Capital Investment: Advanced Technology
and Environmental Considerations 7
How Estimates of Operating Cash Flows Differ
A company is evaluating a potential investment in a flexible
manufacturing system (FMS). The choice is to continue
producing with its traditional equipment, expected to last 10
years, or to switch to the new system, which is also expected
to have a useful life of 10 years. The company’s discount rate
is 12 percent.
Present value ($4,000,000 x 5.65) $22,600,000

Investment 18,000,000
Net present value $ 4,600,000
20-34
Investment Data: Direct, Intangible,
and Indirect Benefits
20-35
Investment Data: Direct, Intangible,
and Indirect Benefits
20-36
Present Value Concepts A
Future Value
Let:
F = future value
i = the interest rate
P = the present value or original outlay
n = the number or periods
Future value can be expressed by the following
formula:
F = P(1 + i)n
20-37
Assume the investment is

$1,000. The interest rate is
8%. What is the future value
if the money is invested for
one year? Two? Three?
20-38
Future Value
F = $1,000(1.08) = $1,080.00 (after one year)
F = $1,000(1.08)2 = $1,166.40 (after two years)
F = $1,000(1.08)3 = $1,259.71 (after three years)
20-39
Present Value
P = F/(1 + i)n
The discount factor, 1/(1 + i), is computed for various
combinations of I and n.
Example: Compute the present value of $300 to be received
three years from now. The interest rate is 12%.
Answer: From Exhibit 23B-1, the discount factor is 0.712.
Thus, the present value (P) is:
P = F(df)
= $300 x 0.712
= $213.60
20-40
Present Value of an Uneven Series of Cash Flows
Present Value of a Uniform Series of Cash Flows
20-41
End of
Chapter 20
20-42

Cost Management: Hansen & Mowen

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Cost Management

ACCOUNTING AND CONTROL

HANSEN & MOWEN

Capital investment decisions are

Capital budgeting is the process of making capital investment

Projects that, if accepted or

Mutually Projects that, if accepted,

*At the beginning of Year 3, $60,000 is needed to

 To help control the risks associated with the uncertainty of

Deficiencies of the payback period:

ARR = Average income ÷ Original investment or

Average annual net

I = the original investment

Polson Company has developed a new

In addition, working capital is expected

Step 1. Cash Flow Identification

1-4 Revenues $ 750,000

Step 2B. NPV Analysis

Decision Criteria for NPV

If NPV > 0, this indicates:

The internal rate of return (IRR) is the interest rate

Example: A project requires a $240,000

There are two major differences between net

Modified Cash Flows with Additional Opportunity

Milagro Travel Agency Example

Annual revenues $240,000 $300,000

The cost of capital is 12 percent

aFrom Exhibit 20B-2.

The cost of capital is composed of two

aFrom Exhibit 20B-2.

Disposition of Old Machine

Acquisition of Flexible System

aSale price minus book value is $780,000 - $600,000.

The two machines are sold:

The net investment is:

A company plans to make a new product that requires new

The income statement for the project is as follows:

Computation of Operating Cash Flows:

MACRS Depreciation Rates

Present value ($4,000,000 x 5.65) $22,600,000

Assume the investment is

Present Value of a Uniform Series of Cash Flows

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