Explanation of the Topic...
|Part 1||Introduction to Evaluating Business Investments, Capital Budgeting, Capital Budgeting Models, Evaluating Capital Expenditures, Noncash, Nondiscounted Model|
|Part 2||Cash Flows (CF), Nondiscounted Cash Flow Model, Discounted Cash Flow Models, Another Application of a Present Value Calculation|
Businesses often face the need to spend large amounts of money on assets that will be functional for many years. Here are a few examples:
Expenditures made for long-term assets are referred to as capital expenditures and are recorded as assets on the balance sheet. During the years that these assets (other than land) are used, their costs are systematically moved from the balance sheet to the income statement through Depreciation Expense.
Limitations such as time, money, and logistics frequently prevent a company from moving forward with too many major expenditure projects at the same time. Instead, a company will often rank its projects by priority and profitability. By using a process called capital budgeting, the company decides which capital expenditure projects will be undertaken and when.
At the top of the list of capital expenditure projects are those for which no real choice exists (e.g., installing an updated sewer line within the plant to replace one that is leaking, correcting a safety hazard, correcting a code violation, etc). The remaining capital expenditures are usually ranked according to their profitability using a capital budgeting model.
There are a number of capital budgeting models available that assess and rank capital expenditure proposals. Let’s take a look at four of the most common models for evaluating business investments:
While each of these models has its benefits and drawbacks, sophisticated financial managers prefer the net present value and the internal rate of return methods. There are two reasons why these models are favored: (a) all of the cash flows over the entire length of the project are considered, and (b) the future cash flows are discounted to reflect the time value of money.
The following table highlights the differences among the four models:
|Accounting Rate of Return||Accrual Accounting Amounts||Average of All Years or a Specific Year|
|Payback||Cash Flows – Not Discounted||Until Cash is Recovered|
|Net Present Value||Discounted Cash Flows||Entire Life of Project|
|Internal Rate of Return||Discounted Cash Flows||Entire Life of Project|
Let's use the capital budgeting models to evaluate a potential business investment at Treeline Manufacturing, Inc.:
1. Accounting Rate of Return. This method of evaluating business investments considers the profitability of a project based on accrual accounting amounts found in the financial statements. The drawback of the accounting rate of return is that the net income amounts are not adjusted for the time value of money. In other words, $10,000 of net income in Year 4 is considered to be as valuable as $10,000 of net income in Year 1.
If the new machine is purchased, Treeline’s income statements will show a reduction of labor expense of about $24,000 in Year 1 and $31,733 in Year 8—an average of $27,729 during the 8 years. The income statements will also show additional depreciation expense of about $12,500 per year (the $100,000 cost of the machine and a useful life of 8 years with no salvage value). The net result of the average annual labor savings of $27,729 minus the additional annual depreciation expense of $12,500 is an average of $15,229 of additional net income before income tax expense. Assuming a combined federal and state income tax rate of 30%, the net income after income tax expense will average approximately $10,660 per year.
Treeline’s balance sheet will start with the new asset’s carrying amount (or the book value) of $100,000. The book value will decrease to $0 at the end of 8 years. In other words, the balance sheet amount will average about $50,000 per year during the 8-year period.
At this point, Treeline must choose one of the following calculations to estimate the accounting rate of return. (As with most "return" calculations, the numerator comes from the income statement and the denominator comes from the balance sheet.)
As you can see, the calculation Treeline chooses depends on (a) whether the company prefers to use before tax or after tax average accounting net income, and (b) whether it prefers to use the initial investment amount or the average investment amount.
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