10.SHORT-TERM DECISIONS & CAPITAL INVESTMENT APPRAISAL

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1 INDUSTRIAL UNIVERSITY OF HO CHI MINH CITY AUDITING ACCOUNTING FACULTY 10.SHORT-TERM DECISIONS & CAPITAL INVESTMENT APPRAISAL 4 Topic List INDUSTRIAL UNIVERSITY OF HO CHI MINH CITY AUDITING ACCOUNTING FACULTY SHORT TERM DECISIONS 4 Relevant costs Limiting factors Make/buy-in problems 1

2 TARGET Management at all levels within an organisation take decisions. The overriding requirement of the information that should be supplied by the cost accountant to aid decision making is relevance. A relevant cost is a future cash flow arising as a direct consequence of a decision. All relevant costs are future, incremental cashflows. Relevant costs 1. Relevant costs are future incremental costs. Past costs/ sunk costs: incurred in the past. Committed cost: a future cash flow that will be incurred anyway, regardless of the decision taken now. 2. Relevant costs are cash flows, reflect additional cash spending Costs or charges which do not reflect additional cash spending should be ignored for the purpose of decision making. (such as depreciation and notional costs) 2

3 Relevant costs 3. Relevant costs are incremental costs, will incurred directly as a direct consequence of a decision. Avoidable costs would not be incurred if the activity to which they relate did not exist. Unavoidable costs would be incurred whether or not the product is discontinued Differential cost is the difference in total cost between alternatives. An opportunity cost. The value of the benefit sacrificed when one course of action is chosen, in preference to an alternative. 3

4 Controllable and uncontrollable costs Controllable costs are items of expenditure which can be directly influenced by a given manager within a given time span. Committed fixed costs are largely uncontrollable in the short term because they have been committed by longer-term decisions. Discretionary fixed costs controllable because they are incurred as a result of decisions made by management and can be raised or lowered at fairly short notice. (eg advertising and research and development costs) Fixed and variable costs Unless you are given an indication to the contrary, you should assume the following. Variable costs will be relevant costs Fixed costs are irrelevant to a decision However you should analyze variable and fixed cost data carefully. Do not forget that 'fixed' costs may only be fixed in the short term. 4

5 Non- relevant variable costs: sunk costs Directly attributable fixed costs General fixed costs: unlikely to be relevant in decision making. Relevant costs of materials The relevant cost of raw materials is generally their current replacement cost A variable cost might be in fact a sunk cost, and therefore is a non-relevant variable cost. 5

6 Relevant costs of materials Relevant costs of labour 6

7 Absorbed overhead Absorbed overhead is a notional accounting cost and hence should be ignored for decision-making purposes. It is overhead incurred which may be relevant to a decision. Attributable fixed costs There might be occasions when a fixed cost is a relevant cost since it is just fixed in a relevant range They could increase if certain extra activities were undertaken. They would decrease or be eliminated entirely if a decision were taken either to reduce the scale of operations or shut down entirely. 7

8 The deprival value of an asset Deprival value is often as 'value to the owner' or 'value to the business Limiting factors A limiting factor is a factor which limits the organization's activities. In a limiting factor situation, contribution will be maximized by earning the biggest possible contribution per unit of limiting factor. 8

9 Optimal production solution Step 1 Identify the limiting factor Step 2 Calculate contribution per unit for each product Step 3 Calculate contribution from each product per unit of limiting factor Step 4 Rank products (make product with highest contribution per unit of limiting factor first) Step 5 Make products in rank order until scarce resource is used up (optimal production solution) Example 9

10 Example Determine the optimal production solution, knowing that both products use the same material, of which there is only $200,000 available Example Material available = 1200 kgs Product A: contribution/unit = $24; uses 10 kg/unit; maximum demand = 80 units Product B: contribution/unit = $15; uses 5 kg/unit; maximum demand = 200 units What is the production plan that would maximise contribution and what is that contribution? 10

11 Example A company makes three products, X, Y and Z, Their contributions per unit are: X $25; Y $45; Z $30 The manufacturing hours for each are: X 5; Y 10; Z 4 If manufacturing hours are a limiting resource, in what order of preference should the units be made? A. X, Y, Z B. Y, Z, X C. Z, X, Y D. Y, X, Z Make/buy-in problems with no limiting factors In a make/buy-in problem with no limiting factors, the relevant costs for the decision are the differential costs between the two options 11

12 Example Make/buy-in problems and limiting factors In a situation where a company must subcontract work to make up a shortfall in its own production capability, its total costs are minimized if those components/products subcontracted are those with the lowest extra variable cost of buying per unit of limiting factor saved by buying. 12

13 Make/buy-in problems and limiting factors Step 1: Indentify the limiting factor and the resource shortfall. Step 2: Calculate the differential variable costs of buying-in per unit of compoment. Step 3: Calculate the differential variable cost costs of buying-in per unit of limiting factor. Step 4: Rank components. Step 5: Determine optimal production/buying-in solution Example 13

14 Example The availability of Material M is limited to 32,000 kg. Calculate how much of each product should be bought. INDUSTRIAL UNIVERSITY OF HO CHI MINH CITY AUDITING ACCOUNTING FACULTY CAPITAL INVESTMENT APPRAISAL Topic List Interest Discounted cashflow Net present value method Internal rate of return method Payback method 14

15 TARGET Capital investment appraisal generally involves looking at the options available when a company (or an individual) puts money into an investment. If a company invests in a project it will expect some sort of financial return. If the project runs for a number of years then whether or not to invest in the project will involve takings a long term decision. Long term investments Long term investments include the purchase of buildings, machinery and equipment. Management will need to have estimates of the initial investment and future costs and revenues of a project in order to make any long term decisions. 15

16 Interest Interest is the amount of money which an investment earns over time. Simple interest Compound interest Effective interest rates Nominal interest rates Simple interest Simple interest is interest which is earned in equal amounts every year (or month) and which is a given proportion of the original investment (the principal). S = P + nrp, S = the sum invested after n periods, consisting of the original capital (P) plus interest earned (future value) P = the original sum invested r = the interest rate (expressed as a proportion, so 10% = 0.1) n = the number of periods (normally years) 16

17 Compound interest If a sum of money is invested and the interest earned each period is added to the investment, then the interest earned in earlier periods wil also earn interest in later periods. S = P(1 + r)n S = the sum invested after n periods (future value) P = the original sum invested r = the interest rate, expressed as a proportion (so 5% = 0.05) n = the number of periods (normally years) Nominal interest rates Nominal interest rate is the interest rate expressed as a per annum figure. E.g 2% compounded every three months. or 8% per annum (= 2%x12/3) 17

18 Effective interest rates The effective rate is the adjusted nominal rate expressed as a per annum figure. Effective Interest Rate = [(1+ r)12/n 1] or = [(1+ r) 365 1] r: the rate of interest for each time period n: the number of months in the time period y: the number of days in the time period. Nominal and Effective rates of interest If a bank offers depositors a nominal 12% per annum, with interest payable quarterly, The effective rate of interest would be 3% compound every three months, which is [(1.03)4 1] = = 12.55% per annum. 18

19 Compounding and Discounting Compounding: the future value of an investment plus accumulated interst after n time period: Discounting: the present value of a future sum of money at the end of n time periods: FV: the future value of the investment with interest PV: the present value of the investment r: the compound rate of return per time period. n: the number of time periods The principles of discounted cash flow The basic principle of discounting involves calculating the present value of an investment (ie the value of an investment today at time 0). 19

20 Present value table Calculate the present value of $4,000 received in 4 years with Interest rate = 7% Annuities (a) Using tables, calculate the present value of $60,000 at year 6, if interest rates are 15% per annum. (b) Using tables, calculate the present value of $100,000 at year 5, if interest rates are 6% per annum. An annuity is a constant sum of money received or paid each year for a given number of years. 20

21 Example What is the present value of a payment of $1,500 had to be made after one, two, and three years, with a discount rate of 9%, Annuity table 21

22 Perpetuities A perpetuity is an annuity which lasts forever. (with annuities, perpetuities start at time 1 and occur every year.) Example A business will receive rent of $10,000 pa on a 999 year lease, starting at year 3. What is the present value of the rental receipts if the discount rate is 5%? 22

23 Net profit and Net cash flow Net profit measures how much the capital of an organization has increased over a period of time. Profit is calculated by applying the matching concept (matching the costs incurred with the sales revenue generated during a period). Net cash flow measures the difference in the payments leaving an organization's bank account and the receipts that are paid into the bank account. Net profit and Net cash flow Net profit and net cash flow differ are due to timing differences. a) Cash is obtained from a transaction which is not reported in the income statement - Share issue - Increase bank overdraft (b) Purchase of non-current assets (c) Sale of non-current assets (d) Matching receipts from receivables and sales invoices raised (e) Matching payments to payables and cost of sales 23

24 Capital investment appraisal Discounted cash flow involves discounting future cash flows from a project in order to decide whether the project will earn a satisfactory rate of return. The two main discounted cash flow methods - the net present value (NPV) - the internal rate of return (IRR) method. Capital investment appraisal Net present value method 1. calculate the present values of income and expenditure related to an investment at a given rate of return. 2. calculate a net present value (NPV) If NPV>0, positive, the investment is considered to be acceptable. - If NPv<0, the investment is considered to be unacceptable. 24

25 Cost of capital Cost of capital is - Cost of funds that a company raises and uses. - The return that investors expect to be paid for putting funds into the company. It is the minimum return that a company should make form its owns investments. Cost of capital is used to derive a discount rate for discounted cash flow analysis and investment appraisal Example 25

26 Example An investment in new machinery would cost $25,000 and would produce additional cash inflows of: Year 1. $8,000 Year 2. $15,000 Year 3. $10,000. The machinery could be sold for $2,000 at time 3. Is the project worthwhile if the discount rate is 8%? Important note The annuity tables and the formulae assume that the first payment or receipt is a year from now. If depreciation has been deducted from a profit figure, it must be added back to give the net cash inflow 26

27 Capital investment appraisal internal rate of return (IRR) method The IRR method of discounted cash flow is a method which determines the rate of interest (the internal rate of return) at which the NPV is 0. The IRR method will indicate that a project is viable if the IRR exceeds the minimum acceptable rate of return. Calculating the IRR The arithmetic for calculating the IRRis more complicated for investments and cash flows extending over a period of time longer than one year. An approximate IRR can be calculated using either a graphical method or by a technique known as the interpolation method. 27

28 Graphical approach A useful way to estimate the IRR of a project is to find the project's NPV at a number of discount rates and sketch a graph of NPV against discount rate. You can then use the sketch to estimate the discount rate at which the NPV is equal to zero (the point where the curve cuts the axis). Graphical approach 28

29 The interpolation method The IRR, where the NPV is zero, can be calculated as follows a is one interest rate b is the other interest rate NPVA is the NPV at rate a NPVB is the NPV at rate b Example At 10% NPV = $1,200 At 20% NPV = $-500 What is the estimated IRR? 29

30 Example Project with conventional cash flows (cash out now, received in the future) has an IRR of 12%. The discount rate is 9%. This means that A. The NPV will be positive, but the project should be rejected B. The NPV will be negative, but the project should be accepted C. The NPV will be negative and the project should be accepted D. The NOV will be positive and the project should be accepted. Capital investment appraisal payback method The payback period is the time that is required for the cash inflows from a capital investment project to equal the cash outflows. -Payback method - Discounted payback 30

31 Payback method There are two ways in which the payback period can be used to appraise projects. (a) If two or more projects are under consideration, the usual decision is to accept the project with the shortest payback period. (b) If the management of a company have a payback period limit, then only projects with payback periods which are less than this limit would be considered for investment. Example 31

32 Discounted payback Payback can be combined with discounted cash flow, and a discounted payback period calculated. The discounted payback period is the time it will take before a project's cumulative NPV turns from being negative to being positive. Example Cost of capital is 10% and the project has cash flow as The discounted payback period is early in year 4. 32

33 Example A company has an investment costing $20,000 and will hope to receive inflows as follows: Year 1 = $7,000; Year 2 = $8,000, Year 3 = $10,000, Year 4 = $8,000. The company uses a discount rate of 8% and has looks for a payback of 4 years and a discounted payback of 5 years. Cash flows arise evenly throughout the year. Is the investment approved? 33

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