Net present value is the combination of the present value of an investment's cash inflows and the present value of the investment's cash outflows. To compute those present value amounts, the future cash flows are discounted by a specified rate. The specified rate could be the investor's cost of capital or it could be some other minimum rate that must be earned.
The advantages of using the net present value to evaluate investments are 1) all of the investment's cash flows are used in the calculation, and 2) the time value of money is considered because the future cash amounts are discounted to the present.
A project or investment that results in a net present value of $0 me that the project is expected to earn exactly the specified rate that was used in discounting the future cash flows. A slightly negative net present value indicates that the project will earn slightly less than the specified rate. For instance, if the specified rate of 16% was used for discounting the cash flows, a slightly negative net present value could mean that the project is expected to earn 15.7%. (Hence, a project could earn a very respectable profit but have a negative net present value because it just missed achieving the specified rate.)
To find the exact rate that a project is expected to earn, the project's cash flows can be used to compute the internal rate of return, which is another discounted cash flow technique for evaluating investments.
Fixed costs such as rent or a supervisor's salary will not change in total within a reasonable range of volume or activity. For example, the rent might be $2,500 per month and the supervisor's salary might be $3,500 per month. This total fixed cost of $6,000 per month will be the same whether the volume is 3,000 units or 4,000 units.
On the other hand, the fixed cost per unit will change as the level of volume or activity changes. Using the amounts above, the fixed cost per unit is $2 when the volume is 3,000 units ($6,000 divided by 3,000 units). When the volume is 4,000 units, the fixed cost per unit is $1.50 ($6,000 divided by 4,000 units).
A non-discount method of capital budgeting does not explicitly consider the time value of money. In other words, each dollar earned in the future is assumed to have the same value as each dollar that was invested many years earlier. The payback method is one of the techniques used in capital budgeting that does not consider the time value of money.
The payback method simply computes the number of years it will take for an investment to return cash equal to the amount invested. For example, if an investment of $100,000 is made and it generates cash of $50,000 for two years followed by $10,000 per year for four additional years, its payback is two years ($50,000 + $50,000). If another investment of $100,000 generates cash of $20,000 per year for two years and then provides cash of $40,000 per year for six additional years, its payback is approximately 3.5 years ($20,000 + $20,000 + $40,000 + 0.5 times $40,000).
As you can see in the examples, payback only wers one question: How long before the cash invested is returned? Payback does not address which investment is more profitable. Payback not only ignored the time value of money, it ignored all of the cash received after the payback period.
The accounting rate of return or return on investment (ROI) are two more examples of methods used in capital budgeting that does not involve discounting future cash amounts.
To overcome the shortcomings of payback, accounting rate of return, and return on investment, capital budgeting should include techniques that consider the time value of money. Two of these methods include (1) the net present value method, and (2) the internal rate of return calculation. Under these techniques, the future cash flows are discounted. This me that each dollar in the distant future will be less valuable than each dollar in the near future, and both of these will have less value than each dollar invested in the present.
A stockholder or shareholder is the holder or owner of stock in a corporation.
A stakeholder is anyone that has an interest or is affected by a corporation. In other words, the stockholder isn't the only party having a stake in the corporation. Other stakeholders in a corporation include the employees, the employees' families, suppliers, customers, community, and others.
Some organizations do not have stockholders, but have stakeholders. For example, the state university doesn't have stockholders, but it has many stakeholders: students, the students' families, professors, administrators, employers, state taxpayers, the local community, the state community, society in general, custodi, suppliers, etc.
Financial leverage refers to the use of debt to acquire additional assets. Financial leverage is also known as trading on equity. Below are two examples to illustrate the use of financial leverage, or simply leverage.
Mary uses $400,000 of her cash to purchase 40 acres of land with a total cost of $400,0@Mary is not using financial leverage.
Sue uses $400,000 of her cash and borrows $800,000 to purchase 120 acres of land having a total cost of $1,200,0@Sue is using financial leverage. Sue is controlling $1,200,000 of land with only $400,000 of her own money.
If the properties owned by Mary and Sue increase in value by 25% and are then sold, Mary will have a $100,000 gain on her $400,000 investment, a 25% return. Sue's land will sell for $1,500,000 and will result in a gain of $300,0@Sue's $300,000 gain on her $400,000 investment results in Sue having a 75% return. When assets increase in value leverage works well.
When assets decline in value the use of leverage works against you. Let's assume that the properties owned by Mary and Sue decrease in value by 10% from their cost and are then sold. Mary will have a loss of $40,000 on her $400,000 investment—a loss of 10% on Mary's investment. Sue will have a loss of $120,000 ($1,200,000 X 10%) on her $400,000 investment. This is a loss of 30% ($120,000 divided by $400,000) on Sue's investment.
In business, disinvestment me to sell off certain assets such as a manufacturing plant, a division or subsidiary, or product line. Disinvestment is sometimes described as the opposite of capital expenditures. Some people use the term divestiture, or to divest when discussing disinvestment.
For example, an electric generator manufacturer might sell off its consumer generator product lines and manufacturing facilities in order to raise money that can be used to expand its industrial generator product line.
Another example is a consumer products company selling off a profitable division that no longer meets its long range goals. The proceeds from this disinvestment are then used to improve the company's financial position by reducing its debt.
The payback reciprocal is a crude estimate of the rate of return for a project or investment. The payback reciprocal is computed by dividing the digit "1" by a project's payback period expressed in years. For example, if a project's payback period is 4 years, the payback reciprocal is 1 divided by 4 = 0.25 = 25%.
The payback reciprocal overstates the true rate of return because it assumes that the annual cash flows will continue forever. It also assumes that the annual cash flows are identical in amount. Since these two conditions are unrealistic you should avoid the use of the payback reciprocal.
Marketable securities are unrestricted financial instruments which can be readily sold on a stock exchange or bond exchange. Marketable securities are often classified into two groups: marketable equity securities and marketable debt securities.
Marketable equity securities include shares of common stock and most preferred stock which are traded on a stock exchange and for which there are quoted market prices.
Marketable debt securities include government bonds and corporate bonds which are traded on a bond exchange and for which there are quoted market prices.
Out-of-pocket costs are those costs or expenses that require a cash payment in the current period or during a project.
For example, the wages of the person setting up a machine for a new production run are an out-of-pocket cost. However, the cost of the lost opportunity to be producing profitable output during the setup time is not an out-of-pocket cost. (The cost of not earning profits during the setup time, known as an opportunity cost, is often far greater than the out-of-pocket costs.)
Another example of out-of-pocket costs are the current year's repairs and maintenance expenses on a church that was constructed 15 years ago. However, the current depreciation expense on the church is not an out-of-pocket cost. The current period's depreciation is also referred to as a noncash expense.
Using the incremental cash flows and discounting them to reflect the time value of money is the preferred method. The two most common techniques involved in discounting cash flows are net present value and internal rate of return.
While the discounted cash flow models are the ideal, I would also want to forecast or project the impact on the company's future financial statements. Therefore, I would also calculate and understand the effect on the accounting profits resulting from the capital expenditure.
Residual value, salvage value and scrap value are three terms that refer to the expected value at the end of the useful life of the property, plant and equipment used in a business. This estimated amount is used in the calculation of an asset's depreciation expense, and often the amount is assumed to be zero.
The term residual value can also refer to the estimated value of a leased asset at the end of the lease term.
In accounting, DCF refers to discounted cash flows or to the discounted cash flow techniques such as net present value or internal rate of return.
DCF is a preferred method for evaluating capital expenditures (and other investments) because DCF recognizes the time value of money. In other words, it recognizes that receiving $10,000 of cash today is more valuable than receiving $10,000 of cash in the future. Similarly, $10,000 cash receipt in Year 10 is less valuable than a $10,000 cash receipt in Year 7.
The recognition of the time value of money occurs by discounting the related future cash flows back to the time when cash is invested. (The date that the cash is invested is often referred to as the "present" or the very beginning of the investment's first year.)
The greater the time value of money, the greater will be the amount of the discount. The smaller the time value of money, the smaller the amount of the discount. In turn, a larger discount will mean a smaller present value. A smaller discount will result in a greater present value.
DCF is also useful for calculating the approximate market value of bonds payable, a product line, or entire companies.
NPV is the acronym for net present value. Net present value is a calculation that compares the amount invested today to the present value of the future cash receipts from the investment. In other words, the amount invested is compared to the future cash amounts after they are discounted by a specified rate of return.
For example, an investment of $500,000 today is expected to return $100,000 of cash each year for 10 years. The $500,000 being spent today is already a present value, so no discounting is necessary for this amount. However, the future cash receipts of $100,000 for 10 years need to be discounted to their present value. Let's assume that the receipts are discounted by 14% (the company's required return). This will mean that the present value of the those future receipts will be approximately $522,0@The $522,000 of present value coming in is compared to the $500,000 of present value going out. The result is a net present value of $22,000 coming in.
Investments with a positive net present value would be acceptable. Investments with a negative net present value would be unacceptable.
Break-even point is the volume of sales or services that will result in no net income or net loss on a company's income statement. In other words, the break-even point focuses on the revenues needed to equal exactly all of the expenses on a single income statement prepared under the accrual method of accounting.
The break-even point in dollars of revenues can be calculated by dividing a company's total fixed expenses by its contribution margin ratio. The break-even calculation assumes that the selling prices, contribution margin ratio, and fixed expenses will not change.
Payback period is the number of years needed for a company to receive net cash inflows that aggregate to the amount of an initial cash investment. Hence the payback period focuses on the pertinent cash flows of multiple accounting years instead of the net income of a single accounting period. The payback period is often computed when evaluating potential capital expenditures. However, the payback period is considered to be flawed because it ignores 1) the cash flows occurring after the payback period, and 2) the time value of money.
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Let's first define expected net receipts. These are future receipts after deducting any related payments. For example, if you are likely to receive $1,200 one year from today, but will have to pay a fee of $200 at the time of the receipts, the expected net receipts will be $1,000.
Often we need to know the present value of amounts expected in the future. We calculate the present value by discounting the future amounts. In this situation discounting me 1) removing a specified amount of interest, or 2) adjusting for the time value of money. The concept is that receiving $1,000 in the future is less valuable than receiving $1,000 today.
If we assume that the time value of money is 10% per year, a net receipt of $1,000 one year from today will have a present value of $9@In other words, we discounted the future value of $1,000 by $9@With a time value of money of 10%, the $909 can be invested today and will grow by $91 ($909 x 10%) to be $1,000 in one year. Receiving a net amount of $1,000 in two years will have a present value of only $82@The reason is that $826 invested today at a compounded rate of 10% will grow to $1,000 in two years. If all amounts are certain, you will be in the same position whether you have $826 today or you receive $1,000 in two years.
Yield to maturity is the total return that will be earned by someone who purchases a bond and holds it until its maturity date. The yield to maturity might also be referred to as yield, internal rate of return, or the market interest rate at the time that the bond was purchased by the investor. The yield to maturity is expressed as an annual percentage rate.
To illustrate, let's assume that a 5% $100,000 bond will mature in 5 years and will pay interest each June 1 and December @Hence the bond will pay interest of $2,500 every six months until it matures. If the current market interest rate for this type of bond is 6%, the bond's current market value will be less than $100,0@The market value of a 5% bond in a 6% bond market will be approximately $95,73@This is the present value of the $2,500 of interest that will be received every six months for 5 years plus the present value of the $100,000 that will be received at the end of 5 years. (All of the cash amounts are discounted by the market interest rate. However, the 6% annual market rate will be restated to be 3% per semiannual period and the 5 years will be restated to be 10 semiannnual periods.)
The investor's yield to maturity will be the market rate of 6% (even though the bond's stated rate is 5%) consisting of the following two components:
Trading on equity is sometimes referred to as financial leverage or the leverage factor.
Trading on equity occurs when a corporation uses bonds, other debt, and preferred stock to increase its earnings on common stock. For example, a corporation might use long term debt to purchase assets that are expected to earn more than the interest on the debt. The earnings in excess of the interest expense on the new debt will increase the earnings of the corporation's common stockholders. The increase in earnings indicates that the corporation was successful in trading on equity.
If the newly purchased assets earn less than the interest expense on the new debt, the earnings of the common stockholders will decrease.
In business the term synergy is often associated with the merger or acquisition of companies. Synergy implies that the outcomes resulting from the merger of two companies will be greater than the sum of the outcomes that would have been achieved if the organizations had not merged. Synergy is sometimes described as 1 + 1 = 3.
Let's use an example. Suppose a company operates solely in the U.S. Another company operates in Asia. The two companies decide to merge because they believe the combined company will have greater results than the total of the two companies operating independently. The synergy might come from shared research, ability to meet the needs of each other's customers, ability to attract new customers that want a single global supplier, elimination of duplicate information technology, and so on.
Synergy is not automatic since the merging organizations may experience problems caused by vastly different leadership styles and company cultures.
I would define a toxic asset as an investment whose value has dropped significantly and there is no market in which to sell the asset.
To illustrate, let's assume that at the peak of the real estate market you lent $150,000 to someone who was purchasing a house for $170,0@In other words, you made a $150,000 investment and recorded it as the asset Mortgage Loan Receivable. The house is the collateral for the loan receivable. Within one year, the local housing market drops by 30% and the borrower loses her job. She stops making the loan payments and at that point your Mortgage Loan Receivable account shows a balance of $147,0@This scenario is widespread in your community and houses are not selling.
I would consider your Mortgage Loan Receivable to be a toxic asset. There are few investors willing to purchase a loan without payments being made by the borrower, the value of the collateral has dropped to less than $120,000 ($170,000 minus the 30% average drop in value), and a lot of houses are for sale with virtually no buyers.
Capital budgeting is a process used by companies for evaluating and ranking potential expenditures or investments that are significant in amount. The large expenditures could include the purchase of new equipment, rebuilding existing equipment, purchasing delivery vehicles, constructing additions to buildings, etc. The large amounts spent for these types of projects are known as capital expenditures.
Capital budgeting usually involves the calculation of each project's future accounting profit by period, the cash flow by period, the present value of the cash flows after considering the time value of money, the number of years it takes for a project's cash flow to pay back the initial cash investment, an assessment of risk, and other factors.
Capital budgeting is a tool for maximizing a company's future profits since most companies are able to manage only a limited number of large projects at any one time.
Cost accounting involves the techniques for:
For example, cost accounting is used to compute the unit cost of a manufacturer's products in order to report the cost of inventory on its balance sheet and the cost of goods sold on its income statement. This is achieved with techniques such as the allocation of manufacturing overhead costs and through the use of process costing, operations costing, and job-order costing systems.
Cost accounting assists management by providing analysis of cost behavior, cost-volume-profit relationships, operational and capital budgeting, standard costing, variance analyses for costs and revenues, trfer pricing, activity-based costing, and more.
Cost accounting had its roots in manufacturing businesses, but today it extends to service businesses. For example, a bank will use cost accounting to determine the cost of processing a customer's check and/or a deposit. This in turn may provide management with guidance in the pricing of these services.
Relevant costs are those costs that will make a difference in a decision. Relevant costs are future costs that will differ among alternatives.
We can demonstrate relevant costs with the following situation. A company is deciding whether or not to eliminate a product line. The product line accounts for approximately 4% of the company's activities. If the product line is eliminated, the officers of the corporation will continue to receive the same salaries and the central office expenses will not change. The product line managers and other employees working directly on the product line will be terminated. Hence, their salaries will be eliminated.
The salaries of the product line managers and other employees whose salaries will be eliminated are relevant to the decision. If these salaries are $700,000 with the product line and $0 without the product line, the $700,000 of savings is relevant. Those cost savings and other possible cost savings will be considered along with the loss of sales revenues.
On the other hand, the officers' salaries are not relevant in the decision. In other words, it doesn't matter if the officers' salaries are $500,000 or $5,000,0@The officers' salaries will be the same with or without the product line. Similarly, the decision maker does not need to know the amount of its central office expenses, since they will be the same with or without the product line. Expenses from previous years are also irrelevant.
To recap, relevant costs are the future costs that will differ among alternatives. You might use the past costs to help you predict those future costs, but the past costs are otherwise irrelevant to the decision. Accountants refer to the past costs as sunk costs.
One technique for deciding whether to buy a new machine or to use an old machine is to look at the future cash flows if you buy a new machine and the future cash flows if you use the old machine. The cash flows will include the cash inflows and the cash outflows for each option. Since these cash flows will occur at different times, you must "discount" the future cash flows to a present value. (This is necessary in order to recognize the time value of money.) The calculation with the highest positive net present value is the option to select. Predicting all of the future cash flows can be difficult especially if the new machine will offer more features that could result in more sales, etc.
Obviously, the further into the future you look, the more uncertain are the cash flows. This problem will be offset when the future cash flows are discounted to the present. The further into the future, the bigger the discounting. This me that the present value for distant amounts will be relatively minor in amount.
Even if it is difficult to predict the near future, you could do several calculations. Each calculation would contain different assumptions. You might find that the wer will be the same under each calculation or set of assumptions.
Of course deciding to buy a new machine or to use an old one might be so obvious that the present value calculations are not necessary. For example, if your old machine is becoming unsafe, or is becoming too noisy for residents, there's little point to calculate the net present value.
The time value of money tells us that receiving cash today is more valuable than receiving cash in the future. The reason is that the cash received today can be invested immediately and will begin growing in value. For instance, if a company receives $1,000 today and it is invested at 8% per year, the company will have $1,080 after 365 days.
A time value of money of 8% per year also tells us that receiving $1,080 one year from now is comparable to receiving $1,000 today. With a time value of money of 8% per year, accountants will state that receiving $1,080 in one year has a present value of $1,000.
In accounting, a time value of money of 8% me that a company performing services today in exchange for cash of $1,080 in one year has earned $1,000 of service revenues today. The $80 difference will become interest income as the company waits 365 days for the money.
The time value of money is important in accounting because of the cost principle and the revenue recognition principle. However, materiality and cost/benefit allow the accountants to ignore the time value of money for its routine accounts receivable and accounts payable having credit terms of 30 or 60 days.
The internal rate of return (IRR) and the net present value (NPV) are both discounted cash flow techniques or models. This me that each of these techniques looks at two things: 1) the current and future cash inflows and outflows (rather than the accrual accounting income amounts), and 2) the time at which the cash inflows and outflows occur. In other words, these models consider the time value of money: a dollar today is more valuable than a dollar in one year, a dollar received in three years is more valuable than a dollar received in five years, and so on.
The internal rate of return or IRR is the rate that will discount all cash inflows and outflows to a net present value of $@In other words, the IRR model provides you with the true, effective interest rate being earned on a project after taking into consideration the time periods when the various cash amounts are flowing in or out. If you use present value tables to calculate the internal rate of return, it will require some trial and error or iterations to determine the exact rate the project is earning. Software or some financial calculators will provide a quicker and more accurate wer.
The net present value (NPV) discounts all of the cash inflows and outflows by a specified interest rate. The net amount of all of the discounted amounts is the net present value. If the net present value is $0, the project is expected to earn exactly the specified rate. If the net present value is a positive amount, the project will be earning more than the specified interest rate. A negative net present value me the project is expected to earn less than the specified interest rate.
A sunk cost is a cost that was incurred in the past and cannot be undone. Since most tractions cannot be undone, most amounts spent in the past can be described as sunk. In other words, a past or sunk cost will be there regardless of what you decide to do today or in the future.
To illustrate a sunk cost, let's assume that a company spent $100,000 last year to purchase and install a machine. Today, a better machine is available for $80,000 and it will reduce expenses by $50,000 in each of the next 10 years. Now the old machine can be sold for just $10,0@When deciding whether to purchase the new machine, the $100,000 that was spent on the old machine is a sunk cost.
Basically the decision is whether to spend an additional $70,000 today ($80,000 minus $10,000) in order to save $50,000 each year for 10 years. (Current and future income taxes will also be relevant.) It may be difficult, but we need to exclude sunk costs from our decisions.
Fixed assets are a company's tangible, non current assets that are used in its business operations. A common example of fixed assets is a manufacturer's plant assets such as its buildings and equipment.
The word fixed indicates that these assets will not be used up or consumed or sold in the current accounting year.
The amount of a company's fixed assets is reported in the noncurrent (or long-term) asset section of the balance sheet under the header Property, plant and equipment.
Internal rate of return and net present value are discounted cash flow techniques. To discount me to remove the interest contained within the future cash amounts.
If the net present value of an investment or project is more than $0, the project is earning more than the interest rate used to discount the future cash amounts. If the net present value of a project is less than $0, the project is earning less than the interest rate used to discount the future cash amounts.
If the present value of a project is exactly $0, the project is earning exactly the interest rate used to discount the future cash amounts. In other words, if a project has an internal rate of return of 15%, and you discount the project's future cash amounts by 15%, the project's net present value will be exactly $0.
Cost behavior often changes outside of the relevant range of activity due to a change in the fixed costs. When volume increases to a certain point, more fixed costs will have to be added. When volume shrinks significantly, some fixed costs could be eliminated.
Here's an illustration. A company manufactures products in its 100,000 square foot plant. The company's depreciation on the plant is $1,000,000 per year. The capacity of the plant is 500,000 units of output and its normal output is 400,000 units per year. When the company is manufacturing between 300,000 and 500,000 units, it needs salaried managers earning $400,000 per year. Below 300,000 units of output, some of the salaried manager positions would be eliminated. Above 500,000 units, the company will need to add plant space and managers.
For this example, the relevant range is between 300,000 units and 500,000 units of output per year. In that range the total of the two fixed costs is $1,400,000 per year. Below 300,000 units, the fixed costs will drop to less than $1,400,000 because some salaries will be eliminated and some of the space might be rented. When the volume exceeds 500,000 units per year, the company will need to add fixed costs because of the additional space and the additional managers. Perhaps the total fixed costs will be $2,000,000 for output between 500,000 units and 700,000 units.
The internal rate of return is the interest rate that will discount an investment's future cash amounts so that the sum of the present values will be equal to cash paid at the beginning of the investment. In capital budgeting, the internal rate of return is also the interest rate that results in an investment having a net present value of zero.
To illustrate, let's assume that a company is considering an investment that will provide net cash inflows of $1,000 at the end of each year for five years. The amount of cash that the company must pay at the beginning of the investment is $3,6@Someone will need to compute the interest rate that will discount the five $1,000 future cash receipts so that their present value at the time of the investment will equal $3,6@Through software or through trial and error, you will find that the internal rate of return on this investment is approximately 12%.
The internal rate of return is one of the tools in capital budgeting that considers the time value of money and also considers all of the cash payments and cash receipts during the life of an investment.
Decentralization refers to a company's top management delegating authority to subunits of the company. Subunits include divisions, subsidiaries, profit centers, investment centers, and so on.
The extent of decentralization varies. For example, a profit center is likely to have authority to make decisions involving revenues and expenses, but will not have authority to make investment decisions or enter into banking relationships.
A benefit of decentralization is having the decision makers closer to the markets in order to make better and faster decisions. Another benefit of decentralization is having more individuals share the work involved in decision making. This in turn provides excellent training and development of future leaders of the company.
A disadvantage of decentralization occurs if a subunit makes a decision that is good for the subunit's financial results, but it me less than optimal results for the company as a whole.
Managerial accounting is also known as management accounting and it includes many of the topics found in cost accounting.
Some managerial accounting topics focus on computing a manufacturer's product costs that are needed for the external financial statements. For example, the manufacturer's income statement must report the actual cost of the products sold, and its balance sheet must report the actual costs in its ending inventories. The managerial accounting topics needed for these calculations include: product vs. period costs, job order costing, process costing, allocation of manufacturing overhead, costing of joint products, and more.
Other managerial accounting topics are more beneficial for planning and controlling a business and in helping management make financial decisions.
These topics include:
The appropriate and relevant amounts for these topics will likely be unaudited, estimated, and future amounts (instead of the past, sunk costs found in the general ledger). Management's focus on these managerial accounting topics can make a difference in a company's profitability.
Net incremental cash flows are the combination of the cash inflows and the cash outflows occurring in the same time period, and between two alternatives. For example, a company could use the net incremental cash flows to decide whether to invest in new, more efficient equipment or to retain its existing equipment.
Net incremental cash flows are necessary for calculating an investment's:
To illustrate net incremental cash flows let's assume that Your Corporation has the opportunity to purchase a product line from Divesting Company for a single cash payment of $800,000.
Your Corporation expects that the product line will result in the following cash flows occurring in each year for 10 years:
These cash flows indicate that the net incremental cash flows are expected to be a positive $150,000 per year for 10 years, or that there will be net incremental cash inflows of $150,000 per year for 10 years.
A cash cow is often a profitable product or service that dominates a market and generates far more cash than is needed to maintain its market position. Companies may use the money from the cash cow to develop new products or to acquire other businesses.
The term cash cow is also used to describe a division or segment of a company that consistently generates substantial amounts of excess cash.
I view cash flow net of tax as the amount of cash spent minus the income tax savings when the amount is deductible on the corporation's income tax return.
To illustrate this, let's assume that a U.S. corporation pays a combined federal and state income tax rate of 40% on its last increment of income. If this corporation spends an additional $10,000 for a tax deductible business expense, its taxable income will decrease by $10,0@This me that the corporation will save paying $4,000 in income taxes ($10,000 less of taxable income being taxed at 40%).
The payback period is calculated by counting the number of years it will take to recover the cash invested in a project.
Let's assume that a company invests $400,000 in more efficient equipment. The cash savings from the new equipment is expected to be $100,000 per year for 10 years. The payback period is 4 years ($400,000 divided by $100,000 per year).
A second project requires an investment of $200,000 and it generates cash as follows: $20,000 in Year 1; $60,000 in Year 2; $80,000 in Year 3; $100,000 in Year 4; $70,000 in Year @The payback period is 3.4 years ($20,000 + $60,000 + $80,000 = $160,000 in the first three years + $40,000 of the $100,000 occurring in Year 4).
Note that the payback calculation uses cash flows, not net income. Also, the payback calculation does not address a project's total profitability. Rather, the payback period simply computes how fast a company will recover its cash investment.
Present value is the result of discounting future amounts to the present. For example, a cash amount of $10,000 received at the end of 5 years will have a present value of $6,210 if the future amount is discounted at 10% compounded annually.
Net present value is the present value of the cash inflows minus the present value of the cash outflows. For example, let's assume that an investment of $5,000 today will result in one cash receipt of $10,000 at the end of 5 years. If the investor requires a 10% annual return compounded annually, the net present value of the investment is $1,2@This is the result of the present value of the cash inflow $6,210 (from above) minus the present value of the $5,000 cash outflow. (Since the $5,000 cash outflow occurred at the present time, its present value is $5,000.)
In capital budgeting, hurdle rate is the minimum rate that a company expects to earn when investing in a project. Hence the hurdle rate is also referred to as the company's required rate of return or target rate. In order for a project to be accepted, its internal rate of return must equal or exceed the hurdle rate.
The hurdle rate is also used to discount a project's cash flows in the calculation of net present value.
The minimum hurdle rate is usually the company's cost of capital (a blend of the cost of debt and the cost of equity). However, the hurdle rate will be increased for projects with greater risk and when the company has an abundance of investment opportunities.
Some capital expenditures are selected out of necessity, such as a government requirement to change the system for discharging environmentally harmful vapors or to comply with an OSHA requirement. After budgeting for the required capital expenditures, companies might use the following techniques for evaluating other capital expenditures.
Payback. This calculates the number of years it will take to recoup the cash spent on a project. A criticism of payback is that the time value of money is not considered and the cash flows over the entire life of the project are not considered.
Accounting Rate of Return or Return on Investment. This approach looks at the increase in accounting profit compared to the increased investment. This approach also ignores the time value of money.
Internal rate of return. This method does consider the time value of money and looks at the cash flows over the entire life of the project. The technique computes the rate that will discount the future cash flows to be equal to the cash outlay for the project.
Net present value. This method discounts the project's future cash flows by a predetermined rate, such as the targeted or needed rate. If the cash flows discounted by the targeted rate exceed the cash investment, the project is accepted. That is, the project provides the targeted return or more.
The rule of 72 is a simple formula that tells you the approximate amount of time or interest rate needed for an amount to double. The formula is Years X Rate per year = 72.
Here's how it works. If you invest an amount for 8 years at 9% annual interest it will double (because 8 years X 9% = 72). If you invest an amount for 9 years at 8% it will also double (since 9 years X 8% = 72). If your investment earns 6%, it will take 12 years for it to double (since 12 years X 6% = 72; or 72 divided by 6 = 12).
If you invest $1,000 at 12% compounded annually, it will grow to approximately $2,000 in 6 years (6 X 12 = 72; or 72/12 = 6). If the $2,000 continues to earn 12% each year, six years later the investment will be worth $4,0@If the investment continues to earn 12% per year, then in six more years it will have a value of $8,000.
If successful investors were able to earn 18% each year, the value of their portfolios would have doubled every four years (72 divided by 18 = 4). If the investors live a long life and continue to earn 18% compounded annually they will become very wealthy.
ROI is the acronym for return on investment. Originally the objective of ROI was to relate a return (the income statement benefit) to the amount invested (such as the asset information from the balance sheet).
During the first half of the 20th century, ROI was helpful in monitoring the decentralized divisions of large diverse corporations. The ROI calculation may have divided a division's operating income by the average amount of operating assets being utilized by the division. For instance, a division with an operating income of $1 million that used $10 million of operating assets had an ROI of 10%.
A drawback of ROI is that the accounting amounts (revenues, expenses, asset book values, etc.) ignore the time value of money. As a result, companies began using discounted cash flows to better assess the profitability of its investments. Calculations such as net present value and internal rate of return became common and ROI was referred to as the accounting rate of return.
In the 21st century we see ROI used in the context of internet marketing and the adoption of wellness programs at large companies. In these examples the income statement benefits (more sales, lower health insurance expense) are related to the amounts being spent. Here, too, the ROI calculations do not consider the time value of money.
The cost of capital is the weighted-average, after-tax cost of a corporation's long-term debt, preferred stock, and the stockholders' equity associated with common stock. The cost of capital is a percentage and it is often used to compute the net present value of the cash flows in a proposed investment. It is also considered to be the minimum after-tax internal rate of return to be earned on new investments.
For a profitable corporation, the costs of bonds and other long-term lo are usually the least expensive components of the cost of capital. One reason is that the interest will be deductible for U.S. income taxes. For example, a corporation paying 6% on its lo may have an after-tax cost of 4% when its combined federal and state income tax rate is 33%. On the other hand, the dividends paid on the corporation's preferred and common stock are not tax deductible.
The cost of common stock (paid-in capital and retained earnings) is considered to be the most expensive component of the cost of capital because of the risks involved.
Let's compute the cost of capital by assuming that a corporation has $40 million of long-term debt with an after-tax cost of 4%, $10 million of 7% preferred stock, and $50 million of common stock and retained earnings with an estimated cost of 15%. Its weighted-average, after-tax cost of capital is: ($40 million X 4% = $1.6 million) + ($10 million X 7% = $0.7 million) + ($50 million X 15% = $7.5 million) = $9.8 million divided by $100 million = 9.8%.
The payback period (which tells the number of years needed to recover the amount of cash that was initially invested) has two limitations or drawbacks:
While Project #187's payback period is faster, Project #188 is a significantly better investment. Hence, the limitation of using the payback period for ranking potential investments.
A budget is a plan expressed in dollar amounts that acts as a road map to carry out an organization's objectives, strategies and assumptions.
A company might have a master budget or profit plan for the upcoming year. The master budget will include a projected income statement and balance sheet. Within the master budget will be operating budgets such as a sales budget, production budget, marketing budget, administrative budget, and budgets for departments. In addition there will be a cash budget and a capital expenditures budget.
It is common that the budgets prepared for the next accounting year will be detailed by quarter and/or by month. It is also typical that the annual budget will not be changed once the actual year begins. Good managers realize that a budget is a guide and that it cannot be so rigid that it prevents timely action when needed. In rare circumstances the annual budget might be revised, but only when the business environment has radically changed.
A rolling budget is also known as a continuous budget, a perpetual budget, or a rolling horizon budget. We will use the following example to explain the meaning of a rolling budget.
Let's assume that a company's accounting year ends on each December 3@Prior to the start of the year 2013, the company prepares its annual budget which is detailed by month for January through December 20@This budget could become a rolling budget if after January 2013 the company drops the budget for January 2013 and adds the budget for January 20@This rolling budget now covers the one year, or 12-month, period of February 1, 2013 through January 31, 20@At the end of February 2013, the rolling budget will drop February 2013 and will add February 20@At this point the rolling budget will cover the one year period of March 1, 2013 through February 29, 2014.
The benefit of a rolling budget is that the company's management will always have a budget that looks forward for one full year.
A rolling budget could use 3-month periods or quarters instead of months. Also, a company might have a 5-year rolling budget for capital expenditures. In this case a full year will be added to replace the year that has just ended. This 5-year rolling budget me that management will always have a 5-year planning horizon.