Chapter 24 accounting

IRR rate when to use

When we use the IRR to evaluate a project, we compare it to a predetermined hurdle rate, which is a minimum acceptable rate of return. If the IRR is higher than the hurdle rate, the investment is made. Calculate the rate at which the NPV is zero to determine which project has the highest rates. Hard to do if there are uneven cash flows.

annuity

a series of equal payments at equal time intervals

Hurdle Rate

required rate of return

Accounting rate of return

Accounting rate of return = Annual after-tax net income of $15,000 ÷ Annual average investment of $60,000 (from Question 1) = 0.25 or 25%. percentage of accounting return on annual average investment

Annual average investment

Annual average investment = [Beginning book value of $110,000 + Ending book value of $10,000 (or Salvage value of $10,000 given that the refrigerator is fully depreciated)] ÷ 2 = $60,000.

SL Depreciation

(cost-salvage)/useful life

Let's assume you wish to have $30,000 on January 1, 2018, and you can invest your money at 5%. If today is January 1, 2013, how much must you invest to earn the desired amount?

FV=$30000 INT=5% N=5 PV=30000*.78353 PV=$23506

Time Value of Money Formula

FV=PV(1+i))^n

Accounting Rate of Return Characteristics

Measurement Basis= Accrual Income Measurement Unit= percent Strengths= easy to understand, allows comparison of projects limitations= ignores time value of money, ignores annual rates over life of project

Internal Rate of Return Characteristics

Measurement Basis= Cash flows Measurement Unit= Percent Strengths= reflects time value of money, allows comparisons of dissimiliar projects limitations= ignores varying risks over life of project

Net Present Value Characteristics

Measurement Basis= Cash flows Measurement Unit= dollars Strengths= reflects time value of money, reflects varying risks over projects life limitations= difficult to compare dissimiliar projects

Payback Period characteristics

Measurement Basis= cash flows Measurement Unit= years Strengths= easy to understand, allows comparison of projects limitations= ignores time value of money, ignores cash flows after payback period

calculating net present value

Net present value = (Cash flow in year 1 of $15,000 x 0.9259) + (Cash flow in year 2 of $15,000 x 0.8573) + (Cash flow in year 3 of $15,000 x 0.7938) + (Cash flow in year 4 of $15,000 x 0.7350) - Amount invested of $40,000 = $9,680 (rounded). computed by discounting future net cash flows from the investment the projects required rate of return and then subtracting the initial investment

Let's assume you have $30,000 today, January 1, 2013, and you can invest your money at 5%. How much will your investment be worth on January 1, 2018?

PV=$30000 INT=5% N=5 years FV=30000*1.27628 FV=$38288

profitability index

Present value of net cash/ investments A higher profitability index suggests a more desirable project. Therefore, Machine B is more desirable. A profitability index less than 1 indicates an investment with a negative net present value. These potential investments are eliminated from further consideration. Ideally, the company would accept all positive NPV projects, but if forced to choose, it should select the project with the higher profitability index.

A company is deciding between investing in Machine A with a break-even time of 4.2 years and Machine B with a break-even time of 4.5 years. Assuming the machines require the same investment and have similar risks, which machine should the company invest in?

The company should invest in Machine A, because it has a lower break-even time than Machine B.

When internal rate of return is used to evaluate a capital investment, the present value factor is computed as:

amount invested divided by net cash flows.

Annual average investment

beg book value + end book value /2 when comparing investments with similar lives and risk, a company will prefer the investment with the higher accounting rate of return.

An investment has a cost $40,000 with net cash flows of $20,000 each year for 4 years. The company has a required rate of return of 8%. If the first four periods' discount factors, based on 8%, taken from a "present value of 1" table are 0.9259, 0.8573, 0.7938, 0.7350, what is the break-even time of the investment?

between years 2 and 3

Payback period

cost of investment / annual net cash flow expected time required to recover initial investment. if there is a salvage value.... cost of investment-salvage value/annual net cash flow

he process of restating future cash flows in today's dollars is known as:

discounting

A company's required rate of return, typically its cost of capital is called the:

hurdle rate

to calulcate net present value...

net cash fflows(income after tax+deductions for depreciation)*present value of annuity at 5 (the last year) -amount invested

Capital Budgeting

process of analyzing alternative long-term investments and deciding which assets to acquire or sell.

Discounting

process of restating future cash flows to their PV