Chapter 8

Although accountants are responsible for providing relevant and objective financial information to help managers make decisions, several important factors play a significant role in the decision-making process as described here:

- NPV and IRR analyses use cash flows to evaluate long-term investments rather than the accrual basis of accounting. - Cash flow projections must include adjustments for inflation to match the required rate of return, which already factor in inflation. - Using quantitative factors to make decisions allows managers to support decisions with measurable data. However, nonfinancial factors (often called qualitative factors) must be considered as well. - Circumstances sometimes exist that cause managers to make decisions that are not in the best interest of the company. For example, managers may be evaluated on short-term financial results even though it is in the best interest of the company to invest in projects that are profitable in the long term. Thus, projects that reduce short-term profitability in lieu of significant long-term profits may be rejected.

net present value (NPV)

A method used to evaluate long-term investments. It is calculated by adding the present value of all cash inflows and subtracting the present value of all cash outflows.

internal rate of return (IRR)

A method used to evaluate long-term investments. It is defined as the rate required to get a net present value of zero for a series of cash flows.

annuity

A term used to describe identical cash flows that occur in regular intervals.

Why is it important for organizations to consider qualitative factors when making capital budgeting decisions?

Although managers prefer to make capital budgeting decisions based on quantifiable data (e.g., using NPV or IRR), nonfinancial factors may outweigh financial factors. For example, maintaining a reputation as the industry leader may require investing in long-term assets, even though the investment does not meet the minimum required rate of return. The management believes the qualitative factor of being the industry leader is critical to the company's future success and decides to make the investment.

post-audit

Compares the original capital budget with the actual results.

working capital

Current assets minus current liabilities.

payback method

Evaluates how long it will take to recover the initial investment.

.4 Why must cash flow projections include adjustments for inflation?

Projected cash flows must include an adjustment for inflation to match the required rate of return. The required rate of return is based on the company's weighted average cost of debt and equity. The cost of debt and equity already factors in inflation. Thus, the cash flows must also factor in inflation to be consistent with the required rate of return.

cash flow

The amount of cash received or paid at a specific point in time.

required rate of return

The interest rate used for evaluating long-term investments; it represents the company's minimum acceptable return (or discount rate; also called hurdle rate).

capital budgeting decision

The process of analyzing and deciding which long-term investments (or capital expenditure decision) to make.

present value

The term used to describe future cash flows (both in and out) in today's dollars.

payback period

The time it takes to generate enough cash receipts from an investment to cover the cash outflows for the investment.

cost of capital

The weighted average costs associated with debt and equity used to fund long-term investments.

Assume the manager of Best Electronics earns an annual bonus based on meeting a certain level of net income. The company is currently considering expanding by adding a second retail store. The second store is expected to become profitable three years after opening. The manager is responsible for making the final decision as to whether the second store should be opened and would be in charge of both stores. a. Why might the manager refuse to invest in the new store even though the investment is projected to achieve a return greater than the company's required rate of return? b. What can the company do to mitigate the conflict between the manager's interest of achieving the bonus and the company's desire to accept investments that exceed the required rate of return?

a. The manager's bonus is based on achieving a certain level of net income each year, and the new store will likely cause net income to decrease in the first two years. Thus, the manager may not be able to achieve the net income necessary to qualify for the bonus if the company invests in the new store. b. To mitigate this conflict, Best Electronics can offer the manager part ownership in the company (perhaps through stock options). This would provide an incentive for the manager to increase profit—and therefore company value—over many years. The company may also adjust the net income required to earn a bonus to account for the losses expected in the new store for the first two years.

Capital budgeting decisions involve:

accepting or rejecting long-term investments

When looking at capital budgeting decisions, companies need to consider: the investment cash outflows for future years. qualitative factors associated with the investment proposal. the time value of money. all of the above are correct. the investment cash inflows for future years.

all of the above are correct.

The term that can also be used to describe the net present value method of evaluating investments is called:

discounted cash flows.

The internal rate of return:

is the rate required to get a net present value of zero for a series of cash flows

The method of evaluating long term investments that does NOT consider the time value of money is the: cost of capital method. internal rate of return. rate of return method. payback method. discounted method.

payback method.

The minimum rate acceptable to a company that represents an acceptable return on a long-term investment is called the: average rate of return. economic rate of return. minimum rate of return. required rate of return. internal rate of return.

required rate of return.

All of the following are factors that affect the net present value and internal rate of return analysis of investments EXCEPT: inflation. the payback period. ethical issues. focusing on cash flows. qualitative factors.

the payback period.