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Principles of Accounting, Volume 2: Managerial Accounting

11.5 Compare and Contrast Non-Time Value-Based Methods and Time Value-Based Methods in Capital Investment Decisions

Principles of Accounting, Volume 2: Managerial Accounting11.5 Compare and Contrast Non-Time Value-Based Methods and Time Value-Based Methods in Capital Investment Decisions
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  1. Preface
  2. 1 Accounting as a Tool for Managers
    1. Why It Matters
    2. 1.1 Define Managerial Accounting and Identify the Three Primary Responsibilities of Management
    3. 1.2 Distinguish between Financial and Managerial Accounting
    4. 1.3 Explain the Primary Roles and Skills Required of Managerial Accountants
    5. 1.4 Describe the Role of the Institute of Management Accountants and the Use of Ethical Standards
    6. 1.5 Describe Trends in Today’s Business Environment and Analyze Their Impact on Accounting
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Thought Provokers
  3. 2 Building Blocks of Managerial Accounting
    1. Why It Matters
    2. 2.1 Distinguish between Merchandising, Manufacturing, and Service Organizations
    3. 2.2 Identify and Apply Basic Cost Behavior Patterns
    4. 2.3 Estimate a Variable and Fixed Cost Equation and Predict Future Costs
    5. Key Terms
    6. Summary
    7. Multiple Choice
    8. Questions
    9. Exercise Set A
    10. Exercise Set B
    11. Problem Set A
    12. Problem Set B
    13. Thought Provokers
  4. 3 Cost-Volume-Profit Analysis
    1. Why It Matters
    2. 3.1 Explain Contribution Margin and Calculate Contribution Margin per Unit, Contribution Margin Ratio, and Total Contribution Margin
    3. 3.2 Calculate a Break-Even Point in Units and Dollars
    4. 3.3 Perform Break-Even Sensitivity Analysis for a Single Product Under Changing Business Situations
    5. 3.4 Perform Break-Even Sensitivity Analysis for a Multi-Product Environment Under Changing Business Situations
    6. 3.5 Calculate and Interpret a Company’s Margin of Safety and Operating Leverage
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  5. 4 Job Order Costing
    1. Why It Matters
    2. 4.1 Distinguish between Job Order Costing and Process Costing
    3. 4.2 Describe and Identify the Three Major Components of Product Costs under Job Order Costing
    4. 4.3 Use the Job Order Costing Method to Trace the Flow of Product Costs through the Inventory Accounts
    5. 4.4 Compute a Predetermined Overhead Rate and Apply Overhead to Production
    6. 4.5 Compute the Cost of a Job Using Job Order Costing
    7. 4.6 Determine and Dispose of Underapplied or Overapplied Overhead
    8. 4.7 Prepare Journal Entries for a Job Order Cost System
    9. 4.8 Explain How a Job Order Cost System Applies to a Nonmanufacturing Environment
    10. Key Terms
    11. Summary
    12. Multiple Choice
    13. Questions
    14. Exercise Set A
    15. Exercise Set B
    16. Problem Set A
    17. Problem Set B
    18. Thought Provokers
  6. 5 Process Costing
    1. Why It Matters
    2. 5.1 Compare and Contrast Job Order Costing and Process Costing
    3. 5.2 Explain and Identify Conversion Costs
    4. 5.3 Explain and Compute Equivalent Units and Total Cost of Production in an Initial Processing Stage
    5. 5.4 Explain and Compute Equivalent Units and Total Cost of Production in a Subsequent Processing Stage
    6. 5.5 Prepare Journal Entries for a Process Costing System
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  7. 6 Activity-Based, Variable, and Absorption Costing
    1. Why It Matters
    2. 6.1 Calculate Predetermined Overhead and Total Cost under the Traditional Allocation Method
    3. 6.2 Describe and Identify Cost Drivers
    4. 6.3 Calculate Activity-Based Product Costs
    5. 6.4 Compare and Contrast Traditional and Activity-Based Costing Systems
    6. 6.5 Compare and Contrast Variable and Absorption Costing
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  8. 7 Budgeting
    1. Why It Matters
    2. 7.1 Describe How and Why Managers Use Budgets
    3. 7.2 Prepare Operating Budgets
    4. 7.3 Prepare Financial Budgets
    5. 7.4 Prepare Flexible Budgets
    6. 7.5 Explain How Budgets Are Used to Evaluate Goals
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  9. 8 Standard Costs and Variances
    1. Why It Matters
    2. 8.1 Explain How and Why a Standard Cost Is Developed
    3. 8.2 Compute and Evaluate Materials Variances
    4. 8.3 Compute and Evaluate Labor Variances
    5. 8.4 Compute and Evaluate Overhead Variances
    6. 8.5 Describe How Companies Use Variance Analysis
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  10. 9 Responsibility Accounting and Decentralization
    1. Why It Matters
    2. 9.1 Differentiate between Centralized and Decentralized Management
    3. 9.2 Describe How Decision-Making Differs between Centralized and Decentralized Environments
    4. 9.3 Describe the Types of Responsibility Centers
    5. 9.4 Describe the Effects of Various Decisions on Performance Evaluation of Responsibility Centers
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Exercise Set A
    11. Exercise Set B
    12. Problem Set A
    13. Problem Set B
    14. Thought Provokers
  11. 10 Short-Term Decision Making
    1. Why It Matters
    2. 10.1 Identify Relevant Information for Decision-Making
    3. 10.2 Evaluate and Determine Whether to Accept or Reject a Special Order
    4. 10.3 Evaluate and Determine Whether to Make or Buy a Component
    5. 10.4 Evaluate and Determine Whether to Keep or Discontinue a Segment or Product
    6. 10.5 Evaluate and Determine Whether to Sell or Process Further
    7. 10.6 Evaluate and Determine How to Make Decisions When Resources Are Constrained
    8. Key Terms
    9. Summary
    10. Multiple Choice
    11. Questions
    12. Exercise Set A
    13. Exercise Set B
    14. Problem Set A
    15. Problem Set B
    16. Thought Provokers
  12. 11 Capital Budgeting Decisions
    1. Why It Matters
    2. 11.1 Describe Capital Investment Decisions and How They Are Applied
    3. 11.2 Evaluate the Payback and Accounting Rate of Return in Capital Investment Decisions
    4. 11.3 Explain the Time Value of Money and Calculate Present and Future Values of Lump Sums and Annuities
    5. 11.4 Use Discounted Cash Flow Models to Make Capital Investment Decisions
    6. 11.5 Compare and Contrast Non-Time Value-Based Methods and Time Value-Based Methods in Capital Investment Decisions
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  13. 12 Balanced Scorecard and Other Performance Measures
    1. Why It Matters
    2. 12.1 Explain the Importance of Performance Measurement
    3. 12.2 Identify the Characteristics of an Effective Performance Measure
    4. 12.3 Evaluate an Operating Segment or a Project Using Return on Investment, Residual Income, and Economic Value Added
    5. 12.4 Describe the Balanced Scorecard and Explain How It Is Used
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Exercise Set A
    11. Exercise Set B
    12. Problem Set A
    13. Problem Set B
    14. Thought Provokers
  14. 13 Sustainability Reporting
    1. Why It Matters
    2. 13.1 Describe Sustainability and the Way It Creates Business Value
    3. 13.2 Identify User Needs for Information
    4. 13.3 Discuss Examples of Major Sustainability Initiatives
    5. 13.4 Future Issues in Sustainability
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Thought Provokers
  15. Financial Statement Analysis
  16. Time Value of Money
  17. Suggested Resources
  18. Answer Key
    1. Chapter 1
    2. Chapter 2
    3. Chapter 3
    4. Chapter 4
    5. Chapter 5
    6. Chapter 6
    7. Chapter 7
    8. Chapter 8
    9. Chapter 9
    10. Chapter 10
    11. Chapter 11
    12. Chapter 12
    13. Chapter 13
  19. Index

When an investment opportunity is presented to a company, there are many financial and non-financial factors to consider. Using capital budgeting methods to narrow down the choices by removing unviable alternatives is an important process for any successful business. The four methods for capital budgeting analysis—payback period, accounting rate of return, net present value, and internal rate of return—all have their strengths and weaknesses, which are discussed as follows.

Summary of the Strengths and Weaknesses of the Non-Time Value-Based Capital Budgeting Methods

Non-time value-based capital budgeting methods are best used in an initial screening process when there are many alternatives to choose from. Two such methods are payback method and accounting rate of return. Their strengths and weaknesses are discussed in Table 11.4 and Table 11.5.

The payback method determines the length of time needed to recoup an investment.

Payback Method
Strengths Weaknesses
  • Simple calculation
  • Screens out many unviable alternatives quickly
  • Removes high-risk investments from consideration
  • Does not consider time value of money
  • Profitability of an investment is ignored
  • Cash flows beyond investment return are not considered
Table 11.4

Accounting rate of return measures incremental increases to net income. This method has several strengths and weaknesses that are similar to payback period but include a deeper evaluation of income.

Accounting Rate of Return
Strengths Weaknesses
  • Simple calculation
  • Screens out many unviable options quickly
  • Considers the impact on income rather than cash flows only (profitability)
  • Does not consider the time value of money
  • Return rates for the entire lifespan of the investment is not considered
  • External factors, such as inflation, are ignored
  • Return rates override the risk of investment
Table 11.5

Because of the limited information each of the non-time value-based methods give, they are typically used in conjunction with time value-based capital budgeting methods.

Summary of the Strengths and Weaknesses of the Time Value-Based Capital Budgeting Methods

Time value-based capital budgeting methods are best used after an initial screening process, when a company is choosing between few alternatives. They help determine the best of the alternatives that a company should pursue. Two such methods are net present value and internal rate of return. Their strengths and weaknesses are presented in Table 11.6 and Table 11.7.

Net present value converts future cash flow dollars into current values to determine if the initial investment is less than the future returns.

Net Present Value
Strengths Weaknesses
  • Considers the time value of money
  • Acknowledges higher risk investments
  • Comparable future earnings with today's value
  • Allows for a selection of investment
  • Requires a more difficult calculation than non-time value methods
  • Required return rate is an estimate, thus any changes to this condition and the impact that has on earnings are unknown
  • Difficult to compare alternatives that have varying investment amounts
Table 11.6

Internal rate of return looks at future cash flows as compared to an initial investment to find the rate of return on investment. The goal is to have an interest rate higher than the predetermined rate of return to consider investment.

Internal Rate of Return
Strengths Weaknesses
  • Considers the time value of money
  • Easy to compare different-sized investments, removes dollar bias
  • A predetermined rate of return is not required
  • Allows for a selection of investment
  • Does not acknowledge higher risk investments because the focus is on return rates
  • More difficult calculation than non-time value methods, and outcome may be uncertain if not using a financial calculator or spreadsheet program
  • If the time for return on investment is important, IRR will not place more importance on shorter-term investments
Table 11.7

After a time-value based capital budgeting method is analyzed, a company can be move toward a decision on an investment opportunity. This is of particular importance when resources are limited.

Before discussing the mechanics of choosing the NPV versus the IRR method for decision-making, we first need to discuss one cardinal rule of using the NPV or IRR methods to evaluate time-sensitive investments or asset purchases: If a project or investment has a positive NPV, then it will, by definition, have an IRR that is above the interest rate used to calculate the NPV.

For example, assume that a company is considering buying a piece of equipment. They determine that it will cost $30,000 and will save them $10,000 a year in expenses for five years. They have decided that the interest rate that they will choose to calculate the NPV and to evaluate the purchase IRR is 8%, predicated on current loan rates available. Based on this sample data, the NPV will be positive $9,927 ($39,927 PV for inflows and $30,000 PV for the outflows), and the IRR will be 19.86%. Since the calculations require at least an 8% return, the company would accept the project using either method. We will not spend additional time on the calculations at this point, since our purpose is to create numbers to analyze. If you want to duplicate the calculations, you can use a software program such as Excel or a financial calculator.

Concepts In Practice

Solar Energy as Capital Investment

A recent capital investment decision that many company leaders need to make is whether or not to invest in solar energy. Solar energy is replacing fossil fuels as a power source, and it provides a low-cost energy, reducing overhead costs. The expensive up-front installation costs can deter some businesses from making the initial investment.

Businesses must now choose between an expensive initial capital outlay and the long-term benefits of solar power. A capital investment such as this would require an initial screening and preference process to determine if the cost savings and future benefits are worth more today than the current capital expenditure. If it makes financial sense, they may look to invest in this increasingly popular energy source.

Now, we return to our comparison of the NPV and IRR methods. There are typically two situations that we want to consider. The first involves looking at projects that are not mutually exclusive, meaning we can consider more than one possibility. If a company is considering non-mutually exclusive opportunities, they will generally consider all options that have a positive NPV or an IRR that is above the target rate of interest as favorable options for an investment or asset purchase. In this situation, the NPV and IRR methods will provide the same accept-or-reject decision. If the company accepts a project or investment under the NPV calculation, then they will accept it under the IRR method. If they reject it under the NPV calculation, then they will also reject under the IRR method.

The second situation involves mutually exclusive opportunities. For example, if a company has one computer system and is considering replacing it, they might look at seven options that have favorable NPVs and IRRs, even though they only need one computer system. In this case, they would choose only one of the seven possible options.

In the case of mutually exclusive options, it is possible that the NPV method will select Option A while the IRR method might choose Option D. The primary reason for this difference is that the NPV method uses dollars and the IRR uses an interest rate. The two methods may select different options if the company has investments with major differences in costs in terms of dollars. While both will identify an investment or purchase that exceeds the required standards of a positive NPV or an interest rate above the target interest rate, they might lead the company to choose different positive options. When this occurs, the company needs to consider other conditions, such as qualitative factors, to make their decision. Future cost accounting or finance courses will cover this content in more detail.

Final Comparison of the Four Capital Budgeting Options

A company will be presented with many alternatives for investment. It is up to management to analyze each investment’s possibilities using capital budgeting methods. The company will want to first screen each possibility with the payback method and accounting rate of return. The payback method will show the company how long it will take to recoup their investment, while accounting rate of return gives them the profitability of the alternatives. This screening will typically get rid of non-viable options and allow the company to further consider a select few alternatives. A more detailed analysis is found in time-value methods, such as net present value and internal rate of return. Net present value converts future cash flows into today’s valuation for comparability purposes to see if an initial outlay of cash is worth future earnings. The internal rate of return determines the minimum expected return on a project given the present value of cash flow expectations and the initial investment. Analyzing these opportunities, with consideration given to time value of money, allows a company to make an informed decision on how to make large capital expenditures.

Ethical Considerations

Barclays and the LIBOR Scandal

As discussed in Volkswagen Diesel Emissions Scandal, when a company makes an unethical decision, it must adjust its budget for fines and lawsuits. In 2012, Barclays, a British financial services company, was caught illegally manipulating LIBOR interest rates. LIBOR sets the interest rate for many types of loans. As CNN reported, “LIBOR, which stands for London Interbank Offered Rate, is the rate at which banks lend to each other, and is used globally to price financial products, such as mortgages, worth hundreds of trillions of dollars.”4

While Volkswagen decided to cover the costs related to fines and lawsuits by reducing its capital budget for technology and research, Barclays took a different approach. The company chose to “cut or claw back of about 450 million pounds ($680 million) of pay from its staff” and from past pay packages “another 140 million pounds ($212 million).”5 Instead of reducing other areas of its capital budget, Barclays decided to cover its fines and lawsuits by cutting employee compensation.

The LIBOR scandal involved a number of international banks and rocked the international banking community. An independent review of Barclays reported that “if Barclays is to achieve a material improvement in its reputation, it will need to continue to make changes to its top levels of pay so as to reflect talent and contribution more realistically, and in ways that mean something to the general public.”6 Previously, as described by the company website, “Barclays has been a leader in innovation; funding the world’s first industrial steam railway, naming the UK’s first female branch manager and introducing the world’s first ATM machine.”7 The positive reputation Barclays built over 300 years was tarnished by just one scandal, and demonstrates the difficulty of calculating just how much unethical behavior will cost a company’s reputation.

Footnotes

  • 4 Charles Riley. “Remember the Libor Scandal? Well It's Coming Back to Haunt the Bank of England.” CNN. April 10, 2017. https://money.cnn.com/2017/04/10/investing/bank-of-england-libor-barclays/index.html
  • 5 Steve Slater. “Barclays to Cut Pay by $890 Million over Scandals: Source.” Reuters. February 27, 2013. https://www.reuters.com/article/us-barclays-libor-pay/barclays-to-cut-pay-by-890-million-over-scandals-source-idUSBRE91Q0SD20130227
  • 6 Anthony Salz. Salz Review: An Independent Review of Barclays’ Business Practices. April 3, 2018. https://online.wsj.com/public/resources/documents/SalzReview04032013.pdf
  • 7 “Our History.” Barclays. n.d. https://www.banking.barclaysus.com/our-history.html
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