ACCT1000 Lecture Notes - Lecture 2: Payback Period, Net Present Value, Sunk Costs
31 May 2018
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ACCT - Module 2
Make or buy questions
- Determine both costs individually
o Lowest cost = best option
- Do’t cosider suk costs
Sunk costs
- Have already happened
- Are not relevant to decision making
Opportunity cost
- Potential benefit foregone to choose a course of action
Special orders
- Once only large orders
- Offers a higher quantity purchased
- Usually offers a lower (worse) selling price than normal/advertised
- Can accept/reject based on marginal analysis
1) Determine whether firm is operating at full capacity
2) If yes, determine opportunity cost (OC), if not, OC = 0
3) Determine profit/loss from special order (R – VC – OC)
4) Accept offer if:
o Revenue exceeds VC + OC
o Deny if otherwise
Capital budgeting
- Planning and financing of capital investments
o Usually involves high costs
o Usually has implication for the future
o Difficult to reverse
Steps
- Calculate net annual cash flows
o Subtract cash coming in
o Cash coming out
- Apply either
o Payback method
o Net Present Value (NPV)
Step 1
Calculating Net Annual Cash Flows
1) Estimate life of project/asset
2) Estimate cash inflows for each year
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Document Summary
Determine both costs individually: lowest cost = best option. Potential benefit foregone to choose a course of action. Usually offers a lower (worse) selling price than normal/advertised. Planning and financing of capital investments: usually involves high costs, usually has implication for the future, difficult to reverse. Calculate net annual cash flows: subtract cash coming in, cash coming out. Apply either: payback method, net present value (npv) Period of time necessary to recoup initial outlay with net cash inflows. To calculate (assuming net cash flows are same each year): (cid:1866)(cid:1872)(cid:1864) (cid:1867)(cid:1871)(cid:1872) (cid:1867)(cid:1858)(cid:1866)(cid:1874)(cid:1857)(cid:1871)(cid:1872)(cid:1865)(cid:1857)(cid:1866)(cid:1872)(cid:1871) (cid:1866)(cid:1857)(cid:1872) (cid:1866)(cid:1866)(cid:1873)(cid:1864) (cid:1871) (cid:1858)(cid:1864)(cid:1867)(cid:1875)(cid:1871) =(cid:1876) (cid:1877)(cid:1857)(cid:1870)(cid:1871) To calculate given different net annual cash flows each year: Determine cumulative net cash flow after each year until it becomes positive. Payback period less than useful life = accept. Crude measure of incorporating awareness of risk into decision. Ignores all cash flows after payback has occurred (so less profitable shot term investments may not be used)
