Hospitality Industry Managerial Accounting

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Hospitality Industry Managerial Accounting

• HRT 374
• Chapter 13
• Don St. Hilaire

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Chapter 13 Capital Budgeting Competencies

• Explain the relationship of capital budgeting to
  operations budgeting and identify types of
  capital budgeting decisions.
• Explain the time value of money and, given
  relevant information, calculate the future value
  of a present amount and the present value of a
  future amount.

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Chapter 13 Capital Budgeting Competencies

• Apply the accounting rate of return model to
  capital budgeting decisions.
• Apply the payback model to capital budgeting
  decisions.
• Identify factors addressed by the net present
  value model for capital budgeting.
• Identify factors addressed by the internal rate
  of return model for capital budgeting.

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Ch. 13 Capital Budgeting-Relationship to
Operations

• Hospitality industry, especially lodging, is
  fixed-asset intensive.
• Majority of assets are fixed.
• Importance of capital budgeting to management
• Prepare an operations budget first.
• How do sales forecast compare to the capabilities
  of the present equipment?

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Ch. 13 Capital Budgeting- Typical Reasons

• How much money to spend on fixed assets?
• Which fixed assets should be purchased?
• Meet government requirements
• Reduce certain operational costs.
• Increase sales.
• Replace an existing fixed asset

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Ch. 13 Capital Budgeting - Time Value of Money

• Process of placing future years income on an
  equal basis with current year expenditures in
  order to facilitate comparison

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Ch. 13 Capital Budgeting - Future Value

• Future Value of a present amount
• F A(1 i)n
• F future value
• A present amount
• I interest rate
• n number of years ( or interest periods)

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Ch. 13 Capital Budgeting - Present Value

• Present Value of a future amount
• P F X 1/(1 i)n
• P present amount
• F future amount
• I interest rate
• n number of years ( or interest periods)

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Ch. 13 Capital Budgeting - Annuity

• Equal amounts at equal intervals.
• Present value will vary based on the interest
  rate ( also called the discount rate) and the
  timing of the future receipts.
• Everything else being the same, the higher the
  discount rate, the lower the present value.
  Also, the more distant the receipt, the smaller
  the present value.

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Ch. 13 Capital Budgeting - Annuity - Present Value

• PVAn,k (1- (1/ (1 k)n))/k
• PVAn,k Present Value of an Annuity for n
  periods at a discount rate of k
• Alternative approach is shown in Exhibit 3 on
  page 539

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Ch. 13 Capital Budgeting - Annuity - Future Value

• FVAn,k (((1 k)n)-1) / k
• FVAn,k Future Value of an Annuity for n periods
  at a discount rate of k.
• Could also use the alternative approach in
  Exhibit 3 on page 539 - substituting Future Value
  calculations for each year
• Present value of a stream of unequal future
  receipts is shown in Exhibit 6 on page 542

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Ch. 13 Capital Budgeting - Cash Flow

• Incremental cash flow is the change in cash flow
  resulting from the investment.
• Includes Investment initial cost (cash outflow)
• Investment revenues (cash inflow)
• Investment expenses except depreciation (cash
  outflow)

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Ch. 13 Capital Budgeting - Cash Flow

• Depreciation is not considered a cash outflow.
• However, Depreciation is used to determine income
  taxes related to the investment
• In capital budgeting models, the discount rate
  includes the interest cost, if any.

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Ch. 13 Capital Budgeting - ARR Model

• ARR is the Accounting Rate of Return
• Considers the average annual project income (
  project revenues less project expenses generated
  by the investment) and the average investment
• ARR Average Annual Project Income / Average
  Investment

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Ch. 13 Capital Budgeting - ARR Model

• Easy to Calculate, easy to understand.
• However, Cash flows and time value of money are
  not considered
• See Exhibit 9 on page 545

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Ch. 13 Capital Budgeting - Payback Model

• Compares annual cash flows to the project cost to
  determine a payback period.
• When annual cash flows are equal, the payback
  period is determined as follows
• Payback Period Project Cost / Annual Cash Flow
• See Exhibit 9 on page 545 and Exhibit 10 on page
  547

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Ch. 13 Capital Budgeting - Payback Model

• Management sets the payback period at the
  determined length of time required for the
  operation to get its money back from the project.
• Stated another way, Payback period equals the
  number of years including fractional years it
  takes for cash flows to equal project cost.

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Ch. 13 Capital Budgeting - Payback Model

• Often used as a screening device in conjunction
  with more sophisticated models.
• Cash flows and time value of money are not
  considered
• Fails to consider project flows after the payback
  period

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Ch. 13 Capital Budgeting - NPV Model

• NPV is the Net Present Value - Considers cash
  flows and the time value of money.
• Discounts cash flows to their present value
• Calculated by subtracting project cost from the
  present value of the discounted cash flow stream
• Project is accepted if NPV is equal to or greater
  than zero.

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Ch. 13 Capital Budgeting - NPV Model

• If considering mutually exclusive projects, the
  alternative with the highest NPV is accepted, and
  other alternatives are rejected.
• See Exhibit 11 on page 548

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Ch. 13 Capital Budgeting - IRR Model

• IRR is the Internal Rate of Return - Considers
  cash flows and the time value of money.
• Determines the rate of return earned by a
  proposed project.
• In determining IRR, net present value of cash
  flows is set at zero and the discount rate is
  determined.

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Ch. 13 Capital Budgeting - IRR Model

• Project is accepted if IRR is equal to, or
  greater than, the established minimum IRR (hurdle
  rate)
• Assumes all project cash flows are reinvested at
  the internal rate of return.

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Ch. 13 Capital Budgeting - NPV vs. IRR

• Generally yield the same results whether applied
  to single projects or to mutually exclusive
  projects.
• However, for some mutually exclusive projects,
  the NPV model could suggest one project while the
  IRR model suggests a different project.

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Ch. 13 Capital Budgeting - NPV vs. IRR

• Different project recommendations is the result
  of different approaches to the assumed
  reinvestment rates of each model.
• NPV assumes reinvestment at the discount rate
  used. IRR assumes reinvestment at the IRR,
  which is doubtful.
• When mutually exclusive projects are considered,
  NPV approach is more useful.

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Ch. 13 Mutually Exclusive Different Lives

• Assume the shorter-lived project is followed by
  another project and the combined lives equal the
  life of the longer-lived project
• Assume the longer-lived project is disposed of at
  the end of the shorter-lived projects life.
• Ignore the differences in lives of the two
  mutually exclusive projects. Exhibit 13,p. 551

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Ch. 13 Capital Budgeting - Capital Rationing

• Limiting funds regardless of expected profit.
• Optimum combinations of projects are selected.
• See Exhibit 15 on page 552

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Ch. 13 Computer Applications

• Computer usage has increased the use of the NPV
  and IRR models.
• Advantage - once the format of the model is set,
  it can be used repeatedly to ensure consistency
  in the evaluation of all projects.
• Advantage - provides a quick and accurate
  results and allows more efficient use of
  management time - to evaluate projects.