Chap 016

McGraw-Hill/Irwin

Capital Expenditure Decisions

Chapter 16

McGraw-Hill/Irwin

Learning Objective

Discounted-Cash-Flow AnalysisDiscounted-Cash-Flow Analysis

Cost reductionCost reductionCost reductionCost reduction

Plant expansionPlant expansionPlant expansionPlant expansion

Equipment selectionEquipment selectionEquipment selectionEquipment selection

Lease or buyLease or buyLease or buyLease or buy

Equipment replacementEquipment replacementEquipment replacementEquipment replacement

Net-Present-Value MethodNet-Present-Value Method

o Prepare a table showing cash flows for each year,o Calculate the present value of each cash flow using a

discount rate,o Compute net present value,o If the net present value (NPV) is positive, accept the

investment proposal. Otherwise, reject it.

o Prepare a table showing cash flows for each year,o Calculate the present value of each cash flow using a

discount rate,o Compute net present value,o If the net present value (NPV) is positive, accept the

investment proposal. Otherwise, reject it.

Net-Present-Value MethodNet-Present-Value MethodMattson Co. has been offered a five year contract to

provide component parts for a large manufacturer.

• At the end of five years the working capital will be released and may be used elsewhere by Mattson.

• Mattson uses a discount rate of 10%.

Should the contract be accepted?

• At the end of five years the working capital will be released and may be used elsewhere by Mattson.

• Mattson uses a discount rate of 10%.

Should the contract be accepted?

Annual net cash inflows from operations

Mattson should accept the contract because the present value of the cash inflows exceeds the present

value of the cash outflows by $85,955. The project has a positivepositive net present value.

Mattson should accept the contract because the present value of the cash inflows exceeds the present

value of the cash outflows by $85,955. The project has a positivepositive net present value.

Internal-Rate-of-Return MethodInternal-Rate-of-Return Method

• The internal rate of return is the true economic return earned by the asset over its life.

• The internal rate of return is computed by finding the discount rate that will cause the net present value of a project to be zero.

• The internal rate of return is the true economic return earned by the asset over its life.

• The internal rate of return is computed by finding the discount rate that will cause the net present value of a project to be zero.

• Black Co. can purchase a new machine at a cost of $104,320 that will save $20,000 per year in cash operating costs.

• The machine has a 10-year life.

• Black Co. can purchase a new machine at a cost of $104,320 that will save $20,000 per year in cash operating costs.

• The machine has a 10-year life.

Future cash flows are the same every year in this example, so we can calculate the

internal rate of return as follows:

Investment required Investment required Net annual cash flowsNet annual cash flows = Present value factor= Present value factor

$104, 320 $104, 320 $20,000$20,000 == 5.2165.216

$104, 320 $104, 320 $20,000$20,000 = 5.216= 5.216

The present value factor (5.216) is located on the Table IV in the Appendix. Scan the 10-

period row and locate the value 5.216. Look at the top of the column and you find a rate of

14% which is the internal rate of return.

The present value factor (5.216) is located on the Table IV in the Appendix. Scan the 10-

period row and locate the value 5.216. Look at the top of the column and you find a rate of

14% which is the internal rate of return.

Here’s the proof . . .

McGraw-Hill/Irwin

Learning Objective

Comparing the NPV and IRR Comparing the NPV and IRR MethodsMethods

Internal Rate of Return The cost of capital is

compared to the internal rate of return on a project.

To be acceptable, a project’s rate of return must be greater than the cost of capital.

Net Present Value The cost of capital is

used as the actual discount rate.

Any project with a negative net present value is rejected.

Net Present Value The cost of capital is

used as the actual discount rate.

Any project with a negative net present value is rejected.

Comparing the NPV and IRR Comparing the NPV and IRR MethodsMethods

The net present value method has the following

advantages over the internal rate of return

method . . .Easier to use.Easier to adjust for risk.

The net present value method has the following

advantages over the internal rate of return

method . . .Easier to use.Easier to adjust for risk.

Assumptions Underlying Assumptions Underlying Discounted-Cash-Flow AnalysisDiscounted-Cash-Flow Analysis

All cash flows areAll cash flows aretreated as thoughtreated as though

they occur at year end.they occur at year end.

Cash flows are Cash flows are treated as iftreated as if

they are knownthey are knownwith certainty.with certainty.

Cash inflows areCash inflows areimmediatelyimmediatelyreinvested atreinvested atthe requiredthe required

rate of return.rate of return.

Assumes aAssumes aperfectperfectcapitalcapitalmarket.market.

Choosing the Hurdle RateChoosing the Hurdle Rate

• The discount rate generally is associated with the company’s cost of capital.

• The cost of capital involves a blending of the costs of all sources of investment funds, both debt and equity.

McGraw-Hill/Irwin

Learning Objective

Comparing Two Investment Comparing Two Investment ProjectsProjects

To compare competing investment projects we can use the following net present value

approaches:– Total-Cost Approach.– Incremental-Cost Approach.

Total-Cost ApproachTotal-Cost Approach

• Each system would last five years.

• 12 percent hurdle rate for the analysis.

MAINFRAME PC _Salvage value old system $ 25,000 $ 25,000Cost of new system (400,000) (300,000)Cost of new software ( 40,000) ( 75,000)Update new system ( 40,000) ( 60,000)Salvage value new system 50,000 30,000================================================Operating costs over 5-year life:Personnel (300,000)(220,000)Maintenance ( 25,000) ( 10,000)Other costs ( 10,000) ( 5,000)Datalink services ( 20,000) ( 20,000)Revenue from time-share 25,000 -

Total-Cost ApproachTotal-Cost ApproachMAINFRAME ($) Today Year 1 Year 2 Year 3 Year 4 Year 5Acquisition cost computer (400,000)Acquisition cost software ( 40,000)System update ( 40,000)Salvage value 50,000Operating costs (335,000) (335,000) (335,000) (335,000) (335,000) (335,000)Time sharing revenue 20,000 20,000 20,000 20,000 20,000 20,000Total cash flow 440,000 (315,000) (315,000) (355,000) (315,000) (265,000)X Discount factor X 1.000 X .893 X .797 X .712 X .636 X .567Present value (440,000) (281,295) (251,055) (252,760) (200,340) (150,255)

SUM = ($1,575,705)

PERSONAL COMPUTER ($) Today Year 1 Year 2 Year 3 Year 4 Year 5Acquisition cost computer (300,000)Acquisition cost software ( 75,000)System update ( 60,000)Salvage value 50,000Operating costs (235,000) (235,000) (235,000) (235,000) (235,000) (235,000)Time sharing revenue -0- -0- -0- -0- -0- -0- _ Total cash flow 375,000 (235,000) (235,000) (295,000) (235,000) (205,000)X Discount factor X 1.000 X .893 X .797 X .712 X .636 X .567Present value (375,000) (209,855) (187,295) (210,040) (149,460) (116,235)

SUM = ($1,247,885)

Total-Cost ApproachTotal-Cost Approach

Net cost of purchasing Mainframe system ($1,575,705)

Net cost of purchasing Personal Computer system ($1,247,885)

Net Present Value of costs ($ 327,820)

Mountainview should purchase the personal computer system for a cost savings of

$327,820.

Incremental-Cost ApproachIncremental-Cost Approach

INCREMENTAL ($)Today Year 1 Year 2 Year 3 Year 4 Year 5

Acquisition cost computer (100,000)Acquisition cost software 35,000 System update 20,000Salvage value 20,000Operating costs (100,000) (100,000) (100,000) (100,000) (100,000)Time sharing revenue 20,000 20,000 20,000 20,000 20,000 20,000Total cash flow ( 65,000) ( 80,000) ( 80,000) ( 80,000) ( 80,000) ( 60,000)X Discount factor X 1.000 X .893 X .797 X .712 X .636 X .567Present value ( 65,000) ( 71,440) ( 63,760) ( 42,720) ( 50,880) ( 34,020)

SUM = ($ 327,820)

Total-Incremental Cost ComparisonTotal-Incremental Cost Comparison

Total Cost:

Net cost of purchasing Mainframe system ($1,575,705)

Net cost of purchasing Personal Computer system ($1,247,885)

Incremental Cost:

Different methods, Same results.

Managerial Accountant’s RoleManagerial Accountant’s Role

Managerial accountants are often asked to predict cash flows related to operating cost

savings, additional working capital requirements, and incremental costs and

revenues.

When cash flow projections are very uncertain, the accountant may . . .

1. increase the hurdle rate,

2. use sensitivity analysis.

Postaudit of Investment ProjectsPostaudit of Investment Projects

A postaudit is a follow-up after the project has been approved to see whether or not expected results are actually realized.

McGraw-Hill/Irwin

Learning Objective

Income Taxes and Capital Income Taxes and Capital BudgetingBudgeting

Cash flows from an investment proposal affect the company’s profit and its income tax

liability.

Income = Revenue - Expenses + Gains - LossesIncome = Revenue - Expenses + Gains - LossesIncome = Revenue - Expenses + Gains - LossesIncome = Revenue - Expenses + Gains - Losses

After-Tax Cash FlowsAfter-Tax Cash Flows

The tax rate is 40%, so income taxes areThe tax rate is 40%, so income taxes are$525,000 × 40% = $ 210,000$525,000 × 40% = $ 210,000

High Country Department Stores

Income Statement

For the Year Ended Jun 30, 2007

Revenue $ 1,000,000

Expenses (475,000)

Income before taxes 525,000

Income taxes (210,000)

Net Income 315,000

Not all expenses require cash outflows. The most common example is depreciation.Not all expenses require cash outflows. The most common example is depreciation.

McGraw-Hill/Irwin

Learning Objective

Modified Accelerated Cost Modified Accelerated Cost Recovery System (MACRS)Recovery System (MACRS)

Tax depreciation is usually computed using MACRS. Here are the depreciation rate for 3,

5, and 7-year class life assets.

McGraw-Hill/Irwin

Learning Objective

Investment in Working CapitalInvestment in Working Capital

Some investment proposals require additional outlays for working capital such as

increases in cash, accounts receivable, and inventory.

Some investment proposals require additional outlays for working capital such as

increases in cash, accounts receivable, and inventory.

Extended IllustrationExtended Illustration

For a complete present value analysis for an investment decision facing High Country

Department Stores, Inc., see the textbook.

For a complete present value analysis for an investment decision facing High Country

Department Stores, Inc., see the textbook.

High Country Department Stores

McGraw-Hill/Irwin

Learning Objective

Ranking Investment ProjectsRanking Investment ProjectsWe can invest in either of these projects.

Use a 10% discount rate to determine the net present value of the cash flows.

We can invest in either of these projects. Use a 10% discount rate to determine

the net present value of the cash flows.

Project A Project BImmediate cash outlay 100,000$ 100,000$ Cash inflows: Year 1 50,000$ 30,000$ Year 2 40,000 40,000 Year 3 30,000 50,000 Total inflows 120,000$ 120,000$

The total cash flows are the same, but the pattern of The total cash flows are the same, but the pattern of the flows is different.the flows is different.

Ranking Investment ProjectsRanking Investment Projects

Let’s calculate the present value of the cash flows associated with Project A.

This project has a positive net present value which means This project has a positive net present value which means the project’s return is greater than the discount rate.the project’s return is greater than the discount rate.

Ranking Investment ProjectsRanking Investment Projects

Here is the net present value of the cash flows associated with Project B.

Project B PV Factor PV

Immediate cash outlay (100,000)$ 1.000 (100,000)$ Cash inflows: Year 1 30,000$ 0.909 27,270 Year 2 40,000 0.826 33,040 Year 3 50,000 0.751 37,550 Net present value (2,140)$

Project B has a negative net present value which means Project B has a negative net present value which means the project’s return is less than the discount rate.the project’s return is less than the discount rate.

McGraw-Hill/Irwin

Learning Objective

Alternative Methods for Making Alternative Methods for Making Investment DecisionsInvestment Decisions

Payback Method

PaybackPaybackperiodperiod

Initial investment Initial investment Annual after-tax cash inflowAnnual after-tax cash inflow

PaybackPaybackperiodperiod ==

$20,000 $20,000 $4,000$4,000 == 5 years5 years

A company can purchase a machine for $20,000 thatA company can purchase a machine for $20,000 thatwill provide annual cash inflows of $4,000 for 7 years.will provide annual cash inflows of $4,000 for 7 years.A company can purchase a machine for $20,000 thatA company can purchase a machine for $20,000 thatwill provide annual cash inflows of $4,000 for 7 years.will provide annual cash inflows of $4,000 for 7 years.

Payback: Pro and ConPayback: Pro and Con

1. Fails to consider the time value of money.

2. Does not consider a project’s cash flows beyond the payback period.

1. Fails to consider the time value of money.

2. Does not consider a project’s cash flows beyond the payback period.

1. Provides a tool for roughly screening investments.

2. For some firms, it may be essential that an investment recoup its initial cash outflows as quickly as possible.

1. Provides a tool for roughly screening investments.

2. For some firms, it may be essential that an investment recoup its initial cash outflows as quickly as possible.

Accounting-Rate-of-Return MethodAccounting-Rate-of-Return Method

Discounted-cash-flow method focuses on cash flows and the time value of money.

Accounting-rate-of-return method focuses on the incremental accounting income that

results from a project.

Discounted-cash-flow method focuses on cash flows and the time value of money.

Accounting-rate-of-return method focuses on the incremental accounting income that

results from a project.

The following formula is used to calculate the accounting rate of return:

AccountingAccountingrate ofrate ofreturnreturn

Average Average Average Average incremental incremental expenses,incremental incremental expenses, revenues including depreciation & revenues including depreciation &

income taxesincome taxes

Initial investmentInitial investment

Meyers Company wants to install an espresso bar in its restaurant.

The espresso bar:– Cost $140,000 and has a 10-year life.

– Will generate incremental revenues of $100,000 and incremental expenses of $80,000 including depreciation.

What is the accounting rate of return on the investment project?

Meyers Company wants to install an espresso bar in its restaurant.

The espresso bar:– Cost $140,000 and has a 10-year life.

– Will generate incremental revenues of $100,000 and incremental expenses of $80,000 including depreciation.

What is the accounting rate of return on the investment project?

The accounting rate of return method is not recommendedThe accounting rate of return method is not recommendedfor a variety of reasons, the most important of which for a variety of reasons, the most important of which

is that it ignores the time value of money.is that it ignores the time value of money.

The accounting rate of return method is not recommendedThe accounting rate of return method is not recommendedfor a variety of reasons, the most important of which for a variety of reasons, the most important of which

is that it ignores the time value of money.is that it ignores the time value of money.

AccountingAccountingrate of returnrate of return

$100,000 - $80,000 $100,000 - $80,000 $140,000$140,000 = 14.3%= 14.3%==

McGraw-Hill/Irwin

Learning Objective

Estimating Cash Flows:Estimating Cash Flows:The Role of Activity-Based CostingThe Role of Activity-Based Costing

ABC systems generally improve the ability of an analyst to estimate the cash flows associated with a proposed project.

Justification of Investments in Justification of Investments in Advanced Manufacturing Advanced Manufacturing

SystemsSystems

HurdleHurdlerates arerates aretoo hightoo high

TimeTimehorizonshorizonsare tooare tooshortshort

BiasBiastowardstowards

incrementalincrementalprojectsprojects

BiasBiastowardstowards

incrementalincrementalprojectsprojects

GreaterGreatercash flowcash flow

uncertaintyuncertainty

GreaterGreatercash flowcash flow

uncertaintyuncertainty

BenefitsBenefitsdifficult todifficult toquantifyquantify

McGraw-Hill/Irwin

Learning Objective

Inflation EffectsInflation Effects

Nominal Dollars

Real dollars

Nominal Dollars

Real dollars

End of Chapter 16End of Chapter 16

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