CITM410 OperationManagementProcessAndSupplyChains Supplement F

8/10/2019 CITM410 OperationManagementProcessAndSupplyChains Supplement F

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F

FINANCIALANALYSIS

FMany decisionsin operations and supply chain management involve large capital in-vestments. Automation, outsourcing decisions, capacity expansion, layout revisions, building anew distribution center, and installing a new ERP system are only a few examples. In fact, most ofa firms assets are tied up in the operations function. Therefore, management should seek high-yield capital projects and then assess their costs, benefits, and risks.

Such projects require strong cross-functional coordination, particularly with finance and ac-counting. The projects must fit in with the organizations financial plans and capabilities. If a firmplans to open a new production facility in 2015, it must begin lining up financing in 2011. Theprojects must also be subjected to one or more types of financial analysis to assess their attractive-ness relative to other investment opportunities. This supplement presents a brief overview of ba-sic financial analyses and the types of computer support available for making such decisions. See

your finance textbook for a more comprehensive treatment of the subject.

Time Value of MoneyAn important concept underlying many financial analysis techniques is that a dollar in hand todayis worth more than a dollar to be received in the future. A dollar in hand can be invested to earna return so that more than one dollar will be available in the future. This concept is known as thetime value of money.

Future Value of an InvestmentIf $5,000 is invested at 10 percent interest for 1 year, at the end of the year the $5,000 will haveearned $500 in interest and the total amount available will be $5,500. If the interest earned is al-lowed to accumulate, it also earns interest and the original investment will grow to $12,970 in10 years. The process by which interest on an investment accumulates and then earns interest

time value of moneyThe concept that a dollar in ha

can be invested to earn a retur

so that more than one dollar w

be available in the future.

SUPPLEMENT

LEARNING GOALS After reading this supplement, you should be able to:

Explain the time value of money concept. Demonstrate the use of the net present value, internal

rate of return, and payback methods of financial analysis.

Discuss the importance of combining managerial judg-ment with quantitative techniques when making invest-

ment decisions.


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F-2 SUPPLEMENT F FINANCIAL ANALYSIS

itself for the remainder of the investment period is known as compounding interest. The valueof an investment at the end of the period over which interest is compounded is called the futurevalue of an investment.

To calculate the future value of an investment, you first express the interest rate and the timeperiod in the same units of time as the interval at which compounding occurs. Let us assume thatinterest is compounded annually, express all time periods in years, and use annual interest rates.To find the value of an investment 1 year in the future, multiply the amount invested by the sumof 1 plus the interest rate (expressed as a decimal). The value of a $5,000 investment at 12 percentper year, 1 year from now is

$5,00011.122 = $5,600If the entire amount remains invested, at the end of 2 years you would have

$5,60011.122 = $5,00011.122 = $6,272In general,

F = P11 + r2nwhere

F = future value of the investment at the end of nperiods

P = amount invested at the beginning, called the prinicipal

r = periodic interest rate

n = number of time periods for which the interest compounds

Present Value of a Future AmountLet us look at the converse problem. Suppose that you want to make an investment now that willbe worth $10,000 in 1 year. If the interest rate is 12 percent and Prepresents the amount investednow, the relation becomes

F = $10,000 = P11 + 0.122Solving for Pgives

P = 11 + r2n =,

11 + 0.1221 = $8,929The amount that must be invested now to accumulate to a certain amount in the future at a

specific interest rate is called the present value of an investment. The process of finding the presentvalue of an investment when the future value and the interest rate are known is called discountingthe future value to its present value. If the number of time periods nfor which discounting is desiredis greater than 1, the present value is determined by dividing the future value by the nth power of thesum of 1 plus the interest rate. The general formula for determining the present value is

P = 11 + r2nThe interest rate is also called the discount rate.

Present Value Factors

Although you can calculate Pfrom its formula in a few steps with most pocket calculators, you alsocan use a table. To do so, write the present value formula another way:

P =F

11 + r2n = F c1

11 + r2ndLet 31> 11 + r2n4 be the present value factor, which is called pf and which you can find inTable F.1. This table gives you the present value of a future amount of $1 for various time periodsand interest rates. To use the table, locate the column for the appropriate interest rate and the rowfor the appropriate period. The number in the body of the table where this row and column inter-sect is the pf value. Multiply it by Fto get P. For example, suppose that an investment will generate$15,000 in 10 years. If the interest rate is 12 percent, Table F.1 shows that pf = 0.3220. Multiplyingit by $15,000 gives the present value, or

P = F

1pf

2 = $15,000

10.3220

2 = $4,830

future value of an investment

The value of an investment atthe end of the period over which

interest is compounded.

compounding interest

The process by which interest

on an investment accumulates

and then earns interest itself for

the remainder of the investment

period.

present value of an investment

The amount that must be

invested now to accumulate to a

certain amount in the future at

a specific interest rate.

discounting

The process of finding the pres-

ent value of an investment when

the future value and the interest

rate are known.

discount rateThe interest rate used in

discounting the future value

to its present value.


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AnnuitiesAn annuityis a series of payments of a fixed amount for a specified number of years. All such pay-ments are treated as happening at the end of a year. Suppose that you want to invest an amountat an interest rate of 10 percent so that you may draw out $5,000 per year for each of the next fouryears. You could determine the present value of this $5,000 four-year annuity by treating the fourpayments as single future payments. The present value of an investment needed now, in order foryou to receive these payments for the next four years, is the sum of the present values of each ofthe four payments. That is,

P =$5,

000

1 + 0.10 +

$5,

000

11 + 0.1022 +$5,

000

11 + 0.1023 +$5,

000

11 + 0.1024 = $4,545 + $4,132 + $3,757 + $3,415

= $15,849

A much easier way to calculate this amount is to use Table F.2. Look for the factor in the tableat the intersection of the 10 percent column and the fourth-period row. It is 3.1699. For annuities,this present value factor is called af to distinguish it from the present value factor for a single pay-ment. To determine the present value of an annuity, multiply its amount by af to get

P = A(af) = $5,000(3.1699)

= $15,849

where= present value of an investment

A = amount of the annuity received each yearaf = persent value factor for an annuity

Techniques of AnalysisYou can now apply these concepts to the financial analysis of proposed investments. Three basicfinancial analysis techniques are as follow:

1. The net present value method

2. The internal rate of return method

3. The payback method

These methods work with cash flows. Cash flow is the cash that will flow into and out of theorganization because of the project, including revenues, costs, and changes in assets and liabili-ties. Be sure to remember two points when determining cash flows for any project:

1. Consider only the amounts of cash flows that will change if the project is undertaken. Theseamounts are called incremental cash flows and are the difference between the cash flows withthe project and without it.

2. Convert cash flows to after-taxamounts before applying the net present value, payback, orinternal rate of return method to them. This step introduces taxes and depreciation into thecalculations.

Depreciation and TaxesDepreciation is an allowance for the consumption of capital. In this type of analysis, deprecia-tion is relevant for only one reason: It acts as a tax shield. Depreciation is not a legitimate cashflow because it is not cash that is actually paid out each year. However, depreciation does af-fect how an accountant calculates net income, against which the income-tax rate is applied.Therefore, depreciation enters into the calculation, as a tax shield, only when tax liability isfigured. Taxes must be paid on pretax cash inflows minus the depreciation that is associatedwith the proposed investment. United States tax laws allow either straight-line or accelerateddepreciation.

Straight-Line Depreciation The straight-line depreciation methodof calculating annual depre-ciation is the simplest and usually is adequate for internal planning purposes. First, subtract theestimated salvage value from the amount of investment required at the beginning of the projectand then divide by the number of years in the assets expected economic life. Salvage valueis the

annuity

A series of payments on a fixed

amount for a specified number

of years.

cash flowThe difference between the

flows of funds into and out of

an organization over a period of

time, including revenues, costs,

and changes in assets and

liabilities.

straight-line depreciation

method

The simplest method of

calculating annual depreciation;found by subtracting the esti-

mated salvage value from the

amount of investment required

at the beginning of the project,

and then dividing by the assets

expected economic life.

salvage value

The cash flow from the sale or

disposal of plant and equipment

at the end of a projects life.


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cash flow from the sale or disposal of plant and equipment at the end of a projects life. 1The gen-eral expression for annual depreciation is

D =I - S

n

where

D = annua epreciation

I =

amount

of

t e

investmentS = salvagevalue

n = numberofyearsofprojectlife

Accelerated Depreciation If the tax shields come earlier, they are worth more. Tax laws allowjust that with what is called accelerated depreciation. Since 1986, the only acceptable accelerateddepreciation method in the United States is the Modified Accelerated Cost Recovery System(MACRS). MACRS shortens the lives of investments, giving firms larger tax deductions. It createssix classes of investments, each of which has a recovery period or class life. Depreciation for eachyear is calculated by multiplying the assets cost by the fixed percentage in Table F.3.2The follow-ing are examples of the first four classes:

3-year class: specially designed tools and equipment used in research

5-year class: autos, copiers, and computers

7-year class: most industrial equipment and office furniture

10-year class: some longer-life equipment

Table F.3 does not show the 27.5- and 31.5-year classes, which are reserved for real estate.MACRS depreciation calculations ignore salvage value and the actual expected economic life. Ifthere is salvage value after the asset has been fully depreciated, it is treated as taxable income.

1Disposal of property often results in an accounting gain or loss that can increase or decrease income tax andaffect cash flows. These tax effects should be considered in determining the actual cash inflow or outflow from

disposal of property.

Modified Accelerated Cost

Recovery System (MACRS)

The only acceptable depreciation

method for tax purposes that

shortens the lives of investments,

giving firms larger early tax

deductions.

2The table can be confusing because it allows a depreciation deduction for one more year than would seemappropriate for a given class. The reason is that MACRS assumes that assets are in service for only six months

of the first year and six months of the last year. An asset in the second class still has a 5-year life, but it spans

six calendar years.

TABLE F.3 MACRS DEPRECIATION ALLOWANCES

CLASS OF INVESTMENT

Year 3-Year 5-Year 7-Year 10-Year

1 33.33 20.00 14.29 10.00

2 44.45 32.00 24.49 18.00

3 14.81 19.20 17.49 14.40

4 7.41 11.52 12.49 11.52

5 11.52 8.93 9.22

6 5.76 8.93 7.37

7 8.93 6.55

8 4.45 6.55

9 6.55

10 6.55

11 3.29

100.0% 100.0% 100.0% 100.0%


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FINANCIAL ANALYSIS SUPPLEMENT F F

Taxes The income-tax rate varies from one state or country to another. Calculation of the taxtotal should include all relevant federal, state, and local income taxes. When doing a financialanalysis, you may want to use an average income-tax rate based on the firms tax rate over the pastseveral years, or you may want to base the tax rate on the highest tax bracket that applies to thetaxpaying unit. The one thing you should never do is ignore taxes in making a financial analysis.

Analysis of Cash FlowsYou now are ready to determine the after-tax cash flow for each year of the projects life. Use the

following four steps to calculate the flow year by year:1. Subtract the new expenses attributed to the project from new revenues. If revenues are unaf-

fected, begin with the projects cost savings.

2. Next subtract the depreciation (D), to get pretax income.

3. Subtract taxes, which constitute the pretax income multiplied by the tax rate. The differenceis called the net operating income (NOI).

4. Compute the total after-tax cash flow as NOI + D, adding back the depreciation that was de-ducted temporarily to compute the tax.

Calculating After-Tax Cash FlowsEXAMPLE F.1

A local restaurant is considering adding a salad bar. The investment required to remodel the dining area and add

the salad bar will be $16,000. Other information about the project is as follows:

1. The price and variable cost per salad are $3.50 and $2.00, respectively.

2. Annual demand should be about 11,000 salads.

3. Fixed costs, other than depreciation, will be $8,000, which cover the energy to operate the refrigerated unit

and wages for another part-time employee to stock the salad bar during peak business hours.

4. The assets go into the MACRS 5-year class for depreciation purposes, with no salvage value.

5. The tax rate is 40 percent.

6. Management wants to earn a return of at least 14 percent on the project.

Determine the after-tax cash flows for the life of this project.

SOLUTION

The cash flow projections are shown in the following table. Depreciation is based on Table F.3. For example, de-preciation in 2013 is $3,200 (or $16,000 * 0.20). The cash flow in 2018 comes from depreciations tax shield

in the first half of the year.

YEAR

Item 2012 2013 2014 2015 2016 2017 2018

Initial Information

Annual demand (salads) 11,000 11,000 11,000 11,000 11,000

Investment $16,000

Interest (discount) rate 0.14

Cash Flows

Revenue $38,500 $38,500 $38,500 $38,500 $38,500

Expenses: Variable costs 22,000 22,000 22,000 22,000 22,000

Expenses: Fixed costs 8,000 8,000 8,000 8,000 8,000

Depreciation (D) 3,200 5,120 3,072 1,843 1,843 922

Pretax income $5,300 $3,380 $5,428 $6,657 $6,657 -$922

Taxes (40%) 2,120 1,352 2,171 2,663 2,663 -369

Net operating Income (NOI) $3,180 $2,208 $3,257 $3,994 $3,994 -$553

Total cash flow (NOI + D) $6,380 $7,148 $6,329 $5,837 $5,837 $369


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Net Present Value MethodThe net present value (NPV) methodis used to evaluate an investment by calculating the presentvalues of all after-tax total cash flows and then subtracting the original investment amount (whichis already a present value) from their total. The difference is the projects net present value. If it ispositive for the discount rate used, the investment earns a rate of return higher than the discountrate. If the net present value is negative, the investment earns a rate of return lower than the dis-count rate. Most firms set the discount rate equal to the overall weighted average cost of capital,which becomes the lowest desired return on investment. If a negative net present value results,

the project is not approved. The discount rate that represents the lowest desired return on invest-ment is thought of as a hurdle over which the investment must pass and is often referred to as thehurdle rate.

Internal Rate of Return MethodA related technique involves calculating the internal rate of return (IRR), which is the discountrate that makes the NPV of a project zero. It is internal because it depends only on the cash flowsof the investment, not on rates offered elsewhere. With this method, a project is acceptable onlyif the IRR exceeds the hurdle rate. The IRR is a single number that summarizes the merits of theinvestment. It can be used to rank multiple projects from best to worst, so it is particularly usefulwhen the budget limits new investments in any year.

You can find the IRR by trial and error. Start with a low discount rate and calculate the NPV. Ifit exceeds 0, increase the discount rate and try again. The NPV will eventually go to 0 and later to a

negative value. When the NPV is near 0, you have found the IRR.

Payback MethodThe other commonly used method of evaluating projects is the paybackmethod which deter-mines how much time will elapse before the total of after-taxcash flows will equal, or pay back,the initial investment.

Even though it is scorned by many academics, the payback method continues to be widelyused, particularly at lower management levels. It can be quickly and easily applied and gives deci-sion makers some idea of how long recovery of invested funds will take. Uncertainty surroundsevery investment project. The costs and revenues on which analyses are based are best estimates,not actual values. An investment project with a quick payback is not considered as risky as onewith a long payback. The payback method also has drawbacks. A major criticism is that it encour-ages managers to focus on the short run. A project that takes a long time to develop but generatesexcellent cash flows later in its life usually is rejected under the payback method. The paybackmethod also has been criticized for its failure to consider the time value of money. For these rea-sons, we recommend that payback analysis be combined with a more sophisticated method such

as NPV or IRR in analyzing the financial implications of a project.

hurdle rate

The interest rate that is the low-

est desired return on an invest-

ment; the hurdle over which the

investment must pass.

net present value (NPV)

method

The method that evaluates an

investment by calculating the

present values of all after-tax

total cash flows and then sub-

tracting the initial investment

amount for their total.

internal rate of return (IRR)

The discount rate that makes the

NPV of a project 0.

payback method

A method for evaluating projects

that determines how much time

will elapse before the total of

after-tax flows will equal, or pay

back, the initial investment.

Calculating NPV, IRR, and Payback PeriodEXAMPLE F.2

What are the NPV, IRR, and payback period for the salad bar project in Example F.1?

SOLUTION

Management wants to earn a return of at least 14 percent on its investment, so we use that rate to find the pf

values in Table F.1. The present value of each years total cash flow and the NPV of the project are as follows:

2012: $6,380(0.8772) = $5,597

2013: $7,148(0.7695) = $5,500

2014: $6,329(0.6750) = $4,272

2015: $5,837(0.5921) = $3,456

2016: $5,837(0.5194) = $3,032

2017: $369(0.4556) = $168

NPV of project

= ($5,597 + $5,500 + $4,272 + $3,456 + $3,032 + $168) - $16,000

= $6,024

Because the NPV is positive, the recommendation would be to approve the project.


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FINANCIAL ANALYSIS SUPPLEMENT F F

Computer SupportThe proliferation of microcomputers and the corresponding use of computer spreadsheets makeit easy to evaluate projected cash flows with NPV, IRR, and payback period methods. The follow-ing computer output shows spreadsheet analysis for the salad bar in Example F.1. The analystinputs the investment expenditure, depreciation method, discount rate, and pretax cash flows. Ifonly cost savings are involved, the revenue row would be replaced by them and there would be noseparate rows for variable costs and fixed costs. The computer then computes the depreciation,taxes, after-tax cash flows, NPV, IRR, and payback period.

OM Explorer makes it easy to evaluate projected cash flows with NPV, IRR, and payback pe-riod methods. Figure F.1 shows the output using the Financial AnalysisSolver for the salad bar inExample F.1.

To find the IRR, let us begin with the 14 percent discount rate, which produced a positive NPV. Increment-

ing at 4 percent with each step, we reach a negative NPV with a 30 percent discount rate. If we back up to

28 percent to fine tune our estimate, the NPV is $322. Therefore, the IRR is about 29 percent. The computer

can provide a more precise answer with much less computation.

Discount Rate NPV

14% $6,025

18% $4,092

22% $2,425

26% $977

30% -$199

To determine the payback per iod, we add the after- tax cash flows at the bottom of the tab le in

Example F.1 for each year until we get as close as possible to $16,000 without exceeding it. For 2012 and

2013, cash flows are $6,380 + $7,148 = $13,528.The payback method is based on the assumption that

cash flows are evenly distributed throughout the year, so in 2014 only $2,472 must be received before the

payback point is reached. As $2,472 / $6,329 is 0.39, the payback period is 2.39 years.

With such spreadsheets, the analyst no longer performs present value calculations by usingformulas or tables but instead focuses on data collection and the evaluation of many differentscenarios relating to a project. They are referred to as what-if analyses and allow an analyst tolook at what would happen to financial performance if certain events or combinations of eventswere to occur.

FIGURE F.1

OM ExplorerOutput for

Salad Bar


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Managing by the NumbersThe precision and analytical detachment that come from using the NPV, IRR, or payback method canbe deceiving. In fact, U.S. business has been accused of managing by the numbers, with a preferencefor short-term results from low-risk projects. Part of the problem lies with managers who are on thefast track to the top of their organizations. They occupy a rung on the ladder for a short time and thenmove up, and so they perceive it to be in their career interests to favor investments that give quickresults. They establish short paybacks and high hurdle rates. They ignore or forgo long-term ben-efits from technological advances, innovative product plans, and strategic capacity additions. Over

the long run, this narrow vision jeopardizes the firms competitive advantageand even its survival.Managing by the numbers has a second cause. Projects with the greatest strategic impact are

likely to be riskier and have qualitative benefits that cannot be easily quantified. Consider an in-vestment in some of the newer types of flexible automation. Benefits can include better quality,quicker delivery times, higher sales, and lower inventory. The equipment might be reprogrammedto handle new products not yet conceived of by the firm. Enough might be learned with the newtechnology that subsequent investments will pay off at an even higher rate of return. The mistakeis to ignore these benefits simply because they cannot be easily quantified. Including risks andqualitative factors as part of the analysis is far better than ignoring them. Using a preference ma-trix also may help an analyst recognize qualitative factors more explicitly.

The message is clear: Financial analysis is a valuable tool for evaluating investment projects.However, it can never replace the insight that comes from hands-on experience. Managers mustuse their judgment, taking into account not only NPV, IRR, or payback data, but also how the proj-ect fits operations and corporate strategy.

LEARNING GOALS IN REVIEW

Explain the time value of money concept. The section TimeValue of Money, pp. 14, covers this concept, including thefuture value of an investment, present value of a future amount,future value factors, and annuities.

Demonstrate the use of the net present value, internal rate ofreturn, and payback methods of financial analysis. We explainthese three methods in the section Techniques of Analysis,pp. 410. Tables F.1 and F.2 make the calculations easy, with

software such as OM Exploreror POM for Windowsavailable

for more complex problems that recognize taxes and cash flowsover time.

Discuss the importance of combining managerial judgmentwith quantitative techniques when making investment deci-sions. See the last section Managing by the Numbers onp. 10 that cautions against relying just on financial analysis,without also bring into play insight that comes from managerialjudgment.

MyOMLab Resources Titles Link to the Book

OM Explorer Solver Financial Analysis Depreciation and Taxes: MACRS or Straight-Line Depreciation (p. 6);Net Present Value (p. 8); Internal Rate of Return (p. 8); PaybackMethod (pp. 89)

OM Explorer Tutors F.1 Present Value of a Future Amount Present Value of a Future Amount (p. 2)

F.2 Present Value of an Annuity Present Value Factors (pp. 24)

F.3 Straight-line Depreciation Depreciation and Taxes (pp. 47)

F.4 NPV, IRR, Payback NPV, IRR, Payback (pp. 89)

POM for Windows Financial Analysis Net Present Value Method (ignoring Depreciation and Taxes) p. 8;Internal Rate of Return (ignoring Depreciation and Taxes) p. 8

Internet Exercise Air-X-Changers Depreciation and Taxes (pp. 47)

Key Equations

Image Library

MyOMLabhelps you develop analytical skills and assesses your progress with multipleproblems.


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FINANCIAL ANALYSIS SUPPLEMENT F F-

Key Equations

1. Future Value of an Investment:

F = P11 + r2n2. Present Value of Future Amount:

P =

11 + r

2n

3. Present Value Factors:

P = F c 111 + r2nd4. Present Value of an Annuity:

P = A(af)

5. Straight-Line Depreciation:

D =-

n

annuity 4

cash flow 4

compounding interest 2

discounting 2

discount rate 2

future value of an investment 2

hurdle rate 8

internal rate of return (IRR) 8

Modified Accelerated Cost Recovery

System (MACRS) 6

net present value (NPV) method 8

payback method 8

present value of an investment 2

salvage value 4

straight-line depreciation method 4

time value of money 1

Key Terms

Selected ReferencesBrealey, Richard A., Stewart C. Meyers, and Alan J. Marcus. Funda-

mentals of Corporate Finance. New York: McGraw-Hill, 1995.

Brigham, Eugene F., and Louis C. Gapenski. Financial Management:

Theory and Practice, 7th ed. Orlando: Dryden, 1994.

Hayes, Robert H., and William J. Abernathy. Managing Our Way to

Economic Decline. Harvard Business Review(JulyAugust 1980),pp. 6777.

Hodder, James E., and Henry E. Riggs. Pitfalls in Evaluating Risky

Projects. Harvard Business Review(JanuaryFebruary 1985),pp. 128135.

Kieso, Donald E., and Jerry J. Weygandt. Intermediate Accounti

4th ed. New York: John Wiley & Sons, 1983.

Luehrman, Timothy A. Whats It Worth? A General ManageGuide to Valuation. Harvard Business Review(MayJune 199

pp. 132142.

Ross, Stephen A., Randolph W. Westerfield, and Bradford D. JordoFundamentals of Corporate Finance, 2nd ed. Homewood, Ill.: Irw

Professional Publication, 1993.


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Documents

CITM410 OperationManagementProcessAndSupplyChains Supplement F