Capital Expenditure Decisions

McGraw-Hill/Irwin

16 Chapter Chapter SixteenSixteen

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%.

Annual net cash inflows from operations

Present value of an annuity of $1 Present value of an annuity of $1 factor for 5 years at 10%.factor for 5 years at 10%.

Present value of $1 Present value of $1 factor for 3 years at 10%.factor for 3 years at 10%.

Present value of $1 Present value of $1 factor for 5 years at 10%.factor for 5 years at 10%.

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

Net Present Value The cost of capital is

used as the actual discount rate.

Any project with a negative net present value is rejected.

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.

The net present value method has the following

advantages over the internal rate of return method . . .

Easier to use.Easier to adjust for risk.Provides more usable

information.

The net present value method has the following

advantages over the internal rate of return method . . .

Easier to use.Easier to adjust for risk.Provides more usable

information.

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.

Depreciable AssetsDepreciable Assets

Both the NPV and IRR methods focus on cash flows, and periodic depreciation

charges are not cash flows . . .

Tax ReturnTax ReturnForm 1120Form 1120 DepreciationDepreciation

is taxis taxdeductibledeductibleand . . .and . . .

ReducesReducescashcashoutflows foroutflows fortaxes.taxes.

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

MAINFRAME PC _ Differentials Salvage value old system $ 25,000 $ 25,000 0Cost of new system (400,000) (300,000) (100,000)Cost of new software ( 40,000) ( 75,000) 35,000Update new system ( 40,000) ( 60,000) 20,000Salvage value new system 50,000 30,000 20,000 ===========================================================Operating costs over 5-year life:Personnel (300,000) (220,000) ( 80,000)Maintenance ( 25,000) ( 10,000) ( 15,000)Other costs ( 10,000) ( 5,000) ( 5,000)Datalink services ( 20,000) ( 20,000) 0Revenue from time-share 20,000 - 20,000

Irrelevant

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 . . . increase the hurdle rate, 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

Cash RevenuesCash Revenues

High Country’s management is considering the purchase of a new truck that will increase cash

revenues by $120,000 and increase cash cost of goods sold by $60,000. The company is subject

to a tax rate of 40%.

Let’s calculate the company’s after-tax cash flows.

High Country’s management is considering the purchase of a new truck that will increase cash

revenues by $120,000 and increase cash cost of goods sold by $60,000. The company is subject

to a tax rate of 40%.

Let’s calculate the company’s after-tax cash flows.

After-Tax Cash FlowsAfter-Tax Cash Flows

The tax rate is 40%, so income taxes areThe tax rate is 40%, so income taxes are$60,000 × 40% = $ 24,000$60,000 × 40% = $ 24,000

High Country Department Stores

Income Statement

Revenue $ 120,000

Cash CGS ( 60,000)

Net Income 36,000_

After-Tax Cash FlowsAfter-Tax Cash FlowsHigh Country Department Stores

Income Statement

Revenue $ 120,000

Cash CGS ( 60,000)

Net Income 36,000_A short cut works like this:A short cut works like this:Increase in income × ( 1 - tax rate)Increase in income × ( 1 - tax rate)

$60,000 × ( 1 - .4) = $36,000$60,000 × ( 1 - .4) = $36,000

Noncash ExpensesNoncash Expenses

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

Recall that High Country’s proposal involved the purchase of a truck. The truck cost $40,000 and will be depreciated over four years using straight-line depreciation. The truck is to be purchased on

June 30, 2007. One-half year depreciation is taken in 2007.

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

Recall that High Country’s proposal involved the purchase of a truck. The truck cost $40,000 and will be depreciated over four years using straight-line depreciation. The truck is to be purchased on

June 30, 2007. One-half year depreciation is taken in 2007.

Noncash ExpensesNoncash Expenses

Here is a complete depreciation schedule for High Country.

Depreciation Tax Reduced Tax

Year Expense Rate Payment _

1 $ 5,000 40% $ 2,000

2 10,000 40% 4,000

3 10,000 40% 4,000

4 10,000 40% 4,000

5 5,000 40% 2,000

40,000 16,000

DepreciationDepreciationTaxTax

ShieldShield

Net Present Value AnalysisNet Present Value Analysis

Calculation of the present value of proposal cash flows.

The sum of the present values from thisThe sum of the present values from thisproposal is a positive $75,000proposal is a positive $75,000

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

Acquisition cost $( 40,000)Cash flows from proposal $ 18,000 $ 36,000 $ 36,000 $ 36,000 $ 18,000Depreciation shield 2,000 4,000 4,000 4,000 2,000Total cash flow ( 40,000) 20,000 40,000 40,000 40,000 20,000X Discount factor X 1.000 X .893 X .797 X .712 X .636 X .567Present value ( 40,000) 17,860 31,880 28,480 25,440 11,340

SUM = $ 75,000

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.

A company is considering the purchase of a machine that will increase after-tax cash flows

by $20,000 over the next five years. The machine is depreciated using MACRS and the company uses a 10% discount rate to compute

all present values. The machine will cost $100,000 and the company is subject to a 28%

tax rate.

Let’s calculate the net present value of the proposal.

A company is considering the purchase of a machine that will increase after-tax cash flows

by $20,000 over the next five years. The machine is depreciated using MACRS and the company uses a 10% discount rate to compute

all present values. The machine will cost $100,000 and the company is subject to a 28%

tax rate.

Let’s calculate the net present value of the proposal.

Modified Accelerated Cost Modified Accelerated Cost Recovery System (MACRS)Recovery System (MACRS)Calculation of the present value of the

depreciation tax shield.

$5,600 × (1.10)^-1$5,600 × (1.10)^-1

$20,000 × 28%$20,000 × 28%

$100,000 × 20%$100,000 × 20%

Calculation of the present value proposal cash flows.

$20,000 × (1.10)^-1$20,000 × (1.10)^-1

Net present value of the proposal.

The presentThe presentvalue of thevalue of the

proposal is lessproposal is lessthan the costthan the cost

of the equipmentof the equipment($100,000). The($100,000). Theproposal has aproposal has a

negativenegative net netpresent value.present value.

The presentThe presentvalue of thevalue of the

proposal is lessproposal is lessthan the costthan the cost

of the equipmentof the equipment($100,000). The($100,000). Theproposal has aproposal has a

negativenegative net netpresent value.present value.

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.

McGraw-Hill/Irwin

Learning Objective

Extended IllustrationExtended Illustration

Let take a close look at a present value analysis for an investment decision

facing James Company.

Let take a close look at a present value analysis for an investment decision

facing James Company.

JamesCompany

Extended IllustrationExtended IllustrationJames Company has been offered a five-year contract to

provide component parts for a large manufacturer.

Extended IllustrationExtended Illustration• At the end of five years the working capital

will be released and may be used elsewhere by James.

• James Company uses a discount rate of 10%.

• James uses straight-line depreciation.• All items in this example are taxed at 30%.

Annual accounting income from operations

RememberRememberdepreciation isdepreciation isa non-casha non-cashexpense thatexpense thatprovides aprovides atax shield.tax shield.

Annual cash inflows from operations

RememberRememberdepreciation isdepreciation isa non-casha non-cashexpense thatexpense thatprovides aprovides atax shield.tax shield.

The relining is considered normal maintenance The relining is considered normal maintenance and will reduce income in year 3. Because the and will reduce income in year 3. Because the cost is tax deductible, income will be lower by cost is tax deductible, income will be lower by

$21,000 ($30,000 × 1- tax rate).$21,000 ($30,000 × 1- tax rate).

Because the salvage value of the equipment will equal Because the salvage value of the equipment will equal the book value (cost less accumulated depreciation), the book value (cost less accumulated depreciation),

there will be no taxable gain or loss.there will be no taxable gain or loss.

Present value of $1 factor for 3 years at 10%.

Present value of $1 factor for 5 years at 10%.

We should accept the contract because the presentWe should accept the contract because the presentvalue of the cash inflows exceeds the present valuevalue of the cash inflows exceeds the present valueof the cash outflows by of the cash outflows by $92,836$92,836. The project has a . The project has a

positivepositive net present value.net present value.

General decision rule . . .

McGraw-Hill/Irwin

Learning Objective

Ranking Investment ProjectsRanking Investment Projects

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

different.different.

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

different.different.

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

(1.10)-1 = 0.909 rounded(1.10)-1 = 0.909 rounded

(1.10)-2 = 0.826 rounded(1.10)-2 = 0.826 rounded

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 the project’s return is greater than greater than the discount rate.the discount rate.

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 the project’s return is less than less than the discount rate.the discount rate.

Internal Rate of Return (IRR)Internal Rate of Return (IRR)

The interest rate that equates the present value of inflows and outflows from an

investment project.

The interest rate that equates the present value of inflows and outflows from an

investment project.

When the cash flows from a project are constant, the present value of an annuity

factor can be used to approximate the rate of return.

A project cost $90,119, and will yield net cash inflows of $25,000 at the end of each of the

next five years.

When the cash flows from a project are constant, the present value of an annuity

factor can be used to approximate the rate of return.

A project cost $90,119, and will yield net cash inflows of $25,000 at the end of each of the

next five years.

Let’s determine the IRR for this project!Let’s determine the IRR for this project!

PV factor = PV factor = Required InvestmentRequired Investment Annual net cash flowAnnual net cash flow

$90,119$90,119 $25,000$25,000

3.605 rounded3.605 rounded

The present value of an annuity factor of 3.605,The present value of an annuity factor of 3.605,is an internal rate of return of is an internal rate of return of 12%12%..

PV factor = PV factor =

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

Fails to consider the time value of money.

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

Fails to consider the time value of money.

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

Payback: Pro and ConPayback: Pro and ConProvides a tool for

roughly screening investments.

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

Provides a tool for roughly screening investments.

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 depreciationrevenues including depreciation

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%==

Capital Budgeting PracticesCapital Budgeting Practices

Percent of managers who believe each technique is important.

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

Capital Expenditure Decisions

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