McGraw-Hill/Irwin 16-1 Capital Expenditure Decisions Capital Expenditure Decisions 16 Chapter Sixteen

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Capital Expenditure Capital Expenditure DecisionsDecisions

16 Chapter Chapter SixteenSixteen

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Discounted-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

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Net-Present-Value Method

Prepare a table showing cash flows for each Prepare a table showing cash flows for each year,year,

Calculate the present value of each cash flow Calculate the present value of each cash flow using a discount rate,using a discount rate,

Compute net present value,Compute net present value, If the net present value (NPV) is positive, If the net present value (NPV) is positive,

accept the investment proposal. Otherwise, accept the investment proposal. Otherwise, reject it.reject it.

Prepare a table showing cash flows for each Prepare a table showing cash flows for each year,year,

Calculate the present value of each cash flow Calculate the present value of each cash flow using a discount rate,using a discount rate,

Compute net present value,Compute net present value, If the net present value (NPV) is positive, If the net present value (NPV) is positive,

accept the investment proposal. Otherwise, accept the investment proposal. Otherwise, reject it.reject it.

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Mattson Co. has been offered a five year contract to Mattson Co. has been offered a five year contract to provide component parts for a large manufacturer.provide component parts for a large manufacturer.

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

Mattson uses a discount rate of 10%.Mattson uses a discount rate of 10%.

Should the contract be accepted?Should the contract be accepted?

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

Mattson uses a discount rate of 10%.Mattson uses a discount rate of 10%.

Should the contract be accepted?Should the contract be accepted?

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Annual net cash inflows from operationsAnnual net cash inflows from operations

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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%.

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

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

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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.

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Internal-Rate-of-Return Method

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

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

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

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

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

The machine has a 10-year life.The machine has a 10-year life.

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

The machine has a 10-year life.The machine has a 10-year life.

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

internal rate of return as follows: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

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$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% 14% which is the internal rate of returnwhich 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% 14% which is the internal rate of returnwhich is the internal rate of return.

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Here’s the proof . . .Here’s the proof . . .

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Comparing the NPV and IRR Methods

Net Present ValueNet Present Value The cost of capital is The cost of capital is

used as theused as the actual actual discount rate.discount rate.

Any project with a Any project with a negative net present negative net present value is rejected.value is rejected.




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Internal Rate of ReturnInternal Rate of Return The cost of capital is The cost of capital is

compared to the internal compared to the internal rate of return on a project.rate of return on a project.

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







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The net present value method The net present value method has the following advantages has the following advantages over the internal rate of return over the internal rate of return

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

information.information.

The net present value method The net present value method has the following advantages has the following advantages over the internal rate of return over the internal rate of return

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

information.information.

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Discounted-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.

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Choosing the Hurdle Rate

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

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

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Depreciable Assets

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

charges are not cash flows . . .charges are not cash flows . . .

Tax ReturnTax ReturnForm 1120Form 1120 DepreciationDepreciation

is taxis taxdeductibledeductibleand . . .and . . .

ReducesReducescashcashoutflows foroutflows fortaxes.taxes.

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Comparing Two Investment Projects

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

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

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Total-Cost Approach

Black Co. is trying to decide whether to remodel an old Black Co. is trying to decide whether to remodel an old car wash or remove it entirely and install a new one.car wash or remove it entirely and install a new one.

The company uses a discount rate of 10%The company uses a discount rate of 10% ..

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Total-Cost Approach The new washer costs $300,000 and will produce The new washer costs $300,000 and will produce

revenues for 10 years.revenues for 10 years. The brushes have to be replaced at the end of 6 years at The brushes have to be replaced at the end of 6 years at

a cost of $50,000.a cost of $50,000. The old washer has a current salvage value of $40,000.The old washer has a current salvage value of $40,000. The estimated salvage value of the new washer will be The estimated salvage value of the new washer will be

$7,000 at the end of 10 years.$7,000 at the end of 10 years. Remodeling the old washer costs $175,000 and the Remodeling the old washer costs $175,000 and the

brushes must be replaced at the end of 6 years at a cost brushes must be replaced at the end of 6 years at a cost of $80,000 .of $80,000 .

Should Black replace the washer?Should Black replace the washer?

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Total-Cost ApproachInstall the New Washer

Year Cash Flows10%

FactorPresent Value

Initial investment Now (300,000)$ 1.000 (300,000)$ Replace brushes 6 (50,000) 0.564 (28,200) Net annual cash inflows 1-10 60,000 6.145 368,700 Salvage old equipment Now 40,000 1.000 40,000 Salvage new equipment 10 7,000 0.386 2,702 Net present value 83,202$

Install the New Washer

Year Cash Flows10%

FactorPresent Value

Initial investment Now (300,000)$ 1.000 (300,000)$ Replace brushes 6 (50,000) 0.564 (28,200) Net annual cash inflows 1-10 60,000 6.145 368,700 Salvage old equipment Now 40,000 1.000 40,000 Salvage new equipment 10 7,000 0.386 2,702 Net present value 83,202$

If Black Co. installs the new washer,If Black Co. installs the new washer,the investment will yield athe investment will yield a

positive net present value of $83,202.positive net present value of $83,202.

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Total-Cost ApproachRemodel the Old Washer

YearCash Flows

10% Factor

Present Value

Initial investment Now (175,000)$ 1.000 (175,000)$ Replace brushes 6 (80,000) 0.564 (45,120) Net annual cash inflows 1-10 45,000 6.145 276,525 Net present value 56,405$

Remodel the Old Washer

YearCash Flows

10% Factor

Present Value

Initial investment Now (175,000)$ 1.000 (175,000)$ Replace brushes 6 (80,000) 0.564 (45,120) Net annual cash inflows 1-10 45,000 6.145 276,525 Net present value 56,405$

If Black Co. remodels the existingIf Black Co. remodels the existingwasher, it will produce awasher, it will produce a

positive net present value of $56,405.positive net present value of $56,405.

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Total-Cost ApproachBoth projects yield a positive net present value.Both projects yield a positive net present value.

However, investing in the new washer will However, investing in the new washer will produce a higher net present value than produce a higher net present value than

remodeling the old washer.remodeling the old washer.

However, investing in the new washer will However, investing in the new washer will produce a higher net present value than produce a higher net present value than

remodeling the old washer.remodeling the old washer.

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Incremental-Cost Approach

Under the incremental-cost approach, only Under the incremental-cost approach, only those cash flows that differ between the those cash flows that differ between the

two alternatives are considered.two alternatives are considered.

Let’s look at an analysis of the Let’s look at an analysis of the Black Co. decision using Black Co. decision using

the incremental-cost approach.the incremental-cost approach.

Under the incremental-cost approach, only Under the incremental-cost approach, only those cash flows that differ between the those cash flows that differ between the

two alternatives are considered.two alternatives are considered.

Let’s look at an analysis of the Let’s look at an analysis of the Black Co. decision using Black Co. decision using

the incremental-cost approach.the incremental-cost approach.

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Year Cash Flows10%

FactorPresent Value

Incremental investment Now $ (125,000) 1.000 $ (125,000)


$300,000 new - $175,000 remodel = $125,000

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Year Cash Flows10%

FactorPresent Value

Incremental investment Now $ (125,000) 1.000 $ (125,000)Incre. cost of brushes 6 30,000$ 0.564 16,920


$80,000 remodel - $50,000 new = $30,000

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Year Cash Flows10%

FactorPresent Value

Incremental investment Now $ (125,000) 1.000 $ (125,000)Incre. cost of brushes 6 30,000$ 0.564 16,920 Increased net cash inflows 1-10 15,000 6.145 92,175


$60,000 new - $45,000 remodel = $15,000

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Year Cash Flows10%

FactorPresent Value

Incremental investment Now $ (125,000) 1.000 $ (125,000)Incre. cost of brushes 6 30,000$ 0.564 16,920 Increased net cash inflows 1-10 15,000 6.145 92,175 Salvage old equipment Now 40,000 1.000 40,000 Salvage new equipment 10 7,000 0.386 2,702 Net present value $ 26,797

We get the same answer under either thetotal-cost and incremental-cost approach.

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Managerial Accountant’s Role

Managerial accountants are often asked to predict Managerial accountants are often asked to predict cash flows related to operating cost savings, cash flows related to operating cost savings, additional working capital requirements, and additional working capital requirements, and

incremental costs and revenues.incremental costs and revenues.

When cash flow projections are very uncertain, the When cash flow projections are very uncertain, the accountant may . . .accountant may . . . increase the hurdle rate,increase the hurdle rate, use sensitivity analysis.use sensitivity analysis.

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Postaudit of Investment Projects

A postaudit is a follow-up after the project A postaudit is a follow-up after the project has been approved to see whether or not has been approved to see whether or not

expected results are actually realized.expected results are actually realized.

A postaudit is a follow-up after the project A postaudit is a follow-up after the project has been approved to see whether or not has been approved to see whether or not

expected results are actually realized.expected results are actually realized.

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Income Taxes and Capital Budgeting

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

tax liability.tax liability.

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

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After-Tax Cash Flows

The tax rate is 28%, so income taxes areThe tax rate is 28%, so income taxes are$525,000 × 28% = $147,000$525,000 × 28% = $147,000

The tax rate is 28%, so income taxes areThe tax rate is 28%, so income taxes are$525,000 × 28% = $147,000$525,000 × 28% = $147,000

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Cash Revenues

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

revenues by $110,000 and increase cash cost of revenues by $110,000 and increase cash cost of goods sold by $60,000. The company is subject goods sold by $60,000. The company is subject

to a tax rate of 28%.to a tax rate of 28%.

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

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

revenues by $110,000 and increase cash cost of revenues by $110,000 and increase cash cost of goods sold by $60,000. The company is subject goods sold by $60,000. The company is subject

to a tax rate of 28%.to a tax rate of 28%.

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

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Cash Revenues

$50,000 × 28% = $14,000$50,000 × 28% = $14,000

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Noncash Expenses

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

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

on June 30, 2001. One-half year depreciation is on June 30, 2001. One-half year depreciation is taken in 2001.taken in 2001.

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

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

on June 30, 2001. One-half year depreciation is on June 30, 2001. One-half year depreciation is taken in 2001.taken in 2001.

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McGraw-Hill/Irwin 16-1 Capital Expenditure Decisions Capital Expenditure Decisions 16 Chapter Sixteen