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CHAPTER

Capital Investment Decisions

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Objectives Objectives
1. Explain what a capital investment decision is, and After studying this After independent distinguish betweenstudying thisand mutually chapter, you should chapter, you should exclusive capital investment decisions. be able to: be period 2. Compute the paybackable to:and accounting rate of return for a proposed investment, and explain their roles in capital investment decisions. 3. Use net present value analysis for capital investment decisions involving independent projects.

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Objectives Objectives
4. Use the internal rate of return to assess the acceptability of independent projects. 5. Discuss the role and value of postaudits. 6. Explain why NPV is better than IRR for capital investment decisions involving mutually exclusive projects. 7. Convert gross cash flows to after-tax cash flows. 8. Describe capital investment in the advanced manufacturing environment.

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Capital investment decisions are concerned with the process of planning, setting goals and priorities, arranging financing, and using certain criteria to select long-term assets.

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Payback Method
Payback period = Original investment Annual cash flow
The cash flows is assume The cash flows is assume to occur evenly. to occur evenly.

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Payback Method
Year Unrecovered Investment (Beginning of year) Annual Cash Flow

1 2 3 4 5

$100,000 70,000 30,000 ------$30,000 was needed

$30,000 was needed in Year 3 to recover in Year 3 to recover the investment the investment

$30,000 40,000 50,000 60,000 70,000

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Payback Method
Deficiency Deficiency
Ignores the time value of

money
Ignores the performance of the

investment beyond the payback period

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Payback Method
The payback period provides information to managers that can be used as follows: To help control the risks associated with the uncertainty of future cash flows. To help minimize the impact of an investment on a firms liquidity problems. To help control the risk of obsolescence. To help control the effect of the investment on performance measures.

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Accounting Rate Of Return (ARR) Accounting Rate Of Return (ARR)

ARR = Average income Original investment or Average investment Average annual net Average annual net cash flows, less cash flows, less average depreciation average depreciation

Average investment Average investment = ((I + S)/2 = I + S)/2

II= the original investment = the original investment S = salvage value S = salvage value Assume that the investment Assume that the investment is uniformly consumed is uniformly consumed

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Accounting Rate Of Return (ARR) Accounting Rate Of Return (ARR)

Example: Suppose that some new equipment requires an initial outlay of $80,000 and promises total cash flows of $120,000 over the next five years (the life of the machine). What is the ARR? Answer: The average cash flow is $24,000 ($120,000 5) and the average depreciation is $16,000 ($80,000 5). ARR = ($24,000 $16,000) $80,000 = $8,000 $80,000 = 10%

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Accounting Rate Of Return (ARR) Accounting Rate Of Return (ARR)

Reasons for Using ARR Reasons for Using ARR A screening measure to ensure that new investment will not adversely affect net income
To ensure a favorable effect on net income so that

bonuses can be earned (increased)

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Accounting Rate Of Return (ARR) Accounting Rate Of Return (ARR)

The major deficiency of the accounting rate of return is that it ignores the time value of money.

The Net Present Value Method The Net Present Value Method
NPV = P I

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where: P I = the present value of the projects future cash inflows = the present value of the projects cost (usually the initial outlay)

Net present value is the difference between the present value of the cash inflows and outflows associated with a project.

The Net Present Value Method The Net Present Value Method
Brannon Company has developed new earphones for portable CD and tape players that are expected to generate an annual revenue of $300,000. Necessary production equipment would cost $320,000 and can be sold in five years for $40,000.

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The Net Present Value Method The Net Present Value Method
In addition, working capital is expected to increase by $40,000 and is expected to be recovered at the end of five years. Annual operating expenses are expected to be $180,000. The required rate of return is 12 percent.

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STEP 1. CASH-FLOW IDENTIFICATION

YEAR FLOW 0 ITEM CASH

Equipment Working capital Total Revenues Operating expenses Total Revenues Operating expenses Salvage Recovery of working capital Total

$-320,000 - 40,000 $-360,000 $300,000 -180,000 $120,000 $300,000 -180,000 40,000 40,000 $200,000

1-4

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STEP 2A. NPV ANALYSIS

YEAR CASH FLOW DISCOUNT FACTOR PRESENT VALUE

0 $-360,000 Present 1 120,000 Value 2 120,000 of $1 3 120,000 4 120,000 5 200,000 Net present value
YEAR CASH FLOW

1.000 0.893 0.797 0.712 0.636 0.567

$-360,000 107,160 95,640 85,440 76,320 113,400 $117,960

PRESENT VALUE

STEP 2B. NPV ANALYSIS

DISCOUNT FACTOR

0 $-360,000 Value Present 1-4 120,000 of an Annuity Present Value 5 200,000$1 of $1 of Net present value

1.000 3.307 0.567

$-360,000 364,400 113,400 $117,840

The Net Present Value Method The Net Present Value Method
Decision Criteria for NPV
If NPV = 0, this indicates: 1. The initial investment has been recovered 2. The required rate of return has been recovered Thus, break even has been achieved and we are indifferent about the project.

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The Net Present Value Method The Net Present Value Method
Decision Criteria for NPV
If the NPV > 0 this indicates: 1. The initial investment has been recovered 2. The required rate of return has been recovered 3. A return in excess of 1. and 2. has been received Thus, the earphones should be manufactured.

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The Net Present Value Method The Net Present Value Method
Reinvestment Assumption The NVP model assumes that all cash flows generated by a project are immediately reinvested to earn the required rate of return throughout the life of the project.

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Internal Rate of Return Internal Rate of Return

The internal rate of return (IRR) is the discount rate that sets the projects NPV at zero. Thus, P = I for the IRR. Example: A project requires a $10,000 investment and will return $12,000 after one year. What is the IRR? $12,000/(1 + i) = $10,000 1 + i = 1.2 i = 0.20

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Internal Rate of Return Internal Rate of Return

Decision Criteria: If the IRR > Cost of Capital, the project should be accepted. If the IRR = Cost of Capital, acceptance or rejection is equal. If the IRR < Cost of Capital, the project should be rejected.

NPV Compared With IRR

There are two major differences between net present value and the internal rate of return: NPV assumes cash inflows are reinvested at the required rate of return whereas the IRR method assumes that the inflows are reinvested at the internal rate of return. NPV measures the profitability of a project in absolute dollars, whereas the IRR method measures it as a percentage.

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NPV Compared With IRR

Bintley Corporation Example Bintley Corporation Example Design A $179,460 119,460 180,000 5 years Design B $239,280 169,280 210,000 5 years

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Annual revenue Annual operating costs Equipment (purchased before Year 1) Project life

NPV Compared With IRR

CASH-FLOW PATTERN Year Design A Design B 0 $-180,000 $-210,000 1 60,000 70,000 2 60,000 70,000 3 60,000 70,000 4 60,000 70,000 5 60,000 70,000 DESIGN A: NPV ANALYSIS Year Cash Flow Discount Factor 1.000 3.605 Present Value $-180,000 216,300 $ 36,300 0 $-180,000 1-5 60,000 Net present value

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NPV Compared With IRR

IRR ANALYSIS Discount factor = = Initial Investment Annual cash flow $180,000 60,000 = 3.000

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From Exhibit 18B-2, df = 3,000 for five years; IRR = 20% = 3,000 DESIGN B: NPV ANALYSIS Year Cash Flow Discount Factor 1.000 3.605 Present Value $-210,000 252,350 $ 42,350 0 $-210,000 1-5 70,000 Net present value

NPV Compared With IRR

IRR ANALYSIS Discount factor = = Initial Investment Annual cash flow $210,000 70,000 = 3.000

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From Exhibit 18B-2, df = 3,000 for five years; IRR = 20% = 3,000

Adjusting Forecast for Inflation Adjusting Forecast for Inflation

WITHOUT INFLATIONARY ADJUSTMENT Year Cash Flow Discount Factor Present Value 0 $-5,000,000 1.000 $-5,000,000 1-2 2,900,000 1.528 4,431,200 Net present value $- 568,800 WITH INFLATIONARY ADJUSTMENT Year Cash Flow Discount Factor Present Value 0 $-5,000,000 1.000 $-5,000,000 1 3,335,000 0.833 2,778,055 2 3,835,250 0.694 2,661,664 Net present value $ 439,719

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After-Tax Operating Cash Flows

The Income Approach
After-tax cash flow = After-tax net income + Noncash expenses Example: Revenues Less: Operating expenses* Income before taxes Less: Income taxes Net income *$100,000 is depreciation After-tax cash flow = $264,000 + $100,000 = $364,000 $1,000,000 600,000 $ 400,000 136,000 $ 264,000

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After-Tax Operating Cash Flows

Decomposition Approach

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After-tax cash revenues = (1 Tax rate) x Cash revenues After-tax cash expense = (1 Tax rate) x Cash expenses Tax savings (noncash expenses) = (Tax rate) x Noncash expenses

Total operating cash is equal to the after-tax cash revenues, less the after-tax cash expenses, plus the tax savings on noncash expenses.

After-Tax Operating Cash Flows

Decomposition Approach
Example: Revenues = $1,000,000, cash expenses = $500,000, and depreciation = $100,000. Tax rate = 34%. After-tax cash revenues (1 .34)($1,000,000) = Less: After-tax cash expense (1 .34)($500,000)= Add: Tax savings (noncash exp.) .34($100,000) = Total

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$660,000 -330,000 34,000 $364,000

Tax-Shielding Effect Tax-Shielding Effect

Depreciation is a noncash expense and is not a cash flow. Depreciation, however SHIELDS revenues from being taxed and, thus, creates a cash inflow equal to the tax savings. Assume initially that tax laws DO NOT allow depreciation to be deducted to arrive at taxable income. If a company had before-tax operating cash flows of $300,000 and depreciation of $100,000, we have the statement found on Slide 33.

Depreciation Depreciation

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Tax-Shielding Effect Tax-Shielding Effect

Net operating cash flows Less: Depreciation Taxable income Less: Income taxes (@ 34%) Net income $300,000 0 $300,000 102,000 $198,000

Depreciation Depreciation

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Tax-Shielding Effect Tax-Shielding Effect

Now assume that the tax laws allow a deduction for depreciation: Net operating cash flows Less: Depreciation Taxable income Less: Income taxes (@ 34%) Net income $300,000 100,000 $200,000 -68,000 $132,000

Depreciation Depreciation

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Tax-Shielding Effect Tax-Shielding Effect

Notice that the taxes saved are $34,000 ($102,000 $68,000). Thus, the firm has additional cash available of $34,000. This savings can be computed by multiplying the tax rate by the amount of depreciation claimed: .34 x $100,000 = $34,000

Depreciation Depreciation

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MACRS Depreciation Rates MACRS Depreciation Rates

The tax laws classify most assets into the following three classes (class = Allowable years): Class 3 5 7 Types of Assets Most small tools Cars, light trucks, computer equipment Machinery, office equipment

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Assets in any of the three classes can be depreciated using either straight-line or MACRS (Modified Accelerated Cost Recovery System) with a half-year convention.

MACRS Depreciation Rates MACRS Depreciation Rates

Half the depreciation for the first year can be claimed regardless of when the asset is actually placed in service. The other half year of depreciation is claimed in the year following the end of the assets class life. If the asset is disposed of before the end of its class life, only half of the depreciation for that year can be claimed.

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ExampleS/L Depreciation
An automobile is purchased on March 1, 2003 at a cost of $20,000. The firm elects the straight-line method for tax purposes. Automobiles are five-year assets (to refer to a chart, click on the car below; to return to this slide, click on the hammer). The annual depreciation is $4,000 ($20,000 5). However, due to the half-year convention, only $2,000 can be deducted in 2003.

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ExampleS/L Depreciation
Year
2003 2004 2005 2006 2007 2008

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Depreciation Deduction
$2,000 (half-year amount) 4,000 4,000 4,000 4,000 2,000 (half-year amount)

Assume that the asset is disposed of in April 2005. Only $2,000 of depreciation can be claimed, so the book value would be $12,000 ($20,000 $8,000).

ExampleMACRS Method
MACRS Depreciation Rates for Five-Year Assets
Year 1 2 3 4 5 6 Percentage of Cost Allowed 20.00% 32.00 19.20 11.52 11.52 5.76

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ExampleS/L Depreciation
Tax Year Depreciation Rate 1 $2,000 0.40 2 4,000 0.40 3 4,000 0.40 4 4,000 0.40 5 4,000 0.40 6 2,000 0.40 Net present value Tax Discount Savings Factor $ 800.00 0.909 1,600.00 0.826 1,600.00 0.751 1,600.00 0.683 1,600.00 0.621 1,600.00 0.564 Present Value $ 727.20 1,321.60 1,201.60 1,092.80 993.60 451.20 $5,788.00

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ExampleMACRS Method
Tax Tax Discount Year Depreciation Rate Savings Factor 1 $4,000 0.40 $1,600.00 0.909 2 6,400 0.40 2,560.00 0.826 3 3,840 0.40 1,536.00 0.751 4 2,304 0.40 921.60 0.683 5 2,304 0.40 921.60 0.621 6 1,152 0.40 460.80 0.564 Net present value Present Value $1,454.40 2,114.56 1,153.54 629.45 572.31 259.89 $6,184.15

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How Estimates of Operating How Estimates of Operating Cash Flows Differ Cash Flows Differ

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A company is evaluating a potential investment in a flexible manufacturing system (FMS). The choice is to continue producing with its traditional equipment, expected to last 10 years, or to switch to the new system, which is also expected to have a useful life of 10 years. The companys discount rate is 12 percent. Present value ($4,000,000 x 5.65) Investment Net present value $22,600,000 18,000,000 $ 4,600,000

How Estimates of Operating How Estimates of Operating Cash Flows Differ Cash Flows Differ
FMS Investment (current outlay): Direct costs Software, engineering Total current outlay Net after-tax cash flows Less: After-tax cash flows for status quo Incremental benefit $10,000,000 8,000,000 $18,000,000 $ 5,000,000 1,000,000 $ 4,000,000 STATUS QUO ----$1,000,000 n/a n/a

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FMS STATUS QUO INCREMENTAL BENEFIT EXPLAINED Direct benefits: Direct labor $1,500,000 Scrap reduction 500,000 Setups 200,000 $2,200,000 Intangible benefits (quality savings): Rework $ 200,000 Warranties 400,000 Maintenance of competitive position 1,000,000 1,600,000 Indirect benefits: Production scheduling $ 110,000 Payroll 90,000 200,000 Total $4,000,000

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Future Value: Time Value Future Value: Time Value of Money of Money
Let:
F = i = P = n = future value the interest rate the present value or original outlay the number or periods F = P(1 + i)n

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Future value can be expressed by the following formula:

Future Value: Time Value Future Value: Time Value of Money of Money
Assume the investment is $1,000. The interest rate is 8%. What is the future value if the money is invested for one year? Two? Three?

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Future Value: Time Value Future Value: Time Value of Money of Money
F = $1,000(1.08) F = $1,000(1.08)2 F = $1,000(1.08)3 = $1,080.00 (after one year) = $1,166.40 (after two years) = $1,259.71 (after three years)

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Present Value Present Value

P = F/(1 + i)n The discount factor, 1/(1 + i), is computed for various combinations of I and n.

Example: Compute the present value of $300 to be received three years from now. The interest rate is 12%. Answer: From Exhibit 18B-1, the discount factor is 0.712. Thus, the present value (P) is: P = F(df) = $300 x 0.712 = $213.60

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Present Value Present Value

Example: Calculate the present value of a $100 per year annuity, to be received for the next three years. The interest rate is 12%. Answer: Discount Present Year Cash Factor Value 1 $100 0.893 $ 89.30 2 100 0.797 79.70 3 100 0.712 71.20 2.402* $240.20
* Notice that it is possible to multiply the sum of the individual discount factors (.40) by $100 to obtain the same answer. See Exhibit 18 B-2 for these sums which can be used as discount factors for uniform series.

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Chapter Eighteen

The End The End

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