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**Capital Equipment Planning**

Kevin Hirst Brigham Young University My name is Kevin Hirst, and I created this PowerPoint presentation. All example problems and exercises were created by me. For any questions or comments, please me at

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**Overview Capital equipment planning defined How is it used?**

Capital budgeting techniques Examples and Real World Exercise Summary Reading List Exercise Solution Table of Contents

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**What Is Capital Equipment Planning?**

Planning for the purchase or replacement of capital equipment Reasons for purchase or replacement include obsolescence, desire for increased capacity, and introduction of a new product or process Planning is put into action through capital budgeting and cash flow analysis Capital equipment planning is very important to businesses, especially long-term capital-intensive businesses like airlines and manufacturers. The purchasing of new capital equipment is a carefully planned and well-thought out process.

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**Capital Equipment Planning—Why?**

Equipment is becoming obsolete Purchase additional equipment to increase productivity Need new equipment for a new product or process Find best investment from several capital equipment options Businesses have many reasons to purchase capital equipment. Planning for these purchases keeps a business prepared for any unexpected “bumps in the road” such as a breakdown or sudden discontinuance of a vital part to a machine. The purpose of a business is to maximize shareholder wealth (Mayes 2004), and by being prepared and choosing the best potential investment, you are helping the firm to maximize wealth.

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**Capital Equipment Planning—How?**

Capital budgeting techniques are used to determine best investment Obsolescence planning can be used to plan for the replacement of old or obsolete equipment Capital budgeting is an important part of a business. This presentation will go into detail about the most widely used and recognized capital budgeting techniques. Obsolescence planning will not be further discussed, although if you wish to learn more, there are a few articles found on the internet that lightly touch on dealing with obsolescence.

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**Capital Budgeting Determining which capital investment projects to do**

Best capital budgeting techniques: Consider the time-value of money Include all incremental cash flows Incorporate the required rate of return for the project Capital budgeting can be defined as the process of determining how a firm should allocate scarce capital resources to available long-term investment opportunities (Mayes 2004). There are usually many options to invest in, and by using capital budgeting, a firm can find the best potential investment. The most effective capital budgeting techniques should follow certain rules: Time-value of money—Would you rather receive a dollar today or a dollar tomorrow? Obviously you’d rather receive it today. That’s because as time goes on, money goes down in value. This is due to inflation. Also, if you take the dollar tomorrow, you lose the chance to invest the dollar today and earn interest. This is called opportunity cost. By delaying the receipt of money (or tying the money up in something that doesn’t earn interest) you are losing the opportunity to invest that money. For these reasons, the time-value of money should always be considered when using capital budgeting. Incremental cash flows—When analyzing an investment, only consider the additional cash flows above those cash flows already being received. In other words, don’t consider any cash flows that would still come in or out if we didn’t take on the investment. Only incremental, or additional cash flows should be considered. Also, make sure that all incremental cash flows are considered, even if it extends far into the future. Required rate of return—a firm’s required rate of return is it’s hurdle rate. It is called this because all investments must earn a high enough rate to clear the hurdle, or required rate of return. If an investment doesn’t clear the hurdle rate, then it will not cover the investment’s cost of financing. The minimum required rate of return is also know as a firm’s cost of capital (Mayes 2004).

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**Capital Budgeting Techniques**

Payback Period Net Present Value (NPV) Internal Rate of Return (IRR) The most popular capital budgeting techniques are payback period, net present value, and internal rate of return. There are other capital budgeting techniques, such as discounted payback period, accounting/book rate of return, profitability index, and modified internal rate of return, but in this lesson we are only going to focus on the three listed above.

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Payback Period The time it takes to for an investment to pay for itself or recoup the initial outlay When positive cash flows are equal: Initial Investment Payback = Payback period is probably the simplest and easiest to calculate of all the capital budgeting techniques. Note: This equation for payback period ONLY works when the net annual cash flows after the initial investment are all equal. In this example, the $50,000 machine would take 2 and a half years to pay back because 2.5 years X 20,000/year = $50,000. Annual Cash Flow Example: A machine that costs $50,000 will earn $20,000 a year. What is the payback period? $50,000 Payback = = 2.5 years, or 2 years 6 months $20,000

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Payback Period When cash flows are not equal, subtract the cash inflows from the initial investment until it reaches zero Example: A machine that costs $50,000 will earn $15,000 in year 1, $25,000 in year 2, and $30,000 in year 3. What is the payback period? If the net annual cash flows aren’t equal each year, then it is easiest to start with the initial investment, then subtract each cash flow from the initial investment amount. Once you change signs (+/-), you know the investment is paid back. You have to take the remainder amount before the sign change and divide it by the following year’s cash flow. That will give you your fractional year payback. Payback occurs between year 2 and 3. To figure this out, divide remainder ($10,000) by the cash flow in year 3 ($30,000) Inflow (50,000) Year 1 15,000 (35,000) Year 2 25,000 (10,000) Year 3 30,000 20,000 $10,000 = years = 2.33 years, or $30,000 2 years 4 months

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**Payback Period Cons Pros**

Easy to calculate Easy to understand Cons Doesn’t take into account the time- value of money Doesn’t consider cash flows after payback period As stated, payback period is fairly simple to understand and calculate. How long will I get my money back from this investment? Payback period will tell you. One of the main flaws with payback period is that it doesn’t consider the time-value of money. The cash you receive a few years down the road, or even tomorrow, isn’t worth what it is today. Another flaw is that is doesn’t consider any cash flows after the payback period. What if the year after the payback period there is a huge cash flow, or there are no more cash flows at all. Obviously knowing this would influence your decision to invest. Note: The discounted payback period, another capital budgeting technique, takes into account the time-value of money. It doesn’t, however, consider subsequent cash flows after the discounted payback period.

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Net Present Value The sum of the present values of all the annual net cash flows minus the initial investment n t = 1 Σ CFt Simply put, to calculate net present value, you take the present value of each annual cash flow, add them together, and then subtract the initial outlay. This shows you how much wealth the investment will add to (or if negative, take away from) the firm (Ryan 2002). In the denominator, r is the required rate of return. NPV = - initial investment (1+ r)t

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**Net Present Value Decision criteria:**

If NPV > 0, the investment is acceptable If NPV < 0, the investment is not acceptable When you have a positive NPV, it means that the return on the investment is greater than the required rate of return, and vice versa. The higher the required rate of return, the more the cash flows will be discounted, and the harder it will be for the NPV to be positive. Setting a high required rate is a way that managers and companies can ensure that investments will be good. The decision criteria for NPV is completely objective.

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Net Present Value Example: A machine that costs $50,000 will produce cash flows of $25,000 in year 1, $20,000 in year 2, and $10,000 in year 3. Assume a 12% required rate of return. What is the NPV? Should we purchase the machine? Initial Investment = $50,000 Year Cash Flow Present Value of 1 $ 25,000 $ 22,321.43 2 $ 20,000 $ 15,943.88 3 $ 10,000 $ 7,117.80 Sum of PV of Cash Flows= $ 45,383.11 NPV = PV of Cash Flows – Initial Investment = 45, – 50,000 = - 4,616.89 This type of problem is most easily done in Excel, although it can be done with a financial calculator or even by hand. Input the cash flows for each year, then discount each cash flow. Sum the discounted cash flows, and then subtract the initial investment from the sum. This gives you the NPV. Because NPV < 0, we should NOT purchase this machine. Discount each cash flow

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**Net Present Value Cons Pros Incorporates time-value of money**

Considers all cash flows Clear decision criteria Shows the amount of wealth that could be created from investment Cons Can’t easily compare two projects if they differ in size (comparing apples to oranges) NPV is a great capital budgeting technique because it considers all cash flows, takes into account time-value of money, and has a clear and objective decision criteria. One problem with NPV is that it is difficult to compare the NPVs of investments of different sizes. For example, you have an investment of $1,000,000 that produces a NPV of $1,0000 and an investment of $10,000 that produces a NPV of $500. Just looking at the NPVs, it appears that the first investment is better because the NPV is higher. But for a million dollar investment, this doesn’t seem too good. The second investment only requires $10,000 and has an NPV that’s half the first investment.

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**Internal Rate of Return**

The rate of return that an investment earns More specifically, the rate of return that makes the present value of the annual cash flows equal to the initial investment No way to calculate IRR by hand (besides trial and error). Excel and financial calculators have built-in functions to solve for IRR. The internal rate of return is related to NPV in that when you look at the NPV equation, you are figuring out what r (rate) would make the discounted cash flows equal the initial investment. As stated, the only way get IRR by hand is by trial and error. Excel has an easy function though that calculates the IRR for you.

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**Internal Rate of Return**

Decision criteria: If IRR >= required rate of return, a.k.a. the hurdle rate, the investment is acceptable If IRR < required rate of return, the investment is not acceptable The decision criteria for internal rate of return is completely objective.

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**Internal Rate of Return**

Example: A machine that costs $50,000 will produce cash flows of $25,000 in year 1, $20,000 in year 2, and $10,000 in year 3. Assume a 12% required rate of return. What is the IRR? Is this machine acceptable? Year Cash Flow (50,000) 1 25,000 2 20,000 3 10,000 IRR= 5.73% IRR = 5.73% This probably is best done in Excel. Input the cash flows for each year, including year 0 (the initial investment), the use the IRR function. Make sure that the initial investment is a negative number or an error will appear. The solution tells us that by discounting the cash flows from years 1 to 3 by 5.73%, we will get a sum of $50,000. Because IRR < 12% (the hurdle rate), we should NOT invest in this machine.

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**Internal Rate of Return**

Pros Incorporates time-value of money Considers all cash flows Clear decision criteria Can compare IRRs of different investments regardless of size Cons Assumes that cash can be reinvested at the IRR, which could be unrealistic if the IRR is very high Can exist multiple IRRs if there is more than one negative net cash flow Internal rate of return is a very good capital budgeting technique. One unique thing is that now matter how different in size two investments are, it makes sense to compare the IRRs. One negative about IRR is that it assumes that cash inflows are reinvested at the IRR rate. If you have a high IRR, it can be unreasonable to assume that you are earning that same high rate on it. Another IRR negative is that however many negative net cash flows there are, there are that many different IRRs for those set of numbers. Basically, if there is more than one negative net cash flow, IRR will not help you. Note: The modified internal rate of return (MIRR) is better version of IRR because you can set a reinvestment rate. MIRR can be found in Excell.

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NPV vs. IRR Traditionally, IRR has been most the popular capital budgeting technique among Fortune 1000 firms. Over the years, NPV use has grown and is now the most popular technique among the Fortune 1000 firms. This is largely due to professors that have been stressing to MBA students over the years that NPV is a better technique than IRR In Capital Budgeting Practices of the Fortune 1000: How Have Things Changed? (Ryan 2004), it states these facts. Also, in this article and in MacEwan’s IRR vs. NPV and What You Need to Know, it alludes that the shift to NPV has been in large part because of college professors.

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Real World Exercise Lumberjack Inc. wants to purchase a wood-cutting machine to increase production. It is considering two different machines, the Cutter 500 and the Saw-tooth The Cutter costs $600,000 and would increase production by 60,000 pieces a year. The machine would be depreciated straight-line over 6 years with no salvage value. The Saw-tooth costs $1,000,000 and would increase production by 110,000 pieces a year. The machine would be depreciated straight-line over 6 years with no salvage value. The sales price per unit is $5 and the variable cost per unit is $ Fixed costs to run either machine are $30,000 per year. Lumberjack’s tax rate is 35% and the cost of capital (required rate of return) is 14%. Using the capital budgeting techniques, which machine is the better investment? On the next slide, I provide a table with all of the important data from this exercise. The solution is found at the end of the slide show after the Reading List.

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Real World Exercise Cutter 500 Saw-tooth 3000 Initial Investment 600,000 1,000,000 Production Increase 60,000 110,000 Sale Price/unit 5.00 Variable Cost/unit 1.50 Fixed Costs/year 30,000 Years 6 Depreciation Exp/year 100,000 166,667 Tax Rate 35% Required Rate 14% This chart summarizes this information in the exercise. Using this information, calculate the payback period, NPV, and IRR. Then determine which machine is the better investment. The solution is found at the end of the slide show after the Reading List.

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Summary Capital equipment planning is important for knowing when to purchase new equipment or replace old or obsolete equipment Capital budgeting techniques are helpful in finding profitable capital equipment investments Summary

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Reading List Mayes, Timothy R. and Todd M. Shank. Financial Analysis with Microsoft Excel Minnesota: South-Western, 2004. Keown, Martin, Petty, and Scott. Financial Management: Principles and Applications. New Jersey: Prentice Hall, 2000. Ryan, Patricia A. and Glenn P. Capital Budgeting Practices of the Fortune 1000: How Have Things Changed? Journal of Business and Management, Vol. 8, No. 4, Oct 2002. This is a excellent reading list for anyone that would like to learn more. I especially recommend the first two books on the list.

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Reading List Cheng, C.S. Agnes, D. Kite, and R. Radtke. The Applicability and Usage of NPV and IRR Capital Budgeting Techniques. Managerial Finance, Vol. 20, No. 7, 1994. Bozarth, Cecil C. and Robert B. Handfield. Introduction to Operations and Supply Chain Management. New Jersey: Prentice Hall, 2006. MacEwen, Bruce. IRR vs. NPV and What You Need to Know. URL: 2004/09/irr_vs_npv_and.html This is a excellent reading list for anyone that would like to learn more.

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**Exercise Solution Cutter 500 Payback = 600,000 / 152,000 = 3.95 years**

Cutter 500 Solution This exercise can most easily be completed in Excel. Set up the columns for the years. Then list out each cash flow and sum the cash flows for each year. This will give you the annual net cash flows for years 0 to 6. Note that you have to take into account taxes because it is a real cash flow. Also note that you do not subtract depreciation expense because it is NOT a cash flow. However, depreciation expense is a valid expense for tax purposes, and because of that you receive a tax shield (equal to depreciation expense X the tax rate). After calculating the net cash flows, discount them. With the discounted cash flows, you can now use Excel NPV and IRR functions to get your answers. Payback = 600,000 / 152,000 = 3.95 years NPV = (133, , , , , ,249) – 600,000 = -8,923 IRR = 13.5%

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**Exercise Solution Saw-tooth 3000**

Saw-tooth 3000 Solution This exercise can most easily be completed in Excel. Set up the columns for the years. Then list out each cash flow and sum the cash flows for each year. This will give you the annual net cash flows for years 0 to 6. Note that you have to take into account taxes because it is a real cash flow. Also note that you do not subtract depreciation expense because it is NOT a cash flow. However, depreciation expense is a valid expense for tax purposes, and because of that you receive a tax shield (equal to depreciation expense X the tax rate). After calculating the net cash flows, discount them. With the discounted cash flows, you can now use Excel NPV and IRR functions to get your answers. Payback = 1,000,000 / 289,083 = 3.46 years NPV = (253, , , , , ,702) – 1,000,000 = 124,149 IRR = 18.4%

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Exercise Solution Cutter 500 Saw-tooth 3000 Payback 3.95 yrs 3.46 yrs NPV $ (8,923) $ ,149 IRR 13.5% 18.4% Because the Saw-tooth 3000 has a shorter payback period, higher net present value, and higher internal rate of return than the Cutter 500, Lumberjack Inc. should invest in the Saw-tooth 3000. It is important to remember that quantitative factors aren’t the only things to consider. Qualitative factors must be taken into account also. I hope that you enjoyed my slideshow and that you are now smarter for having watched it. For questions or comments, me at

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