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© John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1eSlide # 1 Cost Management Measuring, Monitoring, and Motivating Performance Prepared by Gail Kaciuba Midwestern State University Chapter 12 Strategic Investment Decisions

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© John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1eSlide # 2 Chapter 12: Strategic Investment Decisions Learning objectives Q1: How are strategic investment decisions made? Q2: What cash flows are relevant for strategic investment decisions? Q3: How is net present value (NPV) analysis performed and interpreted? Q4: What are the uncertainties and limitations of NPV analysis? Q5: What alternative methods (IRR, payback, and accrual accounting rate of return) are used for long-term decision making? Q6: What additional issues should be considered for strategic investment decisions? Q7: How do income taxes affect strategic investment decision cash flows? Q8: How are the real and nominal methods used to address inflation in NPV analysis (Appendix 12A)

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© John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1eSlide # 3 Q1: Process for Making Strategic Investment Decisions The process used to compare and analyze long-term investment projects is called capital budgeting. The capital budgeting process includes the following stages: Identify decision alternatives. Identify relevant cash flows. Apply the appropriate quantitative techniques. Perform sensitivity analysis. Identify and analyze qualitative factors. Consider quantitative and qualitative factors and make a decision.

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© John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1eSlide # 4 Q1: Capital Budgeting Quantitative Techniques Methods that do not consider the time value of money: Payback method Accounting rate of return method Methods that consider the time value of money: Net present value (NPV) method Internal rate of return (IRR) method

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© John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1eSlide # 5 Q2: Relevant Cash Flows in Capital Budgeting Relevant cash flows occur in the future and are different across the alternatives. Examples of relevant cash outflows include: Initial investment outlay Future operating costs Project closing and cleanup costs Examples of relevant cash inflows include: Future revenues Decreased operating costs Salvage value of assets at project’s end

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© John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1eSlide # 6 Q3: Net Present Value (NPV) Analysis The NPV of a project is the sum of the project’s discounted cash flows:, where t = year of the project’s life in which cash flow occurs n = life of the project r = discount, or hurdle rate If a project’s NPV > 0, it is acceptable

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© John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1eSlide # 7 Q3: NPV Analysis and Project Ranking NPV analysis is often used to screen projects as to whether they are acceptable. After screening, acceptable projects may be ranked according to their profitability index. Profitability index = Present value of benefits Present value of costs The profitability index allows for rankings of projects of various sizes.

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© John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1eSlide # 8 Q3: NPV Example Joseph Leasing is considering an investment in a new apartment building. The Lindie Lane building will cost $450,000 and the net annual cash inflows are expected to be $45,000 for 7 years. At the end of the 7 th year, Joseph expects to be able to sell Lindie Lane building for $400,000. Joseph demands a minimum required rate of return of 8% on all invest- ments. Assume all cash inflows occur at the end of each year. Compute the NPV of the Lindie Lane building. Is it an acceptable investment? Yes, the NPV > 0, so the investment is acceptable Yes, the NPV > 0, so the investment is acceptable

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© John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1eSlide # 9 Q3: NPV Example Joseph Leasing is also looking at the purchase of a lot with a double-wide trailer on it. The cost is $65,000 and the expected net cash inflows are $6,800 per year for 10 years. At the end of the 10 th year, Joseph expects to be able to sell the lot and trailer for $45,000. Compute the NPV of the trailer investment. Is it an acceptable investment? Yes, the NPV > 0, so the invest- ment is acceptable

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© John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1eSlide # 10 Q3: NPV Example Compare the two investments for Joseph using the profitability index, and describe to him what the index means. Which investment (or both) should he make? The Lindie Lane yields a slightly greater PV for each invested dollar than does the trailer. If Joseph has sufficient capital, he should invest in both unless he has alternatives that have even greater profitability indices.

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© John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1eSlide # 11 Q4: Limitations of NPV Analysis The uncertainty about future cash flows increases the further the cash flow is in the future, but NPV analysis uses only one discount rate for all future periods. Individuals providing information about the future cash flows are likely to have a vested interest in the project’s acceptance.

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© John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1eSlide # 12 Q5: Internal Rate of Return (IRR) Method The IRR method computes the discount rate required to set the NPV to zero. For projects with equal annual cash inflows where the only cash outlay is the initial investment, the IRR can be determined by computing the PV of an annuity factor and solving for the interest rate. PV of an annuity factor = Initial investment Annual cash inflow Then the discount rate is found by locating the column for the PV factor, given n.

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© John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1eSlide # 13 Q5: IRR Example Graham Enterprises is considering the purchase of a new machine. The cost is $100,000 and the machine is expected to generate cost savings of $17,700 each year for 10 years. The machine is not expected to have any salvage value at the end of its life. Assume the cost savings are realized at the end of the year. Graham requires a 10% rate of return on all new investments. Compute the IRR for the proposed machine. Should Graham purchase the machine? Since the machine’s IRR exceeds Graham’s minimum rate of return, the machine is an acceptable investment, but of course should still be compared to other, potentially better, investments. 5.650= $100,000 $17,700 Locate the 5.65 factor in the present value of an annuity table, using n = 10 years and note that it is found in the 12% column, so the IRR = 12%.

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© John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1eSlide # 14 Q5: Payback Method The payback method computes the number of years before the initial investment is recovered. If cash inflows are the same each year and the project has only one initial outlay, the payback period is computed as: Payback period in years = Initial investment Annual cash inflow For projects where annual cash inflows are not equal, the payback period is computed by merely counting the years required before the initial investment is recovered.

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© John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1eSlide # 15 Q5: Payback Method The payback method is widely used because of its simplicity. However, the payback method is flawed because: It ignores the time value of money. It ignores cash flows that occur after the payback period. If used at all, the payback method should be used in conjunction with the NPV or IRR methods to help assess project risk.

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© John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1eSlide # 16 Q5: Payback Method Example Graham Enterprises is considering the purchase of a new machine. The cost is $100,000 and the machine is expected to generate cost savings of $17,700 each year for 10 years. The machine is not expected to have any salvage value at the end of its life. Compute the payback period for the proposed machine. Notice that the payback period is the same as the PV factor computed in the IRR example. 5.650 years= $100,000 $17,700

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© John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1eSlide # 17 Q5: Payback Method Example Cophil, Inc. is considering the purchase of a new machine. There are two alternatives, and the cash flow information is given below. Compute the payback period for each and comment on your findings. The payback method shows Machine B to be preferable to Machine A, but ignores the large cash inflows of Machine A that occur after the payback period. The payback period for Machine B is 2 years. The payback period for Machine A is 3.5 years ($60,000 covered after 3 years, and $40,000 is ½ of year 4’s cash inflow).

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© John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1eSlide # 18 Q5: Accrual Accounting Rate of Return Method The accrual accounting rate of return computes the project’s rate of return using operating income in place of cash flows. This method is widely used because the financial accounting information is readily available, but is is flawed because it ignores the time value of money. Accrual accounting rate of return Operating income Annual cash inflow =

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© John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1eSlide # 19 Q5: Accrual Accounting Rate of Return Method Example Blanche Manufacturing is considering the purchase of a new machine. The cost is $100,000 and it is expected to last 5 years and have no salvage value. The machine is expected to generate cost savings of $32,000 per year. Ignoring income tax effects, compute the accrual accounting rate of return for this investment. Annual cost savings$32,000 Annual depreciation expense ($100,000/5 years)20,000 Effect on annual operating income$12,000 Accrual accounting rate of return $12,000 $100,000 = = 12%

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© John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1eSlide # 20 Q6: Additional Considerations in Strategic Investment Decisions Qualitative issues that may arise in capital budgeting include: the effects of the decision on the company’s reputation, the effects on the quality of the company’s products and services, the effects on the company’s community, and the effects on employees. After a capital budgeting decision is made, a post-investment audit should be performed to assess the decision process.

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© John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1eSlide # 21 Q7: Income Tax Considerations All cash flows should first be converted to an after-tax amount. The tax savings that result from the depreciation deduction is called the depreciation tax shield.

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© John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1eSlide # 22 Q7: Capital Budgeting and Income Tax Considerations (NPV) Example Colby Products is considering the purchase of a new machine. The cost is $180,000 and it is expected to last 6 years and have no salvage value. The machine is expected to generate cost savings of $50,000 per year. Colby’s tax rate is 30% and its discount rate is 10%. For simplification, suppose that Colby uses straight-line depreciation for both books and taxes. Compute the IRR of this machine. Cash inflows after taxes [$50,000 x (1 – 30%)]$35,000 Tax savings from depreciation [$30,000 x 30%]9,000 Net after-tax annual cash inflows$44,000 NPV = $44,000 x PV factor of an annuity - $180,000 = $44,000 x 4.355 - $180,000 = $11,620

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© John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1eSlide # 23 Q7: Capital Budgeting and Income Tax Considerations (IRR) Example Colby Products is considering the purchase of a new machine. The cost is $180,000 and it is expected to last 6 years and have no salvage value. The machine is expected to generate cost savings of $50,000 per year. Colby’s tax rate is 30% and its discount rate is 10%. For simplification, suppose that Colby uses straight-line depreciation for both books and taxes. Compute the IRR of this machine. Cash inflows after taxes [$50,000 x (1 – 30%)]$35,000 Tax savings from depreciation [$30,000 x 30%]9,000 Net after-tax annual cash inflows$44,000 PV of an annuity factor = 4.091 = $180,000 $44,000 Locate the 4.091 factor in the present value of an annuity table, using n = 6 years and note that it is found between the 12% & 13% columns, so the IRR is just over 12%.

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© John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1eSlide # 24 Q7: Capital Budgeting and Income Tax Considerations (Payback) Example Colby Products is considering the purchase of a new machine. The cost is $180,000 and it is expected to last 6 years and have no salvage value. The machine is expected to generate cost savings of $50,000 per year. Colby’s tax rate is 30% and its discount rate is 10%. For simplification, suppose that Colby uses straight-line depreciation for both books and taxes. Compute the payback period of this machine. Cash inflows after taxes [$50,000 x (1 – 30%)]$35,000 Tax savings from depreciation [$30,000 x 30%]9,000 Net after-tax annual cash inflows$44,000 = Payback period = 4.91 years. $180,000 $44,000

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© John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1eSlide # 25 Q7: Capital Budgeting and Income Tax Considerations (Accrual Accounting ROR) Example Colby Products is considering the purchase of a new machine. The cost is $180,000 and it is expected to last 6 years and have no salvage value. The machine is expected to generate cost savings of $50,000 per year. Colby’s tax rate is 30% and its discount rate is 10%. For simplification, suppose that Colby uses straight-line depreciation for both books and taxes. Compute the accrual accounting rate of return of this machine. Cash inflows after taxes [$50,000 x (1 – 30%)]$35,000 Tax savings from depreciation [$30,000 x 30%]9,000 Net after-tax annual increase in operating income$44,000 24.44% accrual accounting ROR = $44,000 $180,000

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© John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1eSlide # 26 Q8: Inflation and NPV Analysis When the purchasing power of the dollar declines over time, it is known as inflation. The real rate of interest does not consider changes in the purchasing power of a dollar. The nominal rate of interest is the rate that investors demand when inflation is taken into consideration in their decisions.

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© John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1eSlide # 27 Q8: Inflation and NPV Analysis The risk-free rate is the rate of interest that is paid on long-term government bonds. The risk premium is the additional rate of return investors demand to compensate them for taking risk. The risk premium increases for riskier investments. The real rate of interest is the nominal rate plus the risk premium demanded for that investment.

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© John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1eSlide # 28 Q8: Nominal and Real Methods of NPV Analysis The real and nominal rates of interest are related as follows: Nominal future cash flows are real cash flows inflated to future dollars: Nominal rate of interest =(1 + real rate) x (1 + inflation rate)- 1 Nominal cash flow = Real cash flow x (1 + i) t, where i = rate of inflation, and t = the number of time periods in the future the cash flow occurs

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© John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1eSlide # 29 Q8: Nominal and Real Methods of NPV Analysis In the real method of NPV analysis, future cash flows are state in real dollars (without considering changes in the purchasing power of the dollar) and a real rate of interest is used as the discount rate. In the nominal method of NPV analysis, future cash flows and the terminal project value must be inflated to future dollars and a nominal rate of interest is used as the discount rate.

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© John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1eSlide # 30 Q8: Real Method of NPV Analysis The depreciation tax shield is calculated in 3 steps: 1.Calculate the annual depreciation deduction for tax purposes, 2.Convert each year’s depreciation deduction from year zero dollars to real dollars by dividing by (1 + inflation rate) t, 3.Multiply the real value of the depreciation deduction times the tax rate. Calculate the NPV for the incremental cash flows, including the tax savings from depreciation, using the real rate of interest.

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© John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1eSlide # 31 Q8: Real Method of NPV Analysis Example Stiles, Inc. is considering the purchase of a new machine. The cost is $400,000 and it is expected to last 6 years and have a salvage value of $80,000. Stiles’ tax rate is 30%, the risk-free rate is 3%, the expected inflation rate is 2%, and Stiles believes that a risk premium of 5% for this machine is appropriate. The machine qualifies as 5-year MACRS property for tax purposes, which means that the depreciation deduction is taken over 6 years at 20%, 32%, 19.2%, 11.52%, 11.52%, and 5.76% of asset cost, respectively. Compute the depreciation tax shield in real dollars for this machine. *this is the nominal depreciation over (1.02) t

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© John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1eSlide # 32 Q8: Real Method of NPV Analysis Example Compute the tax on the gain on the sale of the machine, in real dollars. Note that the tax will be paid in the same year as the disposal, so the $24,000 is already in real dollars. On the prior slide, depreciation deductions taken in years 2 – 6 are based on an investment stated in year 1 dollars, so they were not in real dollars and needed to be deflated.

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© John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1eSlide # 33 Q8: Nominal Method of NPV Analysis Incremental cash inflows and the terminal cash flow must be adjusted (inflated) for inflation. Calculate the gain on asset disposal as the historical cost compared to the nominal depreciation deduction. The nominal and real methods yield the same NPV when the inflation rate is constant over the investment’s life.

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© John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1eSlide # 34 Q8: Nominal Method of NPV Analysis Example Stiles, Inc. is considering the purchase of a new machine. The cost is $400,000 and it is expected to last 6 years and have a salvage value of $80,000. Stiles’ tax rate is 30%, the risk-free rate is 3%, the expected inflation rate is 2%, and Stiles believes that a risk premium of 5% for this machine is appropriate. The machine qualifies as 5-year MACRS property for tax purposes, which means that the depreciation deduction is taken over 6 years at 20%, 32%, 19.2%, 11.52%, 11.52%, and 5.76% of asset cost, respectively. Compute the depreciation tax shield in nominal dollars for this machine.

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© John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1eSlide # 35 Q8: Nominal Method of NPV Analysis Example Compute the tax on the gain on the sale of the machine, in nominal dollars. = (1.02) 6 $400,000 cost less depreciation taken of $400,000

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© John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1eSlide # 36 Q8: Nominal Method of NPV Analysis Example Suppose the machine generates cost savings of $60,000 per year for 6 years. Compute the NPV of the machine using the nominal method.

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