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11-1 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Capital Investment Decisions 11 PowerPresentation® prepared by David J. McConomy, Queen’s University

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11-2 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Learning Objectives l Explain what a capital investment decision is and distinguish between independent and mutually exclusive capital investment projects. l Compute the payback period and accounting rate of return for a proposed investment and explain their roles in capital investment decisions.

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11-3 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Learning Objectives (continued) l Use net present value (NPV) analysis for capital investment decisions involving independent projects. l Use the internal rate of return (IRR) to assess the acceptability of independent projects.

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11-4 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Learning Objectives (continued) l Explain why NPV is better than IRR for capital investment decisions involving mutually exclusive projects. l Explain the role and value of postaudits. l Convert gross cash flows to after-tax cash flows. l Describe capital investment in an advanced manufacturing environment.

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11-5 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Capital Budgeting l Capital budgeting is the process of making capital investment decisions. Two types of capital budgeting projects: 1. Independent projects: Projects that, if accepted or rejected, will not affect the cash flows of another project. 2. Mutually exclusive projects: Projects that, if accepted, preclude the accepting all other competing projects.

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11-6 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Payback Method: Uneven Cash Flows Payback Period is the time required to recover a project’s original investment. Example: Investment = $100,000 Unrecovered Annual Cash Investment Flow (beg. Of Year) Year1: $100,000$30,000 2: 70,000$40,000 3: 30,000$50,000 4: --$60,000 5: --$70,000 Payback = 2.6 years. $30,000 (yr. 1) + $40,000 (yr. 2) + $30,000 (60% of yr. 3).

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11-7 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Payback Method Possible reasons for use l To help control the risks associated with the uncertainty of future cash flows l To help minimize the impact of an investment on the company’s liquidity l To help control the risk of obsolescence l To help control the effect of the investment on performance measures

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11-8 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Payback Method Major deficiencies l Ignores the performance of the investment beyond the payback period l Ignores the time value of money

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11-9 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Accounting Rate Of Return (ARR) ARR = Average Income/Investment Average income equals average annual net cash flows, less average amortization. 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?

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11-10 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Accounting Rate Of Return (ARR) (continued) Answer: The average cash flow is $24,000 ($120,000/5) and the average amortization is $16,000 ($80,000/5). ARR=($24,000 - $16,000)/$80,000 =$8,000/$80,000 =10%

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11-11 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Accounting Rate Of Return (ARR) Possible reasons for use l A screening measure to ensure that new investment will not adversely affect financial ratios l To ensure a favourable effect on net income so that bonuses can be earned (increased)

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11-12 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Accounting Rate Of Return (ARR) The major deficiency of the accounting rate of return is that it ignores the time value of money.

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11-13 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Net Present Value (NPV) Definition: NPV = P - I where: P=the present value of the project’s future cash inflows I =the present value of the project’s cost (usually the initial outlay) NPV IS A MEASURE OF THE PROFITABILITY OF AN INVESTMENT, EXPRESSED IN CURRENT DOLLARS.

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11-14 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Net Present Value (NPV): Example Majestic Company has an opportunity to invest $360,000 for new equipment. The new equipment will generate an additional net income of $120,000 per year. Calculate the net present value of the project assuming a 12% discount rate. DiscountPresent YearCash FlowFactorValue 0$(360,000)1.000$(360,000) 1120,000 0.893107,160 2120,000 0.79795,640 3120,0000.71285,440 4120,0000.63676,320 5200,0000.567113,400 $117,960 =====

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11-15 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. 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 project should be accepted.

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11-16 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Decision Criteria for NPV (continued) 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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11-17 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Decision Criteria for NPV (continued) If NPV < 0, this indicates: 1. The initial investment may or may not be recovered 2. The required rate of return has not been recovered Thus, the project should be rejected.

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11-18 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. 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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11-19 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Internal Rate Of Return (IRR) The internal rate of return (IRR) is the discount rate that sets the project’s 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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11-20 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Internal Rate Of Return (IRR) Decision criteria: l If the IRR > Cost of Capital, the project should be accepted. l If the IRR = Cost of Capital, the project breaks even, and acceptance or rejection is equal. l If the IRR < Cost of Capital, the project should be rejected.

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11-21 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Internal Rate Of Return (IRR) Reinvestment Assumption The cash inflows received from the project are immediately reinvested to earn a return equal to the IRR for the remaining life of the project.

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11-22 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. NPV versus IRR There are two major differences between the two approaches: 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 the profitability in relative terms.

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11-23 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. NPV versus IRR (continued) Conflicting Signals (required rate of return) = 20% YearDesign ADesign B 0$(180,000)$(210,000) 160,00070,000 2 60,000 70,000 360,00070,000 460,00070,000 560,00070,000 IRR20%20% NPV$ 36,300 $ 42,350

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11-24 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. NPV versus IRR (continued) Which project should be selected? IRR signals either Design, whereas NPV signals Design B. The terminal value of Design A is $36,300. The terminal value of Design B is $42,350. Design B provides the most wealth and should be selected (AS SIGNALED BY NPV). IRR may be misleading.

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11-25 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Discount Rate: The Cost Of Capital The appropriate discount rate to use for NPV computations is the cost of capital. The COST OF CAPITAL is the weighted average of the returns expected by the different parties contributing funds. The weights are determined by the proportion of funds provided by each source.

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11-26 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Discount Rate: The Cost Of Capital Example: A company is planning on financing a project by borrowing $10,000 and by raising $20,000 by issuing capital stock. The net cost of borrowing is 6% per year. The stock carries an expected return of 9%. The sources of capital for this project and their cost are in the same proportion and amounts that the company usually experiences. Calculate the cost of capital. SourceAmountCostWeightCost x Weight Debt$10,0006%1/32% Stock20,0009%2/36% Weighted-Average Cost of Capital8% ===

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11-27 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Inflationary Adjustment An Illustrative Example Assume that the rate of inflation is 15% per year. Analysis without Inflationary Adjustment (assumes a 20% discount rate) YearCash Flow Discount Factor Present Value 0(5,000,000)1.000 (5,000,000) 1-22,900,0001.528 4,431,200 NPV (568,800) ======== Analysis with Inflationary Adjustment YearCash Flow Discount Factor Present Value 0(5,000,000)1.000 (5,000,000) 13,335,000* 0.833 2,778,055 23,835,250**0.694 2,661,664 NPV 439,719 ======== *1.15 x $2,900,000 **1.15 x 1.15 x $2,900,000 Notice that adjustment for inflation can affect the decision.

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11-28 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. After-Tax Operating Cash Flows The Income Approach After-tax cash flow = After-tax net income + Noncash expenses Example: Revenues$1,000,000 Less: Operating expenses* 600,000 Income before taxes$ 400,000 Less: Income taxes 136,000 Net income$ 264,000 ======== * Includes $100,000 amortization expense After-tax cash flow=$264,000 + $100,000 =$364,000

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11-29 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. After-Tax Flows Decomposition Approach After-tax cash revenues= (1 - Tax rate) x Cash revenues After-tax cash expenses= (1 - Tax rate) x Cash expenses Tax savings (noncash expenses)= (Tax rate) x Noncash expenses Total operating cash = after-tax cash revenues - after-tax cash expenses + tax savings on noncash expenses Example: Revenues = $1,000,000, cash expenses = $500,000, and amortization = $100,000. Tax rate = 34%. After-tax cash revenues(1 -.34) x ($1,000,000)=$660,000 Less: After-tax cash expense(1 -.34) x ($500,000)=(330,000) Add: Tax savings (noncash exp.).34 x ($100,000)= 34,000 Total $364,000 =======

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11-30 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Amortization Tax-Shielding Effect Amortization is a noncash expense and is not a cash flow. Amortization, 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 amortization to be deducted to arrive at taxable income. If a company had before-tax operating cash flows of $300,000 and amortization of $100,000, we have the following statement: Net operating cash flows$ 300,000 Less: amortization 0 Taxable income$ 300,000 Less: Income taxes (@ 34%) (102,000) Net income$ 198,000 ========

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11-31 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Amortization Tax-Shielding Effect Now assume that the tax laws allow a deduction for amortization: Net operating cash flows$300,000 Less: Amortization 100,000 Taxable income$200,000 Less: Income taxes (@ 34%) (68,000) Net income$132,000 ======= 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 amortization claimed:.34 x $100,000 = $34,000

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11-32 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Tax Laws: Capital Cost Allowance l In Canada, amortization is not allowed as a deduction in determining taxable income, but l Capital cost allowance is allowed as a deduction instead. CCA is similar to amortization but is governed by a special set of rules dictated by the income tax act and regulations. l Each capital asset is assigned to a capital asset class along with other similar assets l A pre-determined CCA rate applies to the balance of the capital cost in a particular class l There are currently more than 40 separate classes, each with a specific maximum rate l CCA applies a declining-balance system, and the size of the tax shield will be different for each year l CCA applies to an asset pool in a given class. If there are other assets in the class, a project may continue to affect the firm’s cash flows even after the project’s assets are retired.

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11-33 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Capital Cost Allowance - A Sample of Asset Tax Classes

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11-34 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Capital Cost Allowance Present Value of CCA Tax Shield = (R x C x T) / (R + i) WhereExample R = CCA (R)ate30% C = Original (C)apital cost of the project $300,000 T = (T)ax rate40% i = Required rate of return [(i)nterest factor]10% PV of CCA Tax Shield = (30% x 300,000 x 40%) / (30% + 10%) = $90,000

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11-35 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. APPENDIX A

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11-36 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Future Value: Time Value of Money Let: F=future value i=the interest rate P=the present value or original outlay n=the number or periods Future value can be expressed by the following formula: F = P(1 + i) n

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11-37 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Future Value: Example 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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11-38 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Future Value (continued) F=$1,000(1.08)=$1,080.00 (after one year) F=$1,000(1.08) 2 =$1,166.40 (after two years) F=$1,000(1.08) 3 =$1,259.71 (after three years)

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11-39 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Present Value P = F/(1 + i) n The discount factor, 1/(1 + i), is computed for various combinations of I and n. See Exhibit 11B-1. Example:Compute the present value of $300 to be received three years from now. The interest rate is 12%. Answer: From Exhibit 11B-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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11-40 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Present Value (continued) 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: DiscountPresent YearCashFactorValue 1$1000.893$ 89.30 21000.79779.70 31000.712 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 11 B-2 for these sums which can be used as discount factors for uniform series.

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