Capital Expenditure Decisions Chapter 16 Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Learning Objective

Discounted-Cash-Flow Analysis Cost reduction Plant expansion Equipment selection Lease or buy Equipment replacement 16-3

Net-Present-Value Method o Prepare a table showing cash flows for each year, o Calculate the present value of each cash flow using a discount rate, o Compute net present value, o If the net present value (NPV) is positive, accept the investment proposal. Otherwise, reject it. o Prepare a table showing cash flows for each year, o Calculate the present value of each cash flow using a discount rate, o Compute net present value, o If the net present value (NPV) is positive, accept the investment proposal. Otherwise, reject it. 16-4

Net-Present-Value Method Mattson Co. has been offered a five year contract to provide component parts for a large manufacturer. 16-5

Net-Present-Value Method At the end of five years the working capital will be released and may be used elsewhere by Mattson. Mattson uses a discount rate of 10%. Should the contract be accepted? At the end of five years the working capital will be released and may be used elsewhere by Mattson. Mattson uses a discount rate of 10%. Should the contract be accepted? 16-6

Net-Present-Value Method Annual net cash inflows from operations 16-7

Net-Present-Value Method positive 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 positive net present value. 16-8

Internal-Rate-of-Return Method The internal rate of return is the true economic return earned by the asset over its life. The internal rate of return is computed by finding the discount rate that will cause the net present value of a project to be zero. The internal rate of return is the true economic return earned by the asset over its life. The internal rate of return is computed by finding the discount rate that will cause the net present value of a project to be zero. 16-9

Internal-Rate-of-Return Method Black Co. can purchase a new machine at a cost of $104,320 that will save $20,000 per year in cash operating costs. The machine has a 10-year life. Black Co. can purchase a new machine at a cost of $104,320 that will save $20,000 per year in cash operating costs. The machine has a 10-year life

Internal-Rate-of-Return Method Future cash flows are the same every year in this example, so we can calculate the internal rate of return as follows: Investment required Investment required Net annual cash flows Net annual cash flows = Present value factor = Present value factor $104, 320 $104, 320 $20,000 $20,000 =

Internal-Rate-of-Return Method $104, 320 $104, 320 $20,000 $20,000 = The present value factor (5.216) is located on the Table IV in the Appendix. Scan the 10- period row and locate the value Look at the top of the column and you find a rate of 14% which is the internal rate of return

Internal-Rate-of-Return Method Here’s the proof

Learning Objective

Comparing the NPV and IRR Methods Internal Rate of Return vThe cost of capital is compared to the internal rate of return on a project. vTo be acceptable, a project’s rate of return must be greater than the cost of capital. Net Present Value vThe cost of capital is used as the actual discount rate. vAny project with a negative net present value is rejected. Net Present Value vThe cost of capital is used as the actual discount rate. vAny project with a negative net present value is rejected

Comparing the NPV and IRR Methods The net present value method has the following advantages over the internal rate of return method... 4 Easier to use. 4 Easier to adjust for risk. The net present value method has the following advantages over the internal rate of return method... 4 Easier to use. 4 Easier to adjust for risk

Assumptions Underlying Discounted-Cash-Flow Analysis All cash flows are treated as though they occur at year end. Cash flows are treated as if they are known with certainty. Cash inflows are immediately reinvested at the required rate of return. Assumes a perfectcapitalmarket

Choosing the Hurdle Rate The discount rate generally is associated with the company’s cost of capital. The cost of capital involves a blending of the costs of all sources of investment funds, both debt and equity

Learning Objective

Comparing Two Investment Projects To compare competing investment projects we can use the following net present value approaches: –Total-Cost Approach. –Incremental-Cost Approach

Total-Cost Approach Each system would last five years. 12 percent hurdle rate for the analysis. MAINFRAME PC _ Salvage value old system$ 25,000$ 25,000 Cost of new system(400,000)(300,000) Cost of new software( 40,000)( 75,000) Update new system( 40,000)( 60,000) Salvage value new system 50,000 30,000 ================================================ Operating costs over 5-year life: Personnel(300,000)(220,000) Maintenance( 25,000)( 10,000) Other costs( 10,000)( 5,000) Datalink services( 20,000)( 20,000) Revenue from time-share 25,

Total-Cost Approach MAINFRAME ($)Today Year 1 Year 2 Year 3 Year 4 Year 5 Acquisition cost computer(400,000) Acquisition cost software ( 40,000) System update ( 40,000) Salvage value 50,000 Operating costs(335,000) (335,000) (335,000) (335,000) (335,000) (335,000) Time sharing revenue 20,000 20,000 20,000 20,000 20,000 20,000 Total cash flow 440,000 (315,000) (315,000) (355,000) (315,000) (265,000) X Discount factorX X.893 X.797 X.712 X.636 X.567 Present value (440,000) (281,295) (251,055) (252,760) (200,340) (150,255) SUM = ($1,575,705) PERSONAL COMPUTER ($)Today Year 1 Year 2 Year 3 Year 4 Year 5 Acquisition cost computer(300,000) Acquisition cost software ( 75,000) System update ( 60,000) Salvage value 50,000 Operating costs(235,000) (235,000) (235,000) (235,000) (235,000) (235,000) Time sharing revenue _ Total cash flow 375,000 (235,000) (235,000) (295,000) (235,000) (205,000) X Discount factorX X.893 X.797 X.712 X.636 X.567 Present value (375,000) (209,855) (187,295) (210,040) (149,460) (116,235) SUM = ($1,247,885) 16-22

Total-Cost Approach Net cost of purchasing Mainframe system ($1,575,705) Net cost of purchasing Personal Computer system ($1,247,885) Net Present Value of costs ($ 327,820) Mountainview should purchase the personal computer system for a cost savings of $327,

Incremental-Cost Approach INCREMENTAL ($) Today Year 1 Year 2 Year 3 Year 4 Year 5 Acquisition cost computer(100,000) Acquisition cost software 35,000 System update 20,000 Salvage value 20,000 Operating costs (100,000) (100,000) (100,000) (100,000) (100,000) Time sharing revenue 20,000 20,000 20,000 20,000 20,000 20,000 Total cash flow( 65,000) ( 80,000) ( 80,000) ( 80,000) ( 80,000) ( 60,000) X Discount factorX X.893 X.797 X.712 X.636 X.567 Present value ( 65,000) ( 71,440) ( 63,760) ( 42,720) ( 50,880) ( 34,020) SUM = ($ 327,820) 16-24

Total-Incremental Cost Comparison Total Cost: Net cost of purchasing Mainframe system ($1,575,705) Net cost of purchasing Personal Computer system ($1,247,885) Net Present Value of costs ($ 327,820) Incremental Cost: Net Present Value of costs ($ 327,820) Different methods, Same results

Managerial Accountant’s Role Managerial accountants are often asked to predict cash flows related to operating cost savings, additional working capital requirements, and incremental costs and revenues. When cash flow projections are very uncertain, the accountant may increase the hurdle rate, 2. use sensitivity analysis

Postaudit of Investment Projects A postaudit is a follow-up after the project has been approved to see whether or not expected results are actually realized

Learning Objective

Income Taxes and Capital Budgeting Cash flows from an investment proposal affect the company’s profit and its income tax liability. Income = Revenue - Expenses + Gains - Losses 16-29

After-Tax Cash Flows The tax rate is 40%, so income taxes are $525,000 × 40% = $ 210,000 The tax rate is 40%, so income taxes are $525,000 × 40% = $ 210,000 High Country Department Stores Income Statement For the Year Ended Jun 30, 2007 Revenue$ 1,000,000 Expenses (475,000) Income before taxes 525,000 Income taxes (210,000) Net Income 315,000 Not all expenses require cash outflows. The most common example is depreciation

Learning Objective

Modified Accelerated Cost Recovery System (MACRS) Tax depreciation is usually computed using MACRS. Here are the depreciation rate for 3, 5, and 7-year class life assets

Learning Objective

Investment in Working Capital Some investment proposals require additional outlays for working capital such as increases in cash, accounts receivable, and inventory

Extended Illustration For a complete present value analysis for an investment decision facing High Country Department Stores, Inc., see the textbook. High Country Department Stores 16-35

Learning Objective

Ranking Investment Projects We can invest in either of these projects. Use a 10% discount rate to determine the net present value of the cash flows. The total cash flows are the same, but the pattern of the flows is different

Ranking Investment Projects Let’s calculate the present value of the cash flows associated with Project A. This project has a positive net present value which means the project’s return is greater than the discount rate. This project has a positive net present value which means the project’s return is greater than the discount rate

Ranking Investment Projects Here is the net present value of the cash flows associated with Project B. Project B has a negative net present value which means the project’s return is less than the discount rate. Project B has a negative net present value which means the project’s return is less than the discount rate

Learning Objective

Alternative Methods for Making Investment Decisions Payback Method Paybackperiod Initial investment Initial investment Annual after-tax cash inflow = Paybackperiod = $20,000 $20,000$4,000 = 5 years A company can purchase a machine for $20,000 that will provide annual cash inflows of $4,000 for 7 years. A company can purchase a machine for $20,000 that will provide annual cash inflows of $4,000 for 7 years

Payback: Pro and Con 1.Fails to consider the time value of money. 2.Does not consider a project’s cash flows beyond the payback period. 1.Fails to consider the time value of money. 2.Does not consider a project’s cash flows beyond the payback period. 1.Provides a tool for roughly screening investments. 2.For some firms, it may be essential that an investment recoup its initial cash outflows as quickly as possible. 1.Provides a tool for roughly screening investments. 2.For some firms, it may be essential that an investment recoup its initial cash outflows as quickly as possible

Accounting-Rate-of-Return Method Discounted-cash-flow method focuses on cash flows and the time value of money. Accounting-rate-of-return method focuses on the incremental accounting income that results from a project. Discounted-cash-flow method focuses on cash flows and the time value of money. Accounting-rate-of-return method focuses on the incremental accounting income that results from a project

Accounting-Rate-of-Return Method The following formula is used to calculate the accounting rate of return: Accounting rate of return = Average Average Average Average incremental incremental expenses, revenues including depreciation & revenues including depreciation & income taxes - Initial investment 16-44

Accounting-Rate-of-Return Method Meyers Company wants to install an espresso bar in its restaurant. The espresso bar: –Cost $140,000 and has a 10-year life. –Will generate incremental revenues of $100,000 and incremental expenses of $80,000 including depreciation. What is the accounting rate of return on the investment project? Meyers Company wants to install an espresso bar in its restaurant. The espresso bar: –Cost $140,000 and has a 10-year life. –Will generate incremental revenues of $100,000 and incremental expenses of $80,000 including depreciation. What is the accounting rate of return on the investment project? 16-45

Accounting-Rate-of-Return Method The accounting rate of return method is not recommended for a variety of reasons, the most important of which is that it ignores the time value of money. The accounting rate of return method is not recommended for a variety of reasons, the most important of which is that it ignores the time value of money. Accounting rate of return $100,000 - $80,000 $100,000 - $80,000 $140,000 $140,000 = 14.3% = 14.3%= 16-46

Learning Objective

Estimating Cash Flows: The Role of Activity-Based Costing ABC systems generally improve the ability of an analyst to estimate the cash flows associated with a proposed project

Justification of Investments in Advanced Manufacturing Systems Hurdle rates are too high Hurdle rates are too high Timehorizons are too shortTimehorizons short BiastowardsincrementalprojectsBiastowardsincrementalprojects Greater cash flow uncertaintyGreater uncertainty Benefits difficult to quantifyBenefits quantify 16-49

Learning Objective

Inflation Effects Nominal Dollars Real dollars Nominal Dollars Real dollars 16-51

End of Chapter