Capital Expenditure Decisions 16 Chapter Sixteen Capital Expenditure Decisions

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

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

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

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?

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

Net-Present-Value Method

Net-Present-Value Method Present value of an annuity of $1 factor for 5 years at 10%.

Net-Present-Value Method Present value of $1 factor for 3 years at 10%.

Net-Present-Value Method Present value of $1 factor for 5 years at 10%.

Net-Present-Value Method 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.

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.

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.

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 Net annual cash flows = Present value factor $104, 320 $20,000 = 5.216

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

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

Comparing the NPV and IRR Methods Net Present Value The cost of capital is used as the actual discount rate. Any project with a negative net present value is rejected.

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

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

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

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.

Depreciable Assets Both the NPV and IRR methods focus on cash flows, and periodic depreciation charges are not cash flows . . . Tax Return Form 1120 Depreciation is tax deductible and . . . Reduces cash outflows for taxes.

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 Black Co. is trying to decide whether to remodel an old car wash or remove it entirely and install a new one. The company uses a discount rate of 10%.

Should Black replace the washer? Total-Cost Approach The new washer costs $300,000 and will produce revenues for 10 years. The brushes have to be replaced at the end of 6 years at a cost of $50,000. The old washer has a current salvage value of $40,000. The estimated salvage value of the new washer will be $7,000 at the end of 10 years. Remodeling the old washer costs $175,000 and the brushes must be replaced at the end of 6 years at a cost of $80,000 . Should Black replace the washer?

Total-Cost Approach If Black Co. installs the new washer, the investment will yield a positive net present value of $83,202.

Total-Cost Approach If Black Co. remodels the existing washer, it will produce a positive net present value of $56,405.

Total-Cost Approach Both projects yield a positive net present value. However, investing in the new washer will produce a higher net present value than remodeling the old washer.

Incremental-Cost Approach Under the incremental-cost approach, only those cash flows that differ between the two alternatives are considered. Let’s look at an analysis of the Black Co. decision using the incremental-cost approach.

Incremental-Cost Approach $300,000 new - $175,000 remodel = $125,000

Incremental-Cost Approach $80,000 remodel - $50,000 new = $30,000

Incremental-Cost Approach $60,000 new - $45,000 remodel = $15,000

Incremental-Cost Approach We get the same answer under either the total-cost and incremental-cost approach.

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, 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.

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 18 26

The tax rate is 28%, so income taxes are After-Tax Cash Flows The tax rate is 28%, so income taxes are $525,000 × 28% = $147,000

Cash Revenues High Country’s management is considering the purchase of a new truck that will increase cash revenues by $110,000 and increase cash cost of goods sold by $60,000. The company is subject to a tax rate of 28%. Let’s calculate the company’s after-tax cash flows.

Cash Revenues $50,000 × 28% = $14,000

Noncash Expenses Not all expenses require cash outflows. The most common example is depreciation. Recall that High Country’s proposal involved the purchase of a truck. The truck cost $40,000 and will be depreciated over four years using straight-line depreciation. The truck is to be purchased on June 30, 2001. One-half year depreciation is taken in 2001.