2. Planning for Capital Investments
Chapter 10

3. Capital Investment Decisions
The purchase of long-term operational assets are called capital investments.
Purchase asset
Produce added revenue
The capital investment
decision is essentially
a decision to exchange
current cash outflows for
the promise of receiving
future cash inflows.

4. Typical Capital Budgeting Decisions
Capital budgeting tends to fall into two broad categories . . .
Screening decisions. Does a proposed project meet some present standard of acceptance?
Preference decisions. Selecting from among several competing courses of action.

5. Time Value of Money
A dollar received in the future is of less value than a dollar received today.
A dollar received today could be deposited and earn interest.
Inflation diminishes the buying power of a dollar.
There is an element of risk associated with receiving future dollars.

6. Determining the Minimum Rate of Return
The company’s cost of capital represents the minimum acceptable rate of return on investments.

7. Converting Future Cash Inflows Into Their Equivalent Present Value
Assume that EZ desires to earn a 12% rate of return on all investments.
How much money should EZ be willing to invest today to receive $200,000 in one year?

8. Converting Future Cash Inflows Into Their Equivalent Present Value
Investment + (.12 × Investment) = Future Cash Inflow
1.12 Investment = $200,000
Investment = $178,571*
*rounded to the nearest dollar.

9. Present Value Table for Single Amount Cash Inflows
Part of Table 1 in Appendix A
$200,000 x = $178,571

10. Present Value Table for Annuities
An investment that involves a series of identical cash flows at the end of each year is called an annuity.
$100
$100
$100
$100
$100
$100 1 2 3 4 5 6

11. Time Value of Money
Lacey Co. purchased a tract of land on which a $60,000 payment will be due each year for the next five years. What is the present value of this stream of cash payments when the discount rate is 12%?

12. Time Value of Money $60,000 × 3.604776 = $216,287
We could solve the problem like this . . .
Look at Table 2 in Appendix A for the
Present Value of an Annuity of $1 Table
$60,000 × = $216,287

13. Net Present Value
Carver Hospital is considering the purchase of an attachment for its X-ray machine that will cost $3,170. The attachment will be usable for four years, after which time it will have no salvage value. It will increase net cash inflows by $1,000 per year in the X-ray department. The hospital’s board of directors has instructed that no investments are to be made unless they have an annual return of at least 10%. Will we be allowed to invest in the attachment?

14. Net Present Value
Present value
of an annuity
of $1 table

15. Net Present Value Because the net present value is equal to zero,
the attachment investment provides exactly
a 10% return.

16. Net Present Value

17. Internal Rate of Return
The rate that equates the present value of the cash inflows and outflows. The rate produces a zero net present value.
The internal rate of return is compared to the desired rate of return to see if a project is acceptable.

18. Internal Rate of Return
Decker Company 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.

19. Internal Rate of Return
Future cash flows are the same every year in this example, so we can calculate the internal rate of return as follows:
Factor of the internal
rate of return
Investment required
Net Annual Cash Flows =
$104, 320
$20,000
5.216 =

20. Internal Rate of Return
Using the present value of an annuity of $1 table . . .
Find the 10-period row, move across until you find the factor Look at the top of the column and you find a rate of 14%.

21. Internal Rate of Return
Decker Company 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.
The internal rate of return on this project is 14%.
If the internal rate of return is equal to or greater than the company’s required rate of return, the project is acceptable.

22. Cash Inflows Salvage value Release of working capital Cost Savings
Incremental
revenues

23. Cash Outflows
Working
capital
Initial
investment
Incremental
expenses

24. Comparing Alternative Investment Opportunities
Let’s look at
how we use
present value to
make business
decisions.

25. Net Present Value
Lester Company has been offered a five-year contract to provide component parts for a large manufacturer.

26. Should the contract be accepted?
Net Present Value
At the end of five years the working capital will be released and may be used elsewhere by Lester.
Lester Company uses a discount rate of 10%.
Should the contract be accepted?

27. Annual net cash inflows from operations
Net Present Value
Annual net cash inflows from operations

28. Net Present Value

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

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

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

32. Net Present Value
We should accept the contract because the present value of the cash inflows exceeds the present value of the cash outflows by $85,921. The project has a positive net present value.

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

34. Should White replace the washer?
Net Present Value
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 White replace the washer?

35. Net Present Value
If we install the new washer, the investment will yield a positive net present value of $83,149.

36. Now let’s see what happens if we remodel the existing washer.
Net Present Value
Now let’s see what happens if we
remodel the existing washer.

37. Net Present Value
If we remodel the existing washer, we will produce a positive net present value of $56,348.

38. The Total-Cost Approach
Both projects yield a positive net present value so we need to develop a present value index.
PV Cash Inflows
PV Cash Outflows
PV Index =

39. Net Present Value The index indicates a decision slightly in favor of
PV Index of new
washer =
$411,373
$328,224
1.253
PV Index of
remodeled
washer =
$276,506
$220,158
1.256
The index indicates a decision slightly in favor of
the decision to remodel the exiting washer.

40. Tax Considerations
The effects of income taxes on cash flows must be considered in capital budgeting decisions when an organization is subject to income taxes.
1040

41. Let’s look at an example of a depreciation tax shield.
Tax Considerations
Although depreciation is not a cash flow, it does have an impact on the amount of income taxes that a company will pay. Depreciation deductions shield revenues from taxation and thereby reduce tax payments.
Let’s look at an example of a depreciation tax shield.

42. Tax Considerations
Art and Music Companies are identical except that Art has a $60,000 annual depreciation expense:

43. Tax Considerations
As a result of the depreciation deduction, Art has less net income than Music. But the difference is not $60,000.

44. Let’s look more closely at the difference in net income.
Tax Considerations
Let’s look more closely at the difference in net income.
We can compute the difference in net income as follows:
$60,000 × (1 – .30) = $42,000

45. Depreciation Tax Shield
Tax Considerations
The tax savings provided by the depreciation tax shield is determined like this:
Depreciation Tax Shield
Tax
rate
Depreciation
deduction × =
.30 × $60,000 = $18,000
Depreciation $60,000
Less: tax savings ,000
Difference in income $42,000

46. Modified Accelerated Cost Recovery System (MACRS)
MACRS table of
3 and 5-year assets

47. Modified Accelerated Cost Recovery System (MACRS)
Assumes that all assets enter service halfway through the first year and leave service halfway through the last year (half-year convention).

48. Modified Accelerated Cost Recovery System (MACRS)
Changes from accelerated to straight-line in the year that the straight-line begins to exceed the accelerated depreciation.
Salvage value is not deducted from asset cost when using MACRS.

49. Techniques That Ignore Time Value of Money
Other methods of making capital budgeting decisions include . . .
The Payback Method.
Unadjusted Rate of Return.

50. Payback Method
The payback period is the length of time that it takes for a project to recover its initial cost out of the cash receipts that it generates.
Payback period =
Net Cost of Investment
Annual Net Cash Inflow

51. Compute the payback period for the espresso bar?
Payback Method
Management at The Daily Grind wants to install an espresso bar in its restaurant.
The espresso bar:
Cost $140,000 and has a 10-year life.
Will generate net annual cash inflows of $35,000.
Management requires a payback period of 5 years or less on all investments.
Compute the payback period for the espresso bar?

52. Payback Method
Payback period =
Net Cost of Investment
Annual Net Cash Inflow
$140,000
$35,000
Payback period =
Payback period =
4.0 years
Given management’s decision criterion of a 5-year payback period, The Daily Grind should consider investing in the espresso bar.

53. Interpreting Payback Ignores the time value of money Short-comings
of the Payback
Period.
Provides no
measurement of
profitability of
different
alternatives

54. Unadjusted Rate of Return
Does not focus on cash flows -- rather it focuses on accounting income.
The following formula is used to calculate the simple rate of return:
Unadjusted rate of return =
Average Incremental Increase in
Annual Net Income
Net Cost of Original Investment

55. Unadjusted Rate of Return
Management of The Daily Grind 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 $65,000 including depreciation.
What is the unadjusted rate of return on the investment project?

56. Unadjusted Rate of Return
$100, $65,000
$140,000 =
= 25%
The unadjusted 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.

57. Real-World Reporting Practices

58. Postaudits
A postaudit is a follow-up after the project has been approved to see whether or not expected results are actually realized.

59. End of Chapter 10