Capital Expenditure Decisions Chapter 16 Capital Expenditure Decisions

Discounted-Cash-Flow Analysis Plant expansion Equipment selection Equipment replacement Cost reduction Lease or buy Learning Objective 1

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 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. 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. Learning Objective 2

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.

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. Learning Objectives 3 – 10 can be found in the Text Book