Planning for Capital Investments Chapter 10

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-2 Capital Investment Decisions The purchase of long-term operational assets are called capital investments. The capital investment decision is essentially a decision to exchange current cash outflows for the promise of receiving future cash inflows. The capital investment decision is essentially a decision to exchange current cash outflows for the promise of receiving future cash inflows. Purchase asset Produce added revenue

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-3 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.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-4 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.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-5 Determining the Minimum Rate of Return The company’s cost of capital represents the minimum acceptable rate of return on investments.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-6 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?

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-7 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.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-8 Present Value Table for Single Amount Cash Inflows Part of Table 1 in Appendix A $200,000 x = $178,571

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-9 Present Value Table for Annuities annuity 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

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 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%?

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada Time Value of Money 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

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 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?

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada Net Present Value Present value of an annuity of $1 table Present value of an annuity of $1 table

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada Net Present Value Because the net present value is equal to zero, the attachment investment provides exactly a 10% return. Because the net present value is equal to zero, the attachment investment provides exactly a 10% return.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada Net Present Value General decision rule...

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 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.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 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.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 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: Investment required Investment required Net Annual Cash Flows Net Annual Cash Flows Factor of the internal rate of return = $104, 320 $20,000 = 5.216

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada Internal Rate of Return 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%. Using the present value of an annuity of $1 table...

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 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.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada Cash Inflows CostSavingsSalvagevalueIncrementalrevenues Release of workingcapital

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada Cash Outflows Initialinvestment Increase in operatingexpenses Workingcapital

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada Comparing Alternative Investment Opportunities Let’s look at how we use present value to make business decisions.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada Net Present Value Lester Company has been offered a five-year contract to provide component parts for a large manufacturer.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 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?

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada Net Present Value Annual net cash inflows from operations

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada Net Present Value

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada Net Present Value Present value of an annuity of $1 factor for 5 years at 10%. Present value of an annuity of $1 factor for 5 years at 10%.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada Net Present Value Present value of $1 factor for 3 years at 10%. Present value of $1 factor for 3 years at 10%.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada Net Present Value Present value of $1 factor for 5 years at 10%.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada Net Present Value positive 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.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 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%.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 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?

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada Net Present Value If we install the new washer, the investment will yield a positive net present value of $83,149.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada Net Present Value Now let’s see what happens if we remodel the existing washer.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada Net Present Value If we remodel the existing washer, we will produce a positive net present value of $56,348.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada The Total-Cost Approach Both projects yield a positive net present value so we need to develop a present value index. PV Index PV Cash Inflows PV Cash Outflows =

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada Net Present Value PV Index of remodeled washer == $276,506 $220, PV Index of new washer == $411,373 $328, The index indicates a decision slightly in favor of the decision to remodel the exiting washer. The index indicates a decision slightly in favor of the decision to remodel the exiting washer.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 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

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada Tax Considerations Although amortization is not a cash flow, it does have an impact on the amount of income taxes that a company will pay. Amortization deductions shield revenues from taxation and thereby reduce tax payments. Let’s look at an example of a amortization tax shield.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada Tax Considerations Art and Music Companies are identical except that Art has a $60,000 annual amortization expense:

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada Tax Considerations As a result of the amortization deduction, Art has less net income than Music. But the difference is not $60,000.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada Tax Considerations Let’s look more closely at the difference in net income. $60,000 × (1 –.30) = $42,000 We can compute the difference in net income as follows:

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada Tax Considerations The tax savings provided by the amortization tax shield is determined like this: Amortization Tax Shield =.30 × $60,000 = $18,000 Tax rate Amortization deduction × Amortization $60,000 Less: tax savings 18,000 Difference in income $42,000 Amortization $60,000 Less: tax savings 18,000 Difference in income $42,000

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada Techniques That Ignore Time Value of Money Other methods of making capital budgeting decisions include...  The Payback Method.  Unadjusted Rate of Return.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada Payback Method payback period 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 Net Cost of Investment Annual Net Cash Inflow Annual Net Cash Inflow

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 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?

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada Payback Method Payback period = $140,000 $140,000 $35,000 $35,000 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. Payback period = Net Cost of Investment Net Cost of Investment Annual Net Cash Inflow Annual Net Cash Inflow

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada Provides no measurement of profitability of differentalternatives Interpreting Payback Ignores the time value of money Short-comings of the Payback Period.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada Unadjusted Rate of Return accounting income 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

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 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?

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada Unadjusted Rate of Return Unadjusted rate of return $100,000 - $65,000 $100,000 - $65,000 $140,000 $140,000 = 25% = 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.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada Real-World Reporting Practices

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada Postaudits A postaudit is a follow-up after the project has been approved to see whether or not expected results are actually realized.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada End of Chapter 10