Chapter Fourteen Capital Investment Decisions COPYRIGHT © 2012 Nelson Education Ltd.

Learning Objectives 1.Explain the meaning of capital investment decisions, and distinguish between independent and mutually exclusive capital investment decisions 2.Compute the payback period and accounting rate of return for a proposed investment, and explain their roles in capital investment decisions 3.Use net present value analysis for capital investment decisions involving independent projects 4.Use the internal rate of return to assess the acceptability of independent projects 5.Incorporate the tax shield into capital expenditure analysis 6.Explain the role and value of postaudits 7.Explain why net present value is better than internal rate of return for capital investment decisions involving mutually exclusive projects 14-2

OBJECTIVE  1 1 Explain the meaning of capital investment decisions, and distinguish between independent and mutually exclusive capital investment decisions

COPYRIGHT © 2012 Nelson Education Ltd. Capital Investment Decisions Long range decisions involving opportunities to invest in new assets or projects Among the most important decisions made by managers Place large amounts of resources at risk for long periods of time Affect firm’s future development Decision making process is called “capital budgeting” 14-4

COPYRIGHT © 2012 Nelson Education Ltd. Capital Budgeting Managers must decide whether or not a capital investment will: –Earn back its original outlay and provide a reasonable return To make a capital investment decision, managers must: –Make estimates of the quantity and timing of after- tax cash flows –Assess the risk of the investment –Consider the impact of the project on the firm’s profits 14-5

COPYRIGHT © 2012 Nelson Education Ltd. Capital Budgeting Two types: –Independent projects (“Mutually exclusive projects”) If accepted or rejected, do not affect the cash flows of other projects –Competing projects Acceptance of one alternative precludes the acceptance of another 14-6

COPYRIGHT © 2012 Nelson Education Ltd. Making Capital Investment Decisions Managers must: –Set goals –Set priorities for capital investments –Establish basic criteria for acceptance or rejection of proposed investments Two types of methods: –Nondiscounting models Do not consider time value of money Two methods: Payback period & Accounting rate of return –Discounting models Use time value of money Two methods: Net Present Value and Internal Rate of Return 14-7

OBJECTIVE  2 2 Compute the payback period and accounting rate of return for a proposed investment, and explain their roles in capital investment decisions

COPYRIGHT © 2012 Nelson Education Ltd. Payback Period Time required for a firm to recover its original investment If investment generates even cash flows –Formula: If investment generates uneven cash flows –Formula: Add cash flows until original investment is recovered 14-9 Original investment / Annual cash flow Payback period =

COPYRIGHT © 2012 Nelson Education Ltd. Analyzing Payback Periods Set a maximum payback period Rough measure of risk Firms with riskier cash flows could require shorter payback periods than normal Firms with liquidity problems need quicker paybacks Shortest payback period is preferred 14-10

COPYRIGHT © 2012 Nelson Education Ltd. Uses of Payback Method Information can be used to help: –Control risks associated with uncertainty of future cash flows –Minimize impact of an investment on a firm’s liquidity problems –Control risk of obsolescence –Control effect of investment on performance measures 14-11

COPYRIGHT © 2012 Nelson Education Ltd. Example: Cornerstone 14-1 A new car wash facility requires an investment of $100,000 and either has: –Even cash flows of $50,000 per year or –The following expected annual cash flows: Information: HOW TO Calculate Payback $30,000$60,000 $40,000$70,000 $50,000 Required: Calculate the payback period for each case

COPYRIGHT © 2012 Nelson Education Ltd. Example Even cash flows of $50,000 per year = $100,000 / $50,000 = Original investment / Annual cash flow Payback period = 2 years 14-13

COPYRIGHT © 2012 Nelson Education Ltd. Example Uneven cash flows Year Unrecovered Investment ($) Beginning of year Annual Cash Flow ($) Time Needed for Payback (years) 1100,00030, The payback period will include the entire second year 270,00040, The payback period will include the entire first year

COPYRIGHT © 2012 Nelson Education Ltd. Example Uneven cash flows Year Unrecovered Investment ($) Beginning of year Annual Cash Flow ($) Time Needed for Payback (years) 1100,00030, $30,000 + $50,000 Initial investment would be completely recovered 60% of the way through year 3 270,00040, ,00050, There is $30,000 still to recover as the third year begins

COPYRIGHT © 2012 Nelson Education Ltd. Uneven cash flows Year Unrecovered Investment ($) Beginning of year Annual Cash Flow ($) Time Needed for Payback (years) 1100,00030, ,00040, ,00050, , , years Example 14-16

COPYRIGHT © 2012 Nelson Education Ltd. Accounting Rate of Return Measures return on a project in terms of income as opposed to using cash flow Formula: Average income is not the same as cash flows Formula: Add net income for each year of the project and divide by the number of years Average income / Initial investment Accounting Rate of Return = 14-17

COPYRIGHT © 2012 Nelson Education Ltd. Example: Cornerstone 14-2 An investment requires an initial outlay of $100,000 Life of the investment is five years Net Income stream: Information: HOW TO Calculate the Accounting Rate of Return $30,000 $50,000 $40,000 Required: Calculate the accounting rate of return 14-18

COPYRIGHT © 2012 Nelson Education Ltd. Example = $36,000 = Average Net Income / Initial Investment Accounting Rate of Return = 0.36 or 36% / $100, Averaging the net incomes: $30,000 + $30,000 + $40,000 + $30,000 + $50,000 = $180,000 $180,000 ÷ 5 = $36,000

OBJECTIVE  3 3 Use net present value analysis for capital investment decisions involving independent projects

COPYRIGHT © 2012 Nelson Education Ltd. Net Present Value (NPV) Difference between present value of cash inflows and outflows associated with a project Measures net cash flows of project Size of the positive NPV measures increase in value of firm resulting from an investment A required rate of return must be defined –Minimum acceptable rate of return 14-21

COPYRIGHT © 2012 Nelson Education Ltd. Evaluating Net Present Value (NPV) If NPV is positive: –Rate of return on investment is greater than the required rate of return –Investment, the minimum rate of return, and a return in excess of profit are all recovered –Investment is acceptable 14-22

COPYRIGHT © 2012 Nelson Education Ltd. Evaluating Net Present Value (NPV) If NPV is zero: –Rate of return on the investment is exactly the required rate of return –Investment and minimum rate of return are recovered –Decision maker will be ambivalent regarding acceptance or rejection 14-23

COPYRIGHT © 2012 Nelson Education Ltd. Evaluating Net Present Value (NPV) If NPV is negative: –Rate of return is less than required rate of return –Investment cost may or may not be recovered, and minimum rate of return is not recovered –Initial investment should be rejected 14-24

COPYRIGHT © 2012 Nelson Education Ltd. Example: Cornerstone 14-3 Expected annual earphone revenues, $300,000 Equipment to produce earphones will cost $320,000 After five years, the equipment can be sold for $40,000 Working capital is expected to increase by $40,000 because of increases in inventories and receivables Recovery of investment in working capital is expected at the end of the project’s life Annual cash operating expenses are estimated at $180,000 Required rate of return is 12% Information: HOW TO Assess Cash Flows and Calculate Net Present Value Estimate the annual cash flows, and calculate the NPV Required:

COPYRIGHT © 2012 Nelson Education Ltd. Example Step 1 Cash Flow Identification YearItemCash Flow 0Equipment$(320,000) Working Capital(40,000) Total $(360,000) $360,000 is spent to get the equipment ready The inflows over the next 5 years need to recoup this cost and earn a profit for the firm 14-26

COPYRIGHT © 2012 Nelson Education Ltd. Example Step 1 Cash Flow Identification YearItemCash Flow 0Equipment$(320,000) Working Capital(40,000) Total $(360,000) Revenues1 - 4$ 300,000 Operating expenses(180,000) Total$ 120,000 In the first 4 years, the asset will provide net inflows of $120,000 per year 14-27

COPYRIGHT © 2012 Nelson Education Ltd. Example Step 1 Cash Flow Identification YearItemCash Flow 0Equipment$(320,000) Working Capital(40,000) Total $(360,000) Revenues1 - 4$ 300,000 Operating expenses(180,000) Total$ 120,000 5 Revenues$ 300,000 Operating expenses(180,000) Salvage40,000 Recovery of working capital40,000 Total$ 200, Sale of equipment in year 5

COPYRIGHT © 2012 Nelson Education Ltd. Example Step 2A: Net Present Value Analysis YearCash Flow Present Value Discount Factor 0$(360,000) $(360,000) Since the equipment is paid for now, the amount paid is its present value 14-29

COPYRIGHT © 2012 Nelson Education Ltd. Example Step 2A: Net Present Value Analysis YearCash Flow Present Value Discount Factor 0$(360,000) $(360,000) 1120, ,143 1 ÷ (1 + 12%) 1 or Exhibit 14B

COPYRIGHT © 2012 Nelson Education Ltd. Example Step 2A: Net Present Value Analysis YearCash Flow Present Value Discount Factor 0$(360,000) $(360,000) 1120, , , ,663 1 ÷ (1 + 12%) 2 or Exhibit 14B

COPYRIGHT © 2012 Nelson Education Ltd. Example Step 2A: Net Present Value Analysis YearCash Flow Present Value Discount Factor 0$(360,000) $(360,000) 1120, , , , , , , , , ,486 $117,968 Net Present Value 14-32

COPYRIGHT © 2012 Nelson Education Ltd. Example Step 2B: Net Present Value Analysis YearCash Flow Present Value Discount Factor 0$(360,000) $(360,000) , ,482 Since years 1 through 4 have the same cash flow, we can use the Exhibit 14B-2 or the PV annuity formula: 1/12%[1 – 1 ÷ (1 + 12%) 4 ] 14-33

COPYRIGHT © 2012 Nelson Education Ltd. Example Step 2B: Net Present Value Analysis YearCash Flow Present Value Discount Factor 0$(360,000) $(360,000) , , , ,486 Net Present Value $117,968 Using an annuity table generates the same NPV as discounting the cash flows for each year separately (difference due to rounding) 14-34

OBJECTIVE  4 4 Use the internal rate of return to assess the acceptability of independent projects

COPYRIGHT © 2012 Nelson Education Ltd. Internal Rate of Return (IRR) Interest rate that sets the project’s NPV to zero –Formula: Can use trial and error or PV tables If IRR > Required rate of return –Project is deemed acceptable If IRR < Required rate of return –Project is rejected I = ∑CF t / (1 + i) t

COPYRIGHT © 2012 Nelson Education Ltd. HOW TO Calculate Internal Rate of Return with Uniform Cash Flows Example: Cornerstone 14-4 Hospital has opportunity to invest $205, in a new ultrasound system It will produce net cash inflows of $50,000 at the end of each year for the next six years Information: Required: Calculate the IRR for the ultrasound system

COPYRIGHT © 2012 Nelson Education Ltd. Example Internal Rate of Return Discount factor = Investment / Annual Cash Flow = $202,570.50/ $50,000 = Using the PV of an Annuity table Looking along the 6 period line, is found in the 12% column. IRR is 12% 14-38

OBJECTIVE  5 5 Incorporate the tax shield into capital expenditure analysis

COPYRIGHT © 2012 Nelson Education Ltd. Capital Expenditures and Income Tax Tax treatment of cash inflows and outflows can have a drastic impact on capital expenditure analysis Many companies incorporate a “tax shield” using the following formula: PV = Cdt d+k 1+0.5k 1+k × Where: C is cost of the asset d is CA rate t is rate k is minimum acceptable rate of return.

OBJECTIVE  6 6 Explain the role and value of postaudits

COPYRIGHT © 2012 Nelson Education Ltd. Postaudit of Capital Projects Follow-up analysis of project once it is implemented Should be completed by independent party Compares: –Actual benefits to estimated benefits –Actual operating costs to estimated costs Evaluates overall investment outcome Proposed corrective action if needed 14-42

COPYRIGHT © 2012 Nelson Education Ltd. Benefits of a Postaudit Ensures assets are used wisely Managers held accountable: –More likely to make decisions in firm’s best interest –Feedback is used in future decision making 14-43

COPYRIGHT © 2012 Nelson Education Ltd. Drawbacks of a Postaudit Costly Limitations: –Assumption driving original analysis may often be invalidated by changes in the actual operating environment Accountability must be qualified: –By the impossibility of foreseeing every possible eventuality 14-44

OBJECTIVE  7 7 Explain why net present value is better than internal rate of return for capital investment decisions involving mutually exclusive projects

COPYRIGHT © 2012 Nelson Education Ltd. Mutually Exclusive Projects NPV and IRR can produce different results NPV –Assumes that each cash flow received is reinvested at the required rate of return –Measures cash flow profitability in absolute terms IRR –Assumes that each cash flow is reinvested at the computed IRR –Measure cash flow profitability in relative terms NPV consistently selects the project which maximizes the firm’s wealth 14-46

COPYRIGHT © 2012 Nelson Education Ltd. Steps in Selecting Best Project 1.Assess the flow pattern for each project 2.Compute the net present value (NPV) for each project 3.Identify the project with the greatest NPV 14-47

COPYRIGHT © 2012 Nelson Education Ltd. HOW TO Calculate Net Present Value and Internal Rate of Return for Mutually Exclusive Projects Example: Cornerstone 14-5 Two pollution prevention designs: –Design A Initial outlay of $180,000 Project life of 5 years Net annual after-tax cash inflow of $60,000 –Design B Initial outlay of $210,000 Project life of 5 years Net annual after-tax cash inflow of $70,000 Information:

COPYRIGHT © 2012 Nelson Education Ltd. Example Information continued: Cash Flow Pattern YearDesign ADesign B 0 $(180,000) $(210,000) 1 60,000 70, ,000 70, ,000 70, ,000 70, ,000 70,000 Cost of capital = 12% Required: Calculate NPV and IRR for each product 14-49

COPYRIGHT © 2012 Nelson Education Ltd. Example Design A: NPV Analysis YearCash Flow Present Value Discount Factor 0$(180,000) $(180,000) , ,287 Net present value $ 36,

COPYRIGHT © 2012 Nelson Education Ltd. Example Design A: Internal Rate of Return Discount factor = Investment / Annual Cash Flow = $180,000/ $60,000 = Using the PV of an Annuity table Looking along the 5 period line, is found in the 20% column. IRR is 20% 14-51

COPYRIGHT © 2012 Nelson Education Ltd. Example Design B: NPV Analysis YearCash Flow Present Value Discount Factor 0$(210,000) $(210,000) , ,335 Net present value $ 42,

COPYRIGHT © 2012 Nelson Education Ltd. Example Design B: Internal Rate of Return Discount factor = Investment / Annual Cash Flow = $210,000/ $70,000 = Using the PV of an Annuity table Looking along the 5 period line, is found in the 20% column. IRR is 20% 14-53