McGraw-Hill/Irwin 16-1 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, One-half year depreciation is taken in 2001.

McGraw-Hill/Irwin 16-2 Noncash Expenses Here is a complete depreciation schedule for High Country. DepreciationTaxShield

McGraw-Hill/Irwin 16-3 Net Present Value Analysis Calculation of the present value of proposal cash flows. The sum of the present values from this proposal is a positive $71,550 The sum of the present values from this proposal is a positive $71,550

McGraw-Hill/Irwin 16-4 Modified Accelerated Cost Recovery System (MACRS) Tax depreciation is usually computed using MACRS. Here are the depreciation rate for 3, 5, and 7-year class life assets.

McGraw-Hill/Irwin 16-5 Modified Accelerated Cost Recovery System (MACRS) A company is considering the purchase of a machine that will increase after-tax cash flows by $20,000 over the next five years. The machine is depreciated using MACRS and the company uses a 10% discount rate to compute all present values. The machine will cost $100,000 and the company is subject to a 28% tax rate. Let’s calculate the net present value of the proposal.

McGraw-Hill/Irwin 16-6 Modified Accelerated Cost Recovery System (MACRS) Calculation of the present value of the depreciation tax shield. $5,600 × (1.10)^ -1 $20,000 × 28% $100,000 × 20%

McGraw-Hill/Irwin 16-7 Modified Accelerated Cost Recovery System (MACRS) Calculation of the present value proposal cash flows. $20,000 × (1.10)^ -1

McGraw-Hill/Irwin 16-8 Modified Accelerated Cost Recovery System (MACRS) Net present value of the proposal. The present value of the proposal is less than the cost of the equipment ($100,000). The proposal has a negative net present value. The present value of the proposal is less than the cost of the equipment ($100,000). The proposal has a negative net present value.

McGraw-Hill/Irwin 16-9 Investment in Working Capital Some investment proposals require additional outlays for working capital such as increases in cash, accounts receivable, and inventory.

McGraw-Hill/Irwin Extended Illustration Let take a close look at a present value analysis for an investment decision facing James Company. James Company

McGraw-Hill/Irwin Extended Illustration James Company has been offered a five-year contract to provide component parts for a large manufacturer.

McGraw-Hill/Irwin Extended Illustration [At the end of five years the working capital will be released and may be used elsewhere by James. [James Company uses a discount rate of 10%. [James uses straight-line depreciation. [All items are taxed at 30%. Should the contract be accepted?

McGraw-Hill/Irwin Extended Illustration Annual accounting income from operations Remember depreciation is a non-cash expense that provides a tax shield.

McGraw-Hill/Irwin Extended Illustration Annual cash inflows from operations Remember depreciation is a non-cash expense that provides a tax shield.

McGraw-Hill/Irwin Extended Illustration The relining is considered normal maintenance and will reduce income in year 3. Because the cost is tax deductible, income will be lower by $21,000 ($30,000 × 1- tax rate).

McGraw-Hill/Irwin Extended Illustration Because the salvage value of the equipment will equal the book value (cost less accumulated depreciation), there will be no taxable gain or loss.

McGraw-Hill/Irwin Extended Illustration

McGraw-Hill/Irwin Extended Illustration Present value of $1 factor for 3 years at 10%. Present value of $1 factor for 3 years at 10%.

McGraw-Hill/Irwin Extended Illustration Present value of $1 factor for 5 years at 10%. Present value of $1 factor for 5 years at 10%.

McGraw-Hill/Irwin Extended Illustration We should accept the contract because the present value of the cash inflows exceeds the present value of the cash outflows by $92,836. The project has a positive net present value.

McGraw-Hill/Irwin Extended Illustration General decision rule...

McGraw-Hill/Irwin Ranking Investment Projects We can invest in either of these projects. Use a 10% discount rate to determine the net present value of the cash flows.

McGraw-Hill/Irwin We can invest in either of these projects. Use a 10% discount rate to determine the net present value of the cash flows. Ranking Investment Projects The total cash flows are the same, but the pattern of the flows is different. The total cash flows are the same, but the pattern of the flows is different.

McGraw-Hill/Irwin Ranking Investment Projects Let’s calculate the present value of the cash flows associated with Project A.

McGraw-Hill/Irwin Ranking Investment Projects Let’s calculate the present value of the cash flows associated with Project A. (1.10) -1 = rounded

McGraw-Hill/Irwin Ranking Investment Projects Let’s calculate the present value of the cash flows associated with Project A. (1.10) -2 = rounded

McGraw-Hill/Irwin Ranking Investment Projects Let’s calculate the present value of the cash flows associated with Project A. This project has a positive net present value which means the project’s return is greater than the discount rate. This project has a positive net present value which means the project’s return is greater than the discount rate.

McGraw-Hill/Irwin Ranking Investment Projects Here is the net present value of the cash flows associated with Project B. Project B has a negative net present value which means the project’s return is less than the discount rate. Project B has a negative net present value which means the project’s return is less than the discount rate.

McGraw-Hill/Irwin Internal Rate of Return (IRR) The interest rate that equates the present value of inflows and outflows from an investment project.

McGraw-Hill/Irwin Internal Rate of Return (IRR) When the cash flows from a project are constant, the present value of an annuity factor can be used to approximate the rate of return. A project cost $90,119, and will yield net cash inflows of $25,000 at the end of each of the next five years. When the cash flows from a project are constant, the present value of an annuity factor can be used to approximate the rate of return. A project cost $90,119, and will yield net cash inflows of $25,000 at the end of each of the next five years. Let’s determine the IRR for this project!

McGraw-Hill/Irwin Internal Rate of Return (IRR) PV factor = Required Investment Required Investment Annual net cash flow Annual net cash flow $90,119 $90,119 $25,000 $25, rounded The present value of an annuity factor of 3.605, is an internal rate of return of 12%. The present value of an annuity factor of 3.605, is an internal rate of return of 12%. PV factor =

McGraw-Hill/Irwin Alternative Methods for Making Investment Decisions Payback Method Paybackperiod Initial investment Initial investment Annual after-tax cash inflow = Paybackperiod = $20,000 $20,000$4,000 = 5 years A company can purchase a machine for $20,000 that will provide annual cash inflows of $4,000 for 7 years. A company can purchase a machine for $20,000 that will provide annual cash inflows of $4,000 for 7 years.

McGraw-Hill/Irwin Payback: Pro and Con ÊFails to consider the time value of money. ËDoes not consider a project’s cash flows beyond the payback period. ÊFails to consider the time value of money. ËDoes not consider a project’s cash flows beyond the payback period.

McGraw-Hill/Irwin Payback: Pro and Con ÊProvides a tool for roughly screening investments. ËFor some firms, it may be essential that an investment recoup its initial cash outflows as quickly as possible. ÊProvides a tool for roughly screening investments. ËFor some firms, it may be essential that an investment recoup its initial cash outflows as quickly as possible.

McGraw-Hill/Irwin Accounting-Rate-of-Return Method Discounted-cash-flow method focuses on cash flows and the time value of money. Accounting-rate-of-return method focuses on the incremental accounting income that results from a project. Discounted-cash-flow method focuses on cash flows and the time value of money. Accounting-rate-of-return method focuses on the incremental accounting income that results from a project.

McGraw-Hill/Irwin Accounting-Rate-of-Return Method The following formula is used to calculate the accounting rate of return: Accounting rate of return = Average Average Average Average incremental incremental expenses, revenues including depreciation revenues including depreciation- Initial investment

McGraw-Hill/Irwin Accounting-Rate-of-Return Method Meyers Company wants to install an espresso bar in its restaurant. The espresso bar: l Cost $140,000 and has a 10-year life. l Will generate incremental revenues of $100,000 and incremental expenses of $80,000 including depreciation. What is the accounting rate of return on the investment project? Meyers Company wants to install an espresso bar in its restaurant. The espresso bar: l Cost $140,000 and has a 10-year life. l Will generate incremental revenues of $100,000 and incremental expenses of $80,000 including depreciation. What is the accounting rate of return on the investment project?

McGraw-Hill/Irwin Accounting-Rate-of-Return Method The accounting 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. The accounting 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. Accounting rate of return $100,000 - $80,000 $100,000 - $80,000 $140,000 $140,000 = 14.3% = 14.3%=

McGraw-Hill/Irwin Capital Budgeting Practices Percent of managers who believe each technique is important.

McGraw-Hill/Irwin Estimating Cash Flows: The Role of Activity-Based Costing ABC systems generally improve the ability of an analyst to estimate the cash flows associated with a proposed project.

McGraw-Hill/Irwin Justification of Investments in Advanced Manufacturing Systems Hurdle rates are too high Hurdle rates are too high Timehorizons are too shortTimehorizons shortBiastowardsincrementalprojectsBiastowardsincrementalprojects Greater cash flow uncertaintyGreater uncertaintyBenefits difficult to quantifyBenefits quantify

McGraw-Hill/Irwin End of Chapter 16