©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 8 Long-Term (Capital Investment) Decisions

Key Factor in Capital Investments Do Investment Benefits exceed Costs? Quantitative: Initial Cash Outlays, Future repair or maintenance needs, Increased sales potential, Reductions in production and other costs. Qualitative: Reactions to location changes, Automation’s impact on displaced employees, Quality improvements from new equipment.

Time Value of Money Quantitative analyses of the costs and benefits of capital investment decisions must consider the time value of money. This means cash flow is important, not accounting net income.

Cash Flows

Net Present Value Method Net Present Value (NPV)  Requires the choice of a discount rate* (many use the cost of capital)  Compares present value of cash inflows with the present value of cash outflows Decision Statement  PV inflows > PV outflows, then NPV > 0 and Acceptable Investment  PV inflows < PV outflows, the NPV < 0 and Not an Acceptable Investment * Discount rate Is minimum required rate of return (or hurdle rate) Includes risk and the uncertainty of future cash flows

Internal Rate of Return Actual yield or return earned by an investment. The discount rate that equates the present value of cash inflows to the present value of cash outflows The discount rate that makes the NPV = 0.

Qualitative Issues Although the quantitative analysis indicates that the investment is not acceptable, companies should also consider qualitative factors in their decisions. These include: Improving Healthcare Quality Greater Efficiency Greater Reliability

Two Categories of Capital Investment Decisions Preference decisions: Choosing among alternatives. Screening decisions: whether an investment meets a predetermined company standard.

Define the Problem to Be Addressed: Purchase or Lease? Replace Equipment Based on Projected Cost Efficiency? Expand the Plant? Open a New Retail Store?

Identify the Objectives Quantitative Factors increase production increase sales reduce costs Qualitative Factors make a higher quality product provide better customer service

NPV and IRR as Screening Tools

NPV Advantages over IRR for Screening You can adjust the discount rate to take into account the increased risk and the uncertainty of cash flows expected to occur in future years using NPV. When using the IRR method, users have to modify cash flows directly to adjust for risk.

NPV Modified with the Profitability Index (PI) Cannot be used to make preference decisions. Allows the comparison of investments of different sizes. PI = PV of Cash Inflows Initial Investment PI > 1.0, then NPV is positive and acceptable. NPV Unadjusted: NPV adjusted for initial investment Calculation of PI:

Tax Impacts on Capital Investment Decisions Taxes are a major source of cash outflows for many companies and must be taken into consideration in any long-term investment decision. After Tax Benefit or Cost = Before Tax Inflow or Outflow x (1 – Tax Rate)

Depreciation Tax Savings The disposal of assets may also have tax consequences due to gains or losses. Not all tax-deductible expenses involve cash outflows, such as depreciation. Depreciation expense reduces a company’s taxable income and thus its income tax, resulting in an increase in cash flow. This is known as the depreciation tax shield.

Payback Method Payback method is a nondiscounted method that is useful as an approximation used in capital investment decisions. Capital investment tools that recognize the time value of money and use discounted cash flow techniques are preferred. Payback Period Original Investment Net annual cash inflows =

End of Chapter 8