CHAPTER 12: STRATEGIC INVESTMENT DECISIONS Cost Management, Canadian Edition © John Wiley & Sons, 2009 Chapter 12: Strategic Investment Decisions Cost Management, Cdn Ed, by Eldenburg et al Slide # 1

Learning Objectives © John Wiley & Sons, 2009 Chapter 12: Strategic Investment Decisions Cost Management, Cdn Ed, by Eldenburg et al Slide # 2 Q1: How are strategic investment decisions made? Q2: What cash flows are relevant for strategic investment decisions? Q3: How is net present value (NPV) analysis performed and interpreted? Q4: What are the uncertainties and limitations of NPV analysis? Q5: What alternative methods (IRR, payback, and accrual accounting rate of return) are used for long-term decision making? Q6: What additional issues should be considered for strategic investment decisions? Q7: How do income taxes affect strategic investment decision cash flows? Q8: How are the real and nominal methods used to address inflation in NPV analysis (Appendix 12A)

© John Wiley & Sons, 2009 Chapter 12: Strategic Investment Decisions Cost Management, Cdn Ed, by Eldenburg et al Slide 3 Q1: How are strategic investment decisions made?

Process for Making Strategic Investment Decisions © John Wiley & Sons, 2009 Chapter 12: Strategic Investment Decisions Cost Management, Cdn Ed, by Eldenburg et al Slide # 4 The process used to compare and analyze long-term investment projects is called capital budgeting. The capital budgeting process includes the following stages: –Identify decision alternatives. –Identify relevant cash flows. –Apply the appropriate quantitative techniques. –Perform sensitivity analysis. –Identify and analyze qualitative factors. –Consider quantitative and qualitative factors and make a decision.

Capital Budgeting Quantitative Techniques © John Wiley & Sons, 2009 Chapter 12: Strategic Investment Decisions Cost Management, Cdn Ed, by Eldenburg et al Slide # 5 Methods that do not consider the time value of money: –Payback method –Accounting rate of return method Methods that consider the time value of money: –Net present value (NPV) method –Internal rate of return (IRR) method

© John Wiley & Sons, 2009 Chapter 12: Strategic Investment Decisions Cost Management, Cdn Ed, by Eldenburg et al Slide 6 Q2: What cash flows are relevant for strategic investment decisions?

Relevant Cash Flows in Capital Budgeting © John Wiley & Sons, 2009 Chapter 12: Strategic Investment Decisions Cost Management, Cdn Ed, by Eldenburg et al Slide # 7 Relevant cash flows occur in the future and are different across the alternatives. Examples of relevant cash outflows include: –Initial investment outlay –Future operating costs –Project closing and cleanup costs Examples of relevant cash inflows include: –Future revenues –Decreased operating costs –Salvage value of assets at project’s end

© John Wiley & Sons, 2009 Chapter 12: Strategic Investment Decisions Cost Management, Cdn Ed, by Eldenburg et al Slide 8 Q3: How is net present value (NPV) analysis performed and interpreted?

Net Present Value (NPV) Analysis © John Wiley & Sons, 2009 Chapter 12: Strategic Investment Decisions Cost Management, Cdn Ed, by Eldenburg et al Slide # 9 The NPV of a project is the sum of the project’s discounted cash flows:, where t = year of the project’s life in which cash flow occurs n = life of the project r = discount, or hurdle rate If a project’s NPV > 0, it is acceptable

NPV Analysis and Project Ranking © John Wiley & Sons, 2009 Chapter 12: Strategic Investment Decisions Cost Management, Cdn Ed, by Eldenburg et al Slide # 10 NPV analysis is often used to screen projects as to whether they are acceptable. After screening, acceptable projects may be ranked according to their profitability index. Profitability index = Present value of benefits Present value of costs The profitability index allows for rankings of projects of various sizes.

NPV Example Joseph Leasing is considering an investment in a new apartment building. The Lindie Lane building will cost $450,000 and the net annual cash inflows are expected to be $45,000 for 7 years. At the end of the 7 th year, Joseph expects to be able to sell Lindie Lane building for $400,000. Joseph demands a minimum required rate of return of 8% on all investments. Assume all cash inflows occur at the end of each year. Compute the NPV of the Lindie Lane building. Is it an acceptable investment? © John Wiley & Sons, 2009 Chapter 12: Strategic Investment Decisions Cost Management, Cdn Ed, by Eldenburg et al Slide # 11 Yes, the NPV > 0, so the investment is acceptable

NPV Example Joseph Leasing is also looking at the purchase of a lot with a double-wide trailer on it. The cost is $65,000 and the expected net cash inflows are $6,800 per year for 10 years. At the end of the 10 th year, Joseph expects to be able to sell the lot and trailer for $45,000. Compute the NPV of the trailer investment. Is it an acceptable investment? © John Wiley & Sons, 2009 Chapter 12: Strategic Investment Decisions Cost Management, Cdn Ed, by Eldenburg et al Slide # 12 Yes, the NPV > 0, so the investment is acceptable

NPV Example Compare the two investments for Joseph using the profitability index, and describe to him what the index means. Which investment (or both) should he make? © John Wiley & Sons, 2009 Chapter 12: Strategic Investment Decisions Cost Management, Cdn Ed, by Eldenburg et al Slide # 13 The Lindie Lane yields a slightly greater PV for each invested dollar than does the trailer. If Joseph has sufficient capital, he should invest in both unless he has alternatives that have even greater profitability indices.

© John Wiley & Sons, 2009 Chapter 12: Strategic Investment Decisions Cost Management, Cdn Ed, by Eldenburg et al Slide 14 Q4: What are the uncertainties and limitations of NPV analysis?

Limitations of NPV Analysis © John Wiley & Sons, 2009 Chapter 12: Strategic Investment Decisions Cost Management, Cdn Ed, by Eldenburg et al Slide # 15 The uncertainty about future cash flows increases the further the cash flow is in the future. Many factors have an impact such as customer tastes, changes in technology and competition Other uncertainties exist such as the life of the project, cost of the initial investment and factors which may impact the discount rate. Individuals providing information about the future cash flows are likely to have a vested interest in the project’s acceptance.

© John Wiley & Sons, 2009 Chapter 12: Strategic Investment Decisions Cost Management, Cdn Ed, by Eldenburg et al Slide 16 Q5: What alternative methods (IRR, payback, and accrual accounting rate of return) are used for long-term decision making?

Internal Rate of Return (IRR) Method © John Wiley & Sons, 2009 Chapter 12: Strategic Investment Decisions Cost Management, Cdn Ed, by Eldenburg et al Slide # 17 The IRR method computes the discount rate required to set the NPV to zero. For projects with equal annual cash inflows where the only cash outlay is the initial investment, the IRR can be determined by computing the PV of an annuity factor and solving for the interest rate. PV of an annuity factor = Initial investment Annual cash inflow Then the discount rate is found by locating the column for the PV factor, given n.

IRR Example Graham Enterprises is considering the purchase of a new machine. The cost is $100,000 and the machine is expected to generate cost savings of $17,700 each year for 10 years. The machine is not expected to have any salvage value at the end of its life. Assume the cost savings are realized at the end of the year. Graham requires a 10% rate of return on all new investments. Compute the IRR for the proposed machine. Should Graham purchase the machine? © John Wiley & Sons, 2009 Chapter 12: Strategic Investment Decisions Cost Management, Cdn Ed, by Eldenburg et al Slide # 18 Since the machine’s IRR exceeds Graham’s minimum rate of return, the machine is an acceptable investment, but of course should still be compared to other, potentially better, investments = $100,000 $17,700 Locate the 5.65 factor in the present value of an annuity table, using n = 10 years and note that it is found in the 12% column, so the IRR = 12%.

Payback Method © John Wiley & Sons, 2009 Chapter 12: Strategic Investment Decisions Cost Management, Cdn Ed, by Eldenburg et al Slide # 19 The payback method computes the number of years before the initial investment is recovered. If cash inflows are the same each year and the project has only one initial outlay, the payback period is computed as: Payback period in years = Initial investment Annual cash inflow For projects where annual cash inflows are not equal, the payback period is computed by merely counting the years required before the initial investment is recovered.

Payback Method © John Wiley & Sons, 2009 Chapter 12: Strategic Investment Decisions Cost Management, Cdn Ed, by Eldenburg et al Slide # 20 The payback method is widely used because of its simplicity. However, the payback method is flawed because: –It ignores the time value of money. –It ignores cash flows that occur after the payback period. If used at all, the payback method should be used in conjunction with the NPV or IRR methods to help assess project risk.

Payback Method Example Graham Enterprises is considering the purchase of a new machine. The cost is $100,000 and the machine is expected to generate cost savings of $17,700 each year for 10 years. The machine is not expected to have any salvage value at the end of its life. Compute the payback period for the proposed machine. © John Wiley & Sons, 2009 Chapter 12: Strategic Investment Decisions Cost Management, Cdn Ed, by Eldenburg et al Slide # 21 Notice that the payback period is the same as the PV factor computed in the IRR example years= $100,000 $17,700

Payback Method Example Cophil, Inc. is considering the purchase of a new machine. There are two alternatives, and the cash flow information is given below. Compute the payback period for each and comment on your findings. © John Wiley & Sons, 2009 Chapter 12: Strategic Investment Decisions Cost Management, Cdn Ed, by Eldenburg et al Slide # 22 The payback method shows Machine B to be preferable to Machine A, but ignores the large cash inflows of Machine A that occur after the payback period. The payback period for Machine B is 2 years. The payback period for Machine A is 3.5 years ($60,000 covered after 3 years, and $40,000 is ½ of year 4’s cash inflow).

Accrual Accounting Rate of Return Method © John Wiley & Sons, 2009 Chapter 12: Strategic Investment Decisions Cost Management, Cdn Ed, by Eldenburg et al Slide # 23 The accrual accounting rate of return computes the project’s rate of return using operating income in place of cash flows. This method is widely used because the financial accounting information is readily available, but it is flawed because it ignores the time value of money. Accrual accounting rate of return Operating income Annual cash inflow =

Accrual Accounting Rate of Return Method Example Blanche Manufacturing is considering the purchase of a new machine. The cost is $100,000 and it is expected to last 5 years and have no salvage value. The machine is expected to generate cost savings of $32,000 per year. Ignoring income tax effects, compute the accrual accounting rate of return for this investment. © John Wiley & Sons, 2009 Chapter 12: Strategic Investment Decisions Cost Management, Cdn Ed, by Eldenburg et al Slide # 24 Annual cost savings$32,000 Annual depreciation expense ($100,000/5 years)20,000 Effect on annual operating income$12,000 Accrual accounting rate of return $12,000 $100,000 = = 12%

© John Wiley & Sons, 2009 Chapter 12: Strategic Investment Decisions Cost Management, Cdn Ed, by Eldenburg et al Slide 25 Q6: What additional issues should be considered for strategic investment decisions?

Additional Considerations in Strategic Investment Decisions © John Wiley & Sons, 2009 Chapter 12: Strategic Investment Decisions Cost Management, Cdn Ed, by Eldenburg et al Slide # 26 Qualitative issues that may arise in capital budgeting include: –the effects of the decision on the company’s reputation, –the effects on the quality of the company’s products and services, –the effects on the company’s community, and –the effects on employees. After a capital budgeting decision is made, a post- investment audit should be performed to assess the decision process.

© John Wiley & Sons, 2009 Chapter 12: Strategic Investment Decisions Cost Management, Cdn Ed, by Eldenburg et al Slide 27 Q7: How do income taxes affect strategic investment decision cash flows?

Income Tax Considerations © John Wiley & Sons, 2009 Chapter 12: Strategic Investment Decisions Cost Management, Cdn Ed, by Eldenburg et al Slide # 28 All cash flows should first be converted to an after- tax amount. The tax savings that result from the capital cost allowance (CCA) deduction is called the CCA tax shield. All capital assets are eligible for CCA deductions

Income Tax Considerations CCA deductions are as allowed by Canada Revenue Agency (CRA) CCA rates dictate the maximum CCA that can be deducted on a firm’s tax return each year Rates use a declining balance method and are applied to the opening balance of undepreciated capital cost (UCC) for each asset class CCA claimed in any given year reduces the deductions that can be used in future years Due to significant capital costs of some projects, CCA deductions can be a critical factor in determining whether a project will generate a positive return © John Wiley & Sons, 2009 Chapter 12: Strategic Investment Decisions Cost Management, Cdn Ed, by Eldenburg et al Slide # 29

CCA tax shield formula The tax savings that are provided by CCA can be calculated with the following formula: PV of tax savings: Investment * Tax Rate* CCA Rate CCA Rate + RRR X * RRR 1 + RRR © John Wiley & Sons, 2009 Chapter 12: Strategic Investment Decisions Cost Management, Cdn Ed, by Eldenburg et al Slide # 30

© John Wiley & Sons, 2009 Chapter 12: Strategic Investment Decisions Cost Management, Cdn Ed, by Eldenburg et al Slide 31 Q8: How are the real and nominal methods used to address inflation in NPV analysis (Appendix 12A)

Inflation and NPV Analysis © John Wiley & Sons, 2009 Chapter 12: Strategic Investment Decisions Cost Management, Cdn Ed, by Eldenburg et al Slide # 32 When the purchasing power of the dollar declines over time, it is known as inflation. The real rate of interest does not consider changes in the purchasing power of a dollar. The nominal rate of interest is the rate that investors demand when inflation is taken into consideration in their decisions.

Inflation and NPV Analysis © John Wiley & Sons, 2009 Chapter 12: Strategic Investment Decisions Cost Management, Cdn Ed, by Eldenburg et al Slide # 33 The risk-free rate is the rate of interest that is paid on long-term government bonds. The risk premium is the additional rate of return investors demand to compensate them for taking risk. The risk premium increases for riskier investments. The real rate of interest is the nominal rate plus the risk premium demanded for that investment.

Nominal and Real Methods of NPV Analysis Chapter 12: Strategic Investment Decisions Cost Management, Cdn Ed, by Eldenburg et al Slide # 34 The real and nominal rates of interest are related as follows: Nominal future cash flows are real cash flows inflated to future dollars: Nominal rate of interest =(1 + real rate) x (1 + inflation rate)- 1 Nominal cash flow = Real cash flow x (1 + i) t, where i = rate of inflation, and t = the number of time periods in the future the cash flow occurs © John Wiley & Sons, 2009

Nominal and Real Methods of NPV Analysis © John Wiley & Sons, 2009 Chapter 12: Strategic Investment Decisions Cost Management, Cdn Ed, by Eldenburg et al Slide # 35 In the real method of NPV analysis, future cash flows are state in real dollars (without considering changes in the purchasing power of the dollar) and a real rate of interest is used as the discount rate. In the nominal method of NPV analysis, future cash flows and the terminal project value must be inflated to future dollars and a nominal rate of interest is used as the discount rate.

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