20-1 HANSEN & MOWEN Cost Management ACCOUNTING AND CONTROL

20-2 Capital Investment 20

20-3 Capital investment decisions are concerned with the process of planning, setting goals and priorities, arranging financing, and using certain criteria to select long-term assets. Capital Investment Decisions 1

20-4 Capital budgeting is the process of making capital investment decisions. Two types of capital budgeting projects: Projects that, if accepted or rejected, will not affect the cash flows of another project. Projects that, if accepted, preclude the acceptance of competing projects. Independent Projects Mutually Exclusive Projects Capital Investment Decisions 1

20-5 Payback Analysis Payback and Accounting Rate of Return: Nondiscounting Methods 2 *At the beginning of Year 3, $60,000 is needed to recover the investment. Since a net cash inflow of $100,000 is expected, only 0.6 year ($60,000/$100,000) is needed to recover the $60,000. Thus, the payback period is 2.6 years ( ).

20-6 The payback period provides information to managers that can be used as follows: To help control the risks associated with the uncertainty of future cash flows. To help minimize the impact of an investment on a firm’s liquidity problems. To help control the risk of obsolescence. To help control the effect of the investment on performance measures. Payback and Accounting Rate of Return: Nondiscounting Methods 2 Deficiencies of the payback period:  Ignores the time value of money  Ignores the performance of the investment beyond the payback period

20-7 Accounting Rate Of Return (ARR) ARR = Average income ÷ Original investment or Average investment Average investment = (I + S)/2 I = the original investment S = salvage value Assume that the investment is uniformly consumed I = the original investment S = salvage value Assume that the investment is uniformly consumed Average annual net cash flows, less average depreciation Payback and Accounting Rate of Return: Nondiscounting Methods 2

20-8 The major deficiency of the accounting rate of return is that it ignores the time value of money. Accounting Rate Of Return (ARR) Payback and Accounting Rate of Return: Nondiscounting Methods 2

20-9 NPV = P – I where: P= the present value of the project’s future cash inflows I =the present value of the project’s cost (usually the initial outlay) Net present value is the difference between the present value of the cash inflows and outflows associated with a project. The Net Present Value Method 3

20-10 Polson Company has developed a new cell phone that is expected to generate an annual revenue of $750,000. Necessary production equipment would cost $800,000 and can be sold in five years for $100,000. The Net Present Value Method 3 In addition, working capital is expected to increase by $100,000 and is expected to be recovered at the end of five years. Annual operating expenses are expected to be $450,000. The required rate of return is 12 percent.

20-11 Step 1. Cash Flow Identification Year Item Cash Flow 0Equipment$-800,000 Working capital -100,000 Total$-900, Revenues$ 750,000 Operating expenses -450,000 Total$ 300,000 5Revenues$ 750,000 Operating expenses-450,000 Salvage100,000 Recovery of working capital 100,000 Total$ 500,000 The Net Present Value Method 3

20-12 Step 2A. NPV Analysis Year Cash Flow Discount Factor Present Value 0 $-900, $-900, , , , , , , , , , ,500 Net present value$ 294,900 Present Value of $1 Step 2B. NPV Analysis Year Cash Flow Discount Factor Present Value 0 $-900, $-900, , , , ,500 Net present value$ 294,600 Present Value of $1 Present Value of an Annuity of $1 The Net Present Value Method 3

20-13 If NPV > 0, this indicates: 1. The initial investment has been recovered 2. The required rate of return has been recovered Thus, Polson should manufacture the cell phones. Decision Criteria for NPV The Net Present Value Method 3

20-14 Reinvestment Assumption The NVP model assumes that all cash flows generated by a project are immediately reinvested to earn the required rate of return throughout the life of the project. The Net Present Value Method 3

20-15 The internal rate of return (IRR) is the interest rate that sets the project’s NPV at zero. Thus, P = I for the IRR. Example:A project requires a $240,000 investment and will return $99,900 at the end of each of the next three years. What is the IRR? $240,000 = $99,900( df ) $240,000 / $99,400= i = 12% Internal Rate of Return 4

20-16 If the IRR > Cost of Capital, the project should be accepted. If the IRR = Cost of Capital, acceptance or rejection is equal. If the IRR < Cost of Capital, the project should be rejected. Decision Criteria: Internal Rate of Return 4

20-17 There are two major differences between net present value and the internal rate of return:  NPV assumes cash inflows are reinvested at the required rate of return, whereas the IRR method assumes that the inflows are reinvested at the internal rate of return.  NPV measures the profitability of a project in absolute dollars, whereas the IRR method measures it as a percentage. 5 NPV versus IRR: Mutually Exclusive Projects

20-18 NPV and IRR: Conflicting Signals 5 NPV versus IRR: Mutually Exclusive Projects

20-19 Modified Cash Flows with Additional Opportunity 5 NPV versus IRR: Mutually Exclusive Projects Modified Comparison of Projects A and B *1.08($686,342) + $686,342. a $1,440,000 + [(1.20 x $686,342) - (1.08 x $686,342)]. This last term is what is needed to repay the capital and its cost at the end of Year 2. b $686,342 + (1.20 x $686,342).

20-20 Annual revenues$240,000$300,000 Annual operating costs120,000160,000 System investment360,000420,000 Project life5 years5 years Milagro Travel Agency Example Standard T2 Custom Travel The cost of capital is 12 percent 5 NPV versus IRR: Mutually Exclusive Projects

NPV versus IRR: Mutually Exclusive Projects Cash Flow Pattern, NPV and IRR Analysis: Standard T2 versus Custom Travel

NPV versus IRR: Mutually Exclusive Projects Cash Flow Pattern, NPV and IRR Analysis: Standard T2 versus Custom Travel

NPV versus IRR: Mutually Exclusive Projects Cash Flow Pattern, NPV and IRR Analysis: Standard T2 versus Custom Travel a From Exhibit 20B-2. b From Exhibit 20B-2, df = 3.0 implies that IRR =20%.

20-24 The cost of capital is composed of two elements: 1.The real rate 2.The inflationary element 6 Computing After-Tax Cash Flows

20-25 The Effects of Inflation on Capital Investment 6 Computing After-Tax Cash Flows a From Exhibit 20B-2. b 6,670,000 bolivares = 1.15 x 5,800,000 bolivares (adjustment for one year of inflation) 7,670,500 bolivares = 1.15 x 1.15 x 5,800,000 bolivares (adjustment for two years of inflation). c From Exhibit 20B-1.

Computing After-Tax Cash Flows Disposition of Old Machine Book Value Sale Price M1$ 600,000$ 780,000 M21,500,0001,200,000 Acquisition of Flexible System Purchase cost$7,500,000 Freight60,000 Installation600,000 Additional working capital 540,000 Total$8,700,000

20-27 Tax Effects of the Sale of M1 and M2 6 Computing After-Tax Cash Flows a Sale price minus book value is $780,000 - $600,000. b Sale price minus book value is $1,200,000 - $1,500,000.

20-28 The two machines are sold: Sales price, M1$ 780,000 Sales price, M21,200,000 Tax savings 48,000 Net proceeds$2,028,000 The net investment is: Total cost of flexible system$8,700,000 Less: Net proceeds 2,028,000 Net investment (cash outflow)$6,672,000 6 Computing After-Tax Cash Flows

Computing After-Tax Cash Flows A company plans to make a new product that requires new equipment costing $1,600,000. The new product is expected to increase the firm’s annual revenue by $1,200,000. Materials, labor, etc. will be $500,000 per year. Revenues$1,200,000 Less: Cash operating expenses-500,000 Depreciation (straight-line) -400,000 Income before income taxes$ 300,000 Less: Income taxes 40%) 120,000 Net income$ 180,000 The income statement for the project is as follows: After-Tax Operating Cash Flows: Life of the Project

20-30 Cash flow = [(1– Tax rate) x Revenues] – [(1– Tax rate) x Cash expenses] + (Tax rate x Noncash expenses) After-tax revenues$720,000 After-tax cash expenses-300,000 Depreciation tax shield 160,000 Operating cash flow$580,000 After-Tax Operating Cash Flows: Life of the Project 6 Computing After-Tax Cash Flows Computation of Operating Cash Flows: Decomposition Terms

20-31 The tax laws classify most assets into the following three classes (class = allowable years): ClassTypes of Assets 3Most small tools 5Cars, light trucks, computer equipment 7Machinery, office equipment Assets in any of the three classes can be depreciated using either straight-line or MACRS (Modified Accelerated Cost Recovery System) with a half-year convention. MACRS Depreciation Rates 6 Computing After-Tax Cash Flows

20-32  Half the depreciation for the first year can be claimed regardless of when the asset is actually placed in service.  The other half year of depreciation is claimed in the year following the end of the asset’s class life.  If the asset is disposed of before the end of its class life, only half of the depreciation for that year can be claimed. MACRS Depreciation Rates 6 Computing After-Tax Cash Flows MACRS Depreciation Rates

Computing After-Tax Cash Flows Value of Accelerated Methods Illustrated

20-34 A company is evaluating a potential investment in a flexible manufacturing system (FMS). The choice is to continue producing with its traditional equipment, expected to last 10 years, or to switch to the new system, which is also expected to have a useful life of 10 years. The company’s discount rate is 12 percent. Present value ($4,000,000 x 5.65)$22,600,000 Investment 18,000,000 Net present value$ 4,600,000 How Estimates of Operating Cash Flows Differ 7 Capital Investment: Advanced Technology and Environmental Considerations

Capital Investment: Advanced Technology and Environmental Considerations Investment Data: Direct, Intangible, and Indirect Benefits

Capital Investment: Advanced Technology and Environmental Considerations Investment Data: Direct, Intangible, and Indirect Benefits

20-37 Future Value Let: F=future value i=the interest rate P=the present value or original outlay n=the number or periods Future value can be expressed by the following formula: F = P(1 + i) n A Present Value Concepts

20-38 Assume the investment is $1,000. The interest rate is 8%. What is the future value if the money is invested for one year? Two? Three? A Present Value Concepts

20-39 F=$1,000(1.08)=$1, (after one year) F=$1,000(1.08) 2 =$1, (after two years) F=$1,000(1.08) 3 =$1, (after three years) Future Value A Present Value Concepts

20-40 P = F/(1 + i) n The discount factor, 1/(1 + i), is computed for various combinations of I and n. Example: Compute the present value of $300 to be received three years from now. The interest rate is 12%. Answer: From Exhibit 23B-1, the discount factor is Thus, the present value (P) is: P=F(df) =$300 x =$ A Present Value Concepts Present Value

20-41 Present Value of an Uneven Series of Cash Flows A Present Value Concepts Present Value of a Uniform Series of Cash Flows

20-42 End of Chapter 20