1. 23-1 Capital Investment Prepared by Douglas Cloud Pepperdine University Prepared by Douglas Cloud Pepperdine University

2. 23-2 1.Describe the difference between independent and mutually exclusive capital investment decisions. 2.Explain the roles of the payback period and accounting rate of return in capital investment decisions. 3.Calculate the net present value (NPV) for independent projects. ObjectivesObjectives After studying this chapter, you should be able to: ContinuedContinued

3. 23-3 4.Compute the internal rate of return (IRR) for independent projects. 5.Tell why NPV is better than IRR for choosing among mutually exclusive projects. 6.Convert gross cash flows to after-tax cash flows. 7.Describe the capital investment for advanced technology and environmental impact settings. ObjectivesObjectives

4. 23-4 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.

5. 23-5 Capital Budgeting 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

6. 23-6 Year Beginning of year Annual Cash Flow Unrecovered Investment Unrecovered Investment 1$200,000$60,000 2140,00080,000 360,000100,000 4----120,000 5----140,000 $60,000 was needed in Year 3 to recover the investment. Payback Period Payback period = Original investment/Annual cash flow

7. 23-7 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 Period

8. 23-8  Ignores the time value of money  Ignores the performance of the investment beyond the payback period Deficiency Payback Period

9. 23-9 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

10. 23-10 Accounting Rate Of Return (ARR) The major deficiency of the accounting rate of return is that it ignores the time value of money.

11. 23-11 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

12. 23-12 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

13. 23-13 The Net Present Value Method 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.

14. 23-14 Step 1. Cash Flow Identification Year Item Cash Flow 0Equipment$-800,000 Working capital -100,000 Total$-900,000 1-4Revenues$ 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

15. 23-15 Step 2A. NPV Analysis Year Cash Flow Discount Factor Present Value 0 $-900,0001.000$-900,000 1300,0000.893267,900 2300,0000.797239,100 3300,0000.712213,600 4300,0000.636190,800 5500,0000.567 283,500 Net present value$ 294,900 Present Value of $1 Step 2B. NPV Analysis Year Cash Flow Discount Factor Present Value 0 $-900,0001.000$-900,000 1-4300,0003.307911,100 5500,0000.567 283,500 Net present value$ 294,600 Present Value of $1 Present Value of an Annuity of $1

16. 23-16 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 The Net Present Value Method Decision Criteria for NPV

17. 23-17 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

18. 23-18 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 $10,000 investment and will return $12,000 after one year. What is the IRR? $12,000/(1 + i) = $10,000 1 + i = 1.2 i = 0.20 Internal Rate of Return

19. 23-19 Internal Rate of Return 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:

20. 23-20 NPV Compared With IRR 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.

21. 23-21 NPV Compared With IRR Year Project A Project B Year Project A Project B 0$-1,000,000$-1,000,000 1---686,342 21,440,000686,342 IRR20%24% NPV$234,080$223,748

22. 23-22 Modified Comparison of Projects A and B Projects Year A Modified B 0$-1,000,000$-1,000,000 1------ 21,440,0001,427,591 1.08($686,342) + $686,342

23. 23-23 Modified Cash Flows with Additional Opportunity Projects Year A Modified B 0$-1,000,000$-1,000,000 1------ 21,552,3611,509,952 $1,440,000 + [1.20 x $686,342) – 1.08 x $686,342)] $686,342 + (1.20 x $686,342)

24. 23-24 Annual revenues$240,000$300,000 Annual operating costs120,000160,000 System investment360,000420,000 Project life5 years5 years Milagro Travel Agency Example Example: Mutually Exclusive Projects Standard T2 Custom Travel The cost of capital is 12 percent

25. 23-25 NPV and IRR Analysis: Standard T2 versus Custom Travel Cash Flow Pattern Year Standard T2 Custom Travel Year Standard T2 Custom Travel 0 $-360,000$-420,000 1120,000140,000 2120,000140,000 3120,000140,000 4120,000140,000 5120,000140,000 Standard T2: NPV Analysis Year Cash Flow Discount Factor Present Value Year Cash Flow Discount Factor Present Value 0 $-360,0001.000$-360,000 1-5140,0003.605 432,600 Net present value$ 72,600

26. 23-26 IRR ANALYSIS Discount factor = Initial investment Annual cash flow = $360,000 120,000 = 3.0 Custom Travel Systems: NPV Analysis Year Cash Flow Discount Factor Present Value Year Cash Flow Discount Factor Present Value 0 $-420,0001.000$-420,000 1-5140,0003.605 504,700 Net present value$ 84,700 NPV and IRR Analysis: Standard T2 versus Custom Travel

27. 23-27 IRR ANALYSIS Discount factor = Initial investment Annual cash flow = $420,000 140,000 = 3,000 From Exhibit 23B-2, df = 3.0 implies that IRR = 20% = 3.0 NPV and IRR Analysis: Standard T2 versus Custom Travel

28. 23-28 Adjusting Forecast for Inflation The cost of capital is composed of two elements: 1.The real rate 2.The inflationary element

29. 23-29 Effects of Inflation on Capital Investment Without Inflationary Adjustment Year Cash Flow Discount Factor Present Value Year Cash Flow Discount Factor Present Value 0$-10,000,0001.000$-10,000,000 1-25,800,0001.528 8,862,400 Net present value$ -1,137,600 With Inflationary Adjustment Year Cash Flow Discount Factor Present Value Year Cash Flow Discount Factor Present Value 0 $-10,000,0001.000$-10,000,000 16,670,0000.8335,556,110 27,670,5000.694 5,323,327 Net present value$ 879,437

30. 23-30 After-Tax Cash Flows Lewis Company uses two types of manufacturing equipment (M1 and M2) to produce one of its products. It is now possible to replace these two machines with a flexible manufacturing system. Management wants to know the net investment needed to acquire the flexible equipment. If the system is acquired, the old equipment will be sold.

31. 23-31 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

32. 23-32 After-Tax Cash Flows 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

33. 23-33 After-Tax Cash Flows Asset Gain (Loss) Asset Gain (Loss) M1$ 180,000 M2 -300,000 Net gain (loss)$ 120,000 Tax rate x 0.40 Tax savings$ 48,000

34. 23-34 After-Tax Operating Cash Flows: Life of the Project After-tax cash flow =After-tax net income + Noncash expenses CF =NI + NC 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.

35. 23-35 After-Tax Operating Cash Flows: Life of the Project 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

36. 23-36 After-Tax Operating Cash Flows: Life of the Project 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

37. 23-37 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

38. 23-38 MACRS Depreciation Rates  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.

39. 23-39 Example An automobile is purchased on March 1, 2003 at a cost of $30,000. The firm elects the straight-line method for tax purposes. Automobiles are five-year assets. The annual depreciation is $6,000 ($30,000 ÷ 5). However, due to the half-year convention, only $3,000 can be deducted in 2003.

40. 23-40 Year S/L Depreciation Deduction 2003$3,000(half-year amount) 20046,000 20056,000 20066,000 20076,000 20083,000(half-year amount) Assume that the asset is disposed of in April 2005. Only $3,000 of depreciation can be claimed for 2005 (early disposal rule). Example

41. 23-41 Example MACRS Depreciation Rates for Five-Year Assets Year Percentage of Cost Allowed Year Percentage of Cost Allowed 120.00% 232.00 319.20 411.52 511.52 6 5.76

42. 23-42 Example Year Depreciation Deduction 200320.00% x $30,000$6,000 200432.00% x $30,0009,600 200519.20% x $30,0005,760 200611.52% x $30,0003,456 200711.52% x $30,0003,456 20085.76% x $30,0001,728

43. 23-43 Example A firm is considering the purchase of computer equipment for $60,000. The tax guidelines require that the cost of the equipment be depreciated over five years.

44. 23-44 Example—S/L Method Tax Tax Discount Present Tax Tax Discount Present Year Depreciation Rate Savings Factor Value 1$ 6,0000.40$2,400.000.909$ 2,181.60 212,0000.404,800.000.8263,964.80 312,0000.404,800.000.7513,604.80 412,0000.404,800.000.6833,278.40 512,0000.404,800.000.6212,980.80 66,0000.402,400.000.564 1,353.60 Net present value$17,364.00

45. 23-45 Example—MACRS Method Tax Tax Discount Present Tax Tax Discount Present Year Depreciation Rate Savings Factor Value 1$12,0000.40$4,800.000.909$ 4,362.20 219,2000.407,680.000.8266,343.68 311,5200.404,608.000.7513,460.61 46,9120.402,764.800.6831,888.36 56,9120.402,764.800.6211,716.94 63,4560.401,382.400.564 779.67 Net present value$18,551.46

46. 23-46 How Estimates of Operating Cash Flows Differ 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

47. 23-47 FMS STATUS QUO FMS STATUS QUO Investment (current outlay): Direct costs$10,000,000--- Software, engineering 8,000,000--- Total current outlay$18,000,000 Net after-tax cash flow$ 5,000,000$1,000,000 Less: After-tax cash flow for status quo 1,000,000n/a Incremental benefit$ 4,000,000n/a How Estimates of Operating Cash Flows Differ

48. 23-48 Incremental Benefits Explained Direct benefits: Direct labor$1,500,000 Scrap reduction500,000 Setups 200,000$2,200,000 Intangible benefits (Quality savings): Rework$ 200,000 Warranties400,000 Maintenance of competitive position 1,000,0001,600,000 Indirect benefits: Production scheduling$ 110,000 Payroll 90,000 200,000 Total$4,000,000 FMS STATUS QUO FMS STATUS QUO

49. 23-49 Future Value: Time Value of Money 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

50. 23-50 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? Future Value: Time Value of Money

51. 23-51 F=$1,000(1.08)=$1,080.00 (after one year) F=$1,000(1.08) 2 =$1,166.40 (after two years) F=$1,000(1.08) 3 =$1,259.71 (after three years) Future Value: Time Value of Money

52. 23-52 Present Value 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 0.712. Thus, the present value (P) is: P=F(df) =$300 x 0.712 =$213.60

53. 23-53 Answer: DiscountPresent YearCashFactorValue 1$1000.893$ 89.30 21000.79779.70 31000.712 71.20 2.402*$240.20 Present Value * Notice that it is possible to multiply the sum of the individual discount factors (.40) by $100 to obtain the same answer. See Exhibit 23B-2 for these sums which can be used as discount factors for uniform series. Example: Calculate the present value of a $100 per year annuity, to be received for the next three years. The interest rate is 12%.

54. 23-54 End of Chapter

55. 23-55