1. Capital Expenditure Decisions
Chapter 16
Capital Expenditure Decisions

2. Discounted-Cash-Flow Analysis
Plant expansion
Equipment selection
Equipment replacement
Cost reduction
Lease or buy
Learning Objective 1

3. Net-Present-Value Method
Prepare a table showing cash flows for each year,
Calculate the present value of each cash flow using a discount rate,
Compute net present value,
If the net present value (NPV) is positive, accept the investment proposal. Otherwise, reject it.

4. Net-Present-Value Method
Mattson Co. has been offered a five year contract to provide component parts for a large manufacturer.

5. Net-Present-Value Method
At the end of five years the working capital will be released and may be used elsewhere by Mattson.
Mattson uses a discount rate of 10%.
Should the contract be accepted?

6. Net-Present-Value Method
Annual net cash inflows from operations

7. Net-Present-Value Method
Mattson should accept the contract because the present value of the cash inflows exceeds the present value of the cash outflows by $85,955. The project has a positive net present value.

8. Internal-Rate-of-Return Method
The internal rate of return is the true economic return earned by the asset over its life.
The internal rate of return is computed by finding the discount rate that will cause the net present value of a project to be zero.

9. Internal-Rate-of-Return Method
Black Co. can purchase a new machine at a cost of $104,320 that will save $20,000 per year in cash operating costs.
The machine has a 10-year life.

10. Internal-Rate-of-Return Method
Future cash flows are the same every year in this example, so we can calculate the internal rate of return as follows:
Investment required
Net annual cash flows
= Present value factor
$104, 320
$20,000 =

11. Internal-Rate-of-Return Method
The present value factor (5.216) is located on the Table IV in the Appendix. Scan the 10-period row and locate the value Look at the top of the column and you find a rate of 14% which is the internal rate of return.
$104, 320
$20,000 =

12. Internal-Rate-of-Return Method
Here’s the proof . . .

13. Comparing the NPV and IRR Methods
Net Present Value
The cost of capital is used as the actual discount rate.
Any project with a negative net present value is rejected.
Internal Rate of Return
The cost of capital is compared to the internal rate of return on a project.
To be acceptable, a project’s rate of return must be greater than the cost of capital.
Learning Objective 2

14. Comparing the NPV and IRR Methods
The net present value method has the following advantages over the internal rate of return method . . .
Easier to use.
Easier to adjust for risk.

15. Assumptions Underlying Discounted-Cash-Flow Analysis
Assumes a
perfect
capital
market.
All cash flows are
treated as though
they occur at year end.
Cash inflows are
immediately
reinvested at
the required
rate of return.
Cash flows are
treated as if
they are known
with certainty.
Learning Objectives 3 – 10 can be found in the Text Book