1. Capital Expenditure Decisions16
Chapter Sixteen
Capital Expenditure Decisions
Chapter 16. Capital Expenditure Decisions.

2. Learning Objective 1
Learning objective one. Use the net-present-value method and the internal-rate-of-return method to evaluate an investment proposal.

3. Discounted-Cash-Flow Analysis
Plant expansion
Equipment selection
Equipment replacement
Cost reduction
Lease or buy
Managers in all organizations periodically face major decisions that involve cash flows over several years. Decisions involving the acquisition of machinery, vehicles, buildings, or land are examples of such decisions. Other examples include decisions involving significant changes in a production process or adding a major new line of products or services to the organization’s activities.
Decisions involving cash inflows and outflows beyond the current year are called capital-budgeting decisions.
Discounted cash flow analysis accounts for the time value of money. It is a mistake to add cash flows occurring at different points in time. The proper approach is to use discounted-cash-flow analysis, which takes into account the timing of the cash flows. There are two widely used methods of discounted-cash-flow analysis: the net-present-value method and the internal-rate-of-return method. Those who wish to review the basic concept of present value should read Appendix II on pages 782 through 789 of the text before continuing.

4. 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.
These four steps constitute a net-present-value analysis of an investment proposal:
1. Prepare a table showing the cash flows during each year of the proposed investment.
2. Compute the present value of each cash flow, using a discount rate that reflects the cost of acquiring investment capital. This discount rate is often called the hurdle rate or minimum desired rate of return.
3. Compute the net present value, which is the sum of the present values of the cash flows.
4. If the net present value (NPV) is equal to or greater than zero, accept the investment proposal. Otherwise, reject it.

5. Net-Present-Value Method
Mattson Co. has been offered a five year contract to provide component parts for a large manufacturer.
Here a table has been prepared by Mattson’s accountant showing the cash flows during each year of a proposed investment to provide component parts to another manufacturer. The proposal requires special equipment that would need to be purchased if the proposal is accepted. Associated cash revenue and expense items are also included.

6. 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?
Other information available is that the working capital required to accept the proposal will be returned at the end of the contract, and Mattson requires a minimum of a ten percent hurdle rate. We need to decide whether we should accept or reject the proposal.

7. Net-Present-Value Method
Annual net cash inflows from operations
First, we calculate the net annual cash inflows to Mattson. Mattson would have net cash inflows of $80,000 per year for the next five years if the proposal is accepted.

8. Net-Present-Value Method
Two costs that would be incurred immediately if the proposal is accepted are the investment in equipment and the immediate need for working capital. The present value of those expenditures are the same, because we would purchase the equipment today and need the working capital today.

9. Net-Present-Value Method
The annual net cash inflows would be received over a five-year period, so we must bring that value back to the present, in order to compare apples to apples. The present value of the net cash inflows is $303,280.
Present value of an annuity of $1
factor for 5 years at 10%.

10. Net-Present-Value Method
We will also need to reline the equipment in three years at a cost of $30,000. The present value of this amount is $22,530.
Present value of $1
factor for 3 years at 10%.

11. Net-Present-Value Method
In addition, when the contract is completed, we will sell the equipment. The present value of the salvage value is $3,105.
Present value of $1
factor for 5 years at 10%.

12. Net-Present-Value Method
We then add together all of the present values. A positive net present value means that the value of accepting the proposal exceeds the negatives, and that the return on this investment is at least as high as the hurdle rate. Considering the net present value method only, this proposal should be accepted by Mattson.
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.

13. 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.
An alternative discounted-cash-flow method for analyzing investment proposals is the internal-rate-of-return method. An asset’s internal rate of return, or time-adjusted rate of return is the true economic return earned by the asset over its life.
Another way of stating the definition is that an asset’s internal rate of return, IRR is the discount rate that would be required in a net-present-value analysis in order for the asset’s net present value to be exactly zero.

14. 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.
A new machine will cost $104,320 and will save Black Company $20,000 per year n cash operating costs. This machine will last ten years.

15. 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
The IRR is calculated by taking the amount of the investment and dividing it by the net annual cash inflows. This gives us a present value factor to enter into the tables with.
$104, 320
$20,000 =

16. 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.
We look in a present value table across the ten year line until we find the number that is closest to our calculated factor. We find our factor under the 14% column. This is the internal rate of return.
$104, 320
$20,000 =

17. Internal-Rate-of-Return Method
Here’s the proof . . .
To prove that 14% is the rate of return, we work backwards and calculate the net present value to be zero.
The decision rule in the internal-rate-of-return method is to accept an investment proposal if its internal rate of return is greater than the organization’s cost of capital, or hurdle rate.

18. Learning Objective 2
Learning objective two. Compare the net-present-value and internal-rate-of-return methods, and state the assumptions underlying each method.

19. 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.
Calculation of the net present value is relatively simple. The cost of capital is used as the actual discount rate and any negative value is rejected because it does not return the hurdle rate.

20. 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.
The internal rate of return, once calculated is compared to the hurdle rate. If the return is greater than the cost of capital the project is acceptable.

21. 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.
Provides more usable information.
The net-present-value method exhibits two potential advantages over the internal-rate-of-return method. First, if the investment analysis is carried out by hand, it is easier to compute a project’s NPV than its IRR. For example, if the cash flows are uneven across time, trial and error must be used to find the IRR. This advantage of the NPV approach is not as important, however, when a computer is used.
A second potential advantage of the NPV method is that the analyst can adjust for risk considerations. For some investment proposals, the further into the future that a cash flow occurs, the less certain the analyst can be about the amount of the cash flow. Thus, the later a projected cash flow occurs, the riskier it may be. It is possible to adjust a net-present-value analysis for such risk factors by using a higher discount rate for later cash flows than earlier cash flows. It is not possible to include such a risk adjustment in the internal-rate-of-return method, because the analysis solves for only a single discount rate, the project’s IRR.

22. 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.
Some assumptions are made in discounted cash flow analyses.
In the present-value calculations used in the NPV and IRR methods, all cash flows are treated as though they occur at year-end. Most annual operating-cost savings actually would occur uniformly throughout each year. The additional computational complexity that would be required to reflect the exact timing of all cash flows would complicate an investment analysis considerably. The error introduced by the year-end cash-flow assumption generally is not large enough to cause any concern.
Discounted-cash-flow analyses treat the cash flows associated with an investment project as though they were known with certainty. Although methods of capital budgeting under uncertainty have been developed, they are not used widely in practice. Most decision makers do not feel that the additional benefits in improved decisions are worth the additional complexity involved. As mentioned above, however, risk adjustments can be made in an NPV analysis to partially account for uncertainty about the cash flows.
Both the NPV and IRR methods assume that each cash inflow is immediately reinvested in another project that earns a return for the organization. In the NPV method, each cash inflow is assumed to be reinvested at the same rate used to compute the project’s NPV, the organization’s hurdle rate. In the IRR method, each cash inflow is assumed to be reinvested at the same rate as the project’s internal rate of return.
A discounted-cash-flow analysis assumes a perfect capital market. This implies that money can be borrowed or lent at an interest rate equal to the hurdle rate used in the analysis.

23. Choosing the Hurdle Rate
The discount rate generally is associated with the company’s cost of capital.
The cost of capital involves a blending of the costs of all sources of investment funds, both debt and equity.
The choice of a hurdle rate is a complex problem in finance. The hurdle rate is determined by management based on the investment opportunity rate. This is the rate of return the organization can earn on its best alternative investments of equivalent risk.
In general, the greater a project’s risk is, the higher the hurdle rate should be.

24. Depreciable Assets
Both the NPV and IRR methods focus on cash flows, and periodic depreciation charges are not cash flows . . .
Tax Return
Form 1120
Depreciation
is tax
deductible
and . . .
Reduces
cash
outflows for
taxes.
When a long-lived asset is purchased, its acquisition cost is allocated to the time periods in the asset’s life through depreciation charges. However, we did not include any depreciation charges in our discounted-cash-flow analysis. Both the NPV and IRR methods focus on cash flows, and periodic depreciation charges are not cash flows.
The tax implications of depreciation do cause a positive cash flow however.

25. Learning Objective 3
Learning objective three. Use both the total-cost approach and the incremental-cost approach to evaluate an investment proposal.

26. Comparing Two Investment Projects
To compare competing investment projects we can use the following net present value approaches:
Total-Cost Approach.
Incremental-Cost Approach.
The total-cost approach, uses all of the relevant costs of each proposal and are included in the analysis.
The incremental-cost approach, is where just the difference in the cost of each relevant item under the two alternative systems is included in the analysis.

27. Total-Cost Approach Each system would last five years.
12 percent hurdle rate for the analysis.
MAINFRAME PC _
Salvage value old system $ 25,000 $ 25,000
Cost of new system (400,000) (300,000)
Cost of new software ( 40,000) ( 75,000)
Update new system ( 40,000) ( 60,000)
Salvage value new system 50, ,000
================================================
Operating costs over 5-year life:
Personnel (300,000) (220,000)
Maintenance ( 25,000) ( 10,000)
Other costs ( 10,000) ( 5,000)
Datalink services ( 20,000) ( 20,000)
Revenue from time-share 25,
The computing system used by the city of Mountainview is outdated. The city council has voted to purchase a new computing system to be funded through municipal bonds. The mayor has asked the city’s controller to make a recommendation as to which of two computing systems should be purchased.
The two systems are equivalent in their ability to meet the city’s needs and in their ease of use. The mainframe system consists of one large mainframe computer with remote terminals and printers located throughout the city offices. The personal computer system consists of a much smaller mainframe computer, a few remote terminals, and a dozen personal computers, which will be networked to the small mainframe.
Mountainview’s accountant has prepared the above schedule of net costs.
Before we begin the steps of the net-present-value method, let’s examine the cashflow data in the slide to determine if any of the data can be ignored as irrelevant. Notice that salvage values and data link do not differ between the two alternatives. Regardless of which new computing system is purchased, certain components of the old system can be sold now for $25,000. Moreover, the data-link service will cost $20,000 annually, regardless of which system is acquired. If the only purpose of the NPV analysis is to determine which computer system is the least-cost alternative, then salvage values and data link can be ignored as irrelevant, since they will affect both alternatives’ NPVs equally.

28. Total-Cost Approach SUM = ($1,575,705) SUM = ($1,247,885)
MAINFRAME ($) Today Year Year Year Year Year 5
Acquisition cost computer (400,000)
Acquisition cost software ( 40,000)
System update ( 40,000)
Salvage value ,000
Operating costs (335,000) (335,000) (335,000) (335,000) (335,000) (335,000)
Time sharing revenue , , , , , ,000
Total cash flow 440, (315,000) (315,000) (355,000) (315,000) (265,000)
X Discount factor X X X X X X
Present value (440,000) (281,295) (251,055) (252,760) (200,340) (150,255)
SUM = ($1,575,705)
PERSONAL COMPUTER ($) Today Year Year Year Year Year 5
Acquisition cost computer (300,000)
Acquisition cost software ( 75,000)
System update ( 60,000)
Salvage value ,000
Operating costs (235,000) (235,000) (235,000) (235,000) (235,000) (235,000)
Time sharing revenue _
Total cash flow 375, (235,000) (235,000) (295,000) (235,000) (205,000)
X Discount factor X X X X X X
Present value (375,000) (209,855) (187,295) (210,040) (149,460) (116,235)
SUM = ($1,247,885)
The slide shown here displays a net-present-value analysis of the two alternative computing systems. The exhibit uses the total-cost approach, in which all of the relevant costs of each computing system are included in the analysis. Then the net present value of the cost of the mainframe system is compared with that of the personal computer system.

29. Total-Cost Approach
Net cost of purchasing Mainframe system ($1,575,705)
Net cost of purchasing Personal Computer system ($1,247,885)
Net Present Value of costs ($ 327,820)
Since the NPV of the costs is lower with the personal computer system, that will be the controller’s recommendation to the Mountainview City Council. A decision such as Mountainview’s computing-system choice, in which the objective is to select the alternative with the lowest cost, is called a least-cost decision. Rather than maximizing the NPV of cash inflows minus cash outflows, the objective is to minimize the NPV of the costs to be incurred.
Mountainview should purchase the personal computer system for a cost savings of $327,820.

30. Incremental-Cost Approach
Irrelevant
MAINFRAME PC _ Differentials
Salvage value old system $ 25,000 $ 25,000 0
Cost of new system (400,000) (300,000) (100,000)
Cost of new software ( 40,000) ( 75,000) ,000
Update new system ( 40,000) ( 60,000) ,000
Salvage value new system 50, , ,000 ===========================================================
Operating costs over 5-year life:
Personnel (300,000) (220,000) ( 80,000)
Maintenance ( 25,000) ( 10,000) ( 15,000)
Other costs ( 10,000) ( 5,000) ( 5,000)
Datalink services ( 20,000) ( 20,000)
Revenue from time-share 20, ,000
Here is the same information presented in the total cost approach slide. Recall that the salvage value of the old equipment and the Datalink services are irrelevant to this decision because they are the same no matter which computer system we choose.
Here, we have taken the differences between the relevant items. This slide uses the incremental-cost approach, in which only the difference in the cost of each relevant item under the two alternative systems is included in the analysis. For example, the incremental computer acquisition cost is a negative $100,000. This is the amount by which the acquisition cost of the mainframe system exceeds that of the personal computer system.

31. Incremental-Cost Approach
Today Year Year Year Year Year 5
Acquisition cost computer (100,000)
Acquisition cost software ,000
System update ,000
Salvage value ,000
Operating costs (100,000) (100,000) (100,000) (100,000) (100,000)
Time sharing revenue , , , , , ,000
Total cash flow ( 65,000) ( 80,000) ( 80,000) ( 80,000) ( 80,000) ( 60,000)
X Discount factor X X X X X X
Present value ( 65,000) ( 71,440) ( 63,760) ( 42,720) ( 50,880) ( 34,020)
SUM = ($ 327,820)
The slide shown here displays the incremental net-present-value analysis of the city’s two alternative computing systems. The result of this analysis is that the NPV of the costs of the mainframe system exceeds that of the personal computer system by $327,820.

32. Total-Incremental Cost Comparison
Total Cost:
Net cost of purchasing Mainframe system ($1,575,705)
Net cost of purchasing Personal Computer system ($1,247,885)
Net Present Value of costs ($ 327,820)
Incremental Cost:
Net Present Value of costs ($ 327,820)
The total-cost and incremental-cost approaches always will yield equivalent conclusions. Choosing between them is a matter of personal preference.
Different methods, Same results.

33. Managerial Accountant’s Role
Managerial accountants are often asked to predict cash flows related to operating cost savings, additional working capital requirements, and incremental costs and revenues.
When cash flow projections are very uncertain, the accountant may . . .
increase the hurdle rate,
use sensitivity analysis.
To use discounted-cash-flow analysis in deciding about investment projects, managers need accurate cash-flow projections. This is where the managerial accountant plays an important role. The accountant often is asked to predict cash flows related to operating-cost savings, additional working-capital requirements, or incremental costs and revenues. Such predictions are difficult in a world of uncertainty. The managerial accountant often draws upon historical accounting data to help in making cost predictions. Knowledge of market conditions, economic trends, and the likely reactions of competitors can also be important in projecting cash flows.

34. Postaudit of Investment Projects
A postaudit is a follow-up after the project has been approved to see whether or not expected results are actually realized.
The discounted-cash-flow approach to evaluating investment proposals requires cash flow projections. The desirability of a proposal depends heavily on those projections. If they are highly inaccurate, they may lead the organization to accept undesirable projects or to reject projects that should be pursued. Because of the importance of the capital-budgeting process, most organizations systematically follow up on projects to see how they turn out. This procedure is called a postaudit or reappraisal.
In a postaudit, the managerial accountant gathers actual information about the actual cash flows generated by a project. Then the project’s actual net present value or internal rate of return is computed. Finally, the projections made for the project are compared with the actual results. If the project has not lived up to expectations, an investigation may be warranted to determine what went awry.
Sometimes a postaudit will reveal shortcomings in the cash-flow projection process. In such cases, action may be taken to improve future cash-flow predictions. Two types of errors can occur in discounted-cash-flow analyses; undesirable projects may be accepted and desirable projects may be rejected. The postaudit is a tool for following up on accepted projects.
Thus, a postaudit helps to detect only the first kind of error, not the second. As in any performance-evaluation process, a postaudit should not be used punitively.
The focus of a postaudit should provide information to the capital-budgeting staff, the project manager, and the management team.

35. Learning Objective 4
Learning objective four. Determine the after-tax cash flows in an investment analysis.

36. Income Taxes and Capital Budgeting
Cash flows from an investment proposal affect the company’s profit and its income tax liability.
Income = Revenue - Expenses + Gains - Losses
When a business makes a profit, it usually must pay income taxes, just as individuals do. Since many of the cash flows associated with an investment proposal affect the company’s profit, they also affect the firm’s income-tax liability.
Any aspect of an investment project that affects any of the items in this equation generally will affect the company’s income-tax payments. These income-tax payments are cash flows, and they must be considered in any discounted-cash-flow analysis. In some cases, tax considerations are so crucial in a capital-investment decision that they dominate all other aspects of the analysis. 18 26

37. The tax rate is 40%, so income taxes are
After-Tax Cash Flows
High Country Department Stores
Income Statement
For the Year Ended Jun 30, 2007
Revenue $ 1,000,000
Expenses (475,000)
Income before taxes ,000
Income taxes (210,000)
Net Income ,000
High Country’s after tax cash flows are $315,000.
The tax rate is 40%, so income taxes are
$525,000 × 40% = $ 210,000

38. Cash Revenues
High Country’s management is considering the purchase of a new truck that will increase cash revenues by $120,000 and increase cash cost of goods sold by $60,000. The company is subject to a tax rate of 40%. Let’s calculate the company’s after-tax cash flows.
High Country is considering the purchase of a new truck. The new truck will increase cash revenues by $120,000, and increase the cost of goods sold by $60,000. High Country incurs a 40% tax rate.

39. The tax rate is 40%, so income taxes are
After-Tax Cash Flows
High Country Department Stores
Income Statement
For the Year Ended Jun 30, 2007
Revenue $ 120,000
Cash CGS ( 60,000)
Income before taxes ,000
Income taxes (24,000)
Net Income ,000_
High Country’s after tax cash flows from the purchase of the new truck are $30,000.
The tax rate is 40%, so income taxes are
$60,000 × 40% = $ 24,000

40. High Country Department Stores
After-Tax Cash Flows
High Country Department Stores
Income Statement
For the Year Ended Jun 30, 2007
Revenue $ 120,000
Cash CGS ( 60,000)
Income before taxes ,000
Income taxes (24,000)
Net Income ,000_
A short cut to calculating after tax cash flows is to multiply pre tax cash flows times one minus the tax rate.
A short cut works like this:
Increase in income × ( tax rate)
$60,000 × ( ) = $36,000

41. Noncash Expenses
Not all expenses require cash outflows. The most common example is depreciation. Recall that High Country’s proposal involved the purchase of a truck. The truck cost $40,000 and will be depreciated over four years using straight-line depreciation. The truck is to be purchased on June 30, One-half year depreciation is taken in 2007.
Some expenses, depreciation being one of them, require no cash flows, yet they reduce the amount of taxable net income.

42. Here is a complete depreciation schedule for High Country.
Noncash Expenses
Here is a complete depreciation schedule for High Country.
Depreciation Tax Reduced Tax
Year Expense Rate Payment _
1 $ 5, % $ 2,000
, % 4,000
, % 4,000
, % 4,000
5 5, % 2,000
40, ,000
Depreciation
Tax
Shield
A depreciation schedule is prepared by High Country’s accountant. Depreciation reduces the net income, reducing taxes that must be paid in cash.

43. Net Present Value Analysis
Calculation of the present value of proposal cash flows.
INCREMENTAL ($)
Today Year Year Year Year Year 5
Acquisition cost $( 40,000)
Cash flows from proposal $ 18,000 $ 36,000 $ 36, $ 36, $ 18,000
Depreciation shield , , , , ,000
Total cash flow ( 40,000) 20, , , , ,000
X Discount factor X X X X X X
Present value ( 40,000) 17, , , , ,340
SUM = $ 75,000
We then calculate the present value of the cash flows after depreciation. The sum of the present values, after tax, is $75,000, indicating that the truck should be purchased.
The sum of the present values from this
proposal is a positive $75,000 29

44. Learning Objective 5
Learning objective five. Use the Modified Accelerated Cost Recovery System to determine an asset’s depreciation schedule for tax purposes.

45. Modified Accelerated Cost Recovery System (MACRS)
Tax depreciation is usually computed using MACRS. Here are the depreciation rate for 3, 5, and 7-year class life assets.
The Modified Accelerated Cost Recovery System, or MACRS (pronounced makers) is a depreciation schedule created by the Internal Revenue Service in order to account for the depreciation of assets, or, investments. Assets are classified as three, five or seven year investments for taxation purposes. The depreciation percentages that may be taken for the classes of assets are shown in the above schedule. 30

46. Modified Accelerated Cost Recovery System (MACRS)
A company is considering the purchase of a machine that will increase after-tax cash flows by $20,000 over the next five years. The machine is depreciated using MACRS and the company uses a 10% discount rate to compute all present values. The machine will cost $100,000 and the company is subject to a 28% tax rate. Let’s calculate the net present value of the proposal.
A business is considering a proposal to purchase a machine that will increase their after tax cash flows over the next five years. A 10% discount rate is used. The machine will cost $100, 000 and the business is subject to a 28% tax rate on income.

47. Modified Accelerated Cost Recovery System (MACRS)
Calculation of the present value of the depreciation tax shield.
$5,600 × (1.10)^-1
$100,000 × 20%
$20,000 × 28%
The tax shield from the depreciation is calculated first, then the present value of the tax shield is calculated. The present value of the tax shield is $21,644. 30

48. Modified Accelerated Cost Recovery System (MACRS)
Calculation of the present value proposal cash flows.
$20,000 × (1.10)^-1
Next, the present value of the cash flows is calculated. 30

49. Modified Accelerated Cost Recovery System (MACRS)
Net present value of the proposal.
The present
value of the
proposal is less
than the cost
of the equipment
($100,000). The
proposal has a
negative net
present value.
The present value of the after tax cash flows is less than the cost of the equipment, indicating that the proposal should not be accepted 30

50. Investment in Working Capital
Some investment proposals require additional outlays for working capital such as increases in cash, accounts receivable, and inventory.
Some investment proposals require additional outlays for working capital. Working capital, defined as the excess of current assets over current liabilities, often increases as the result of higher balances in accounts receivable or inventory necessary to support a project. Such increases are uses of cash and should be included in a discounted cash-flow analysis. 2 2

51. Learning Objective 6
Learning objective six. Evaluate an investment proposal using a discounted-cash-flow analysis, giving full consideration to income-tax issues.

52. Extended Illustration
Let take a close look at a present value analysis for an investment decision facing James Company.
James
Company
Here is a complete present value analysis for James company. 36

53. Extended Illustration
James Company has been offered a five-year contract to provide component parts for a large manufacturer.
James is considering a proposal to provide parts for another manufacturer. The accountant has prepared the cash flow schedule shown here. 37 21

54. Extended Illustration
At the end of five years the working capital will be released and may be used elsewhere by James.
James Company uses a discount rate of 10%.
James uses straight-line depreciation.
All items in this example are taxed at 30%.
Should the contract be accepted?
Other information gathered by James Company’s accountant are the working capital requirements, the discount rate to be used, depreciation schedule used and tax rate. 38 22

55. Extended Illustration
Annual accounting income from operations
Remember
depreciation is
a non-cash
expense that
provides a
tax shield.
The net income, including depreciation from the proposal will be $48,300. Although depreciation is a non-cash expense, it does have the benefit of reducing the amount of cash paid out in taxes. 23 39

56. Extended Illustration
Annual cash inflows from operations
Remember
depreciation is
a non-cash
expense that
provides a
tax shield.
Removing the depreciation from the net income modifies the income statement to a cash income statement. 23 39

57. Extended Illustration
Another after tax consideration is the relining of the equipment in the third year. The cash benefit of the relining is $21,000.
The relining is considered normal maintenance and will reduce income in year 3. Because the cost is tax deductible, income will be lower by $21,000 ($30,000 × 1- tax rate). 41 25

58. Extended Illustration
At the end of the equipment’s life, the salvage value will equal book value, so there are no tax implication of disposal of the asset.
Because the salvage value of the equipment will equal the book value (cost less accumulated depreciation),
there will be no taxable gain or loss. 41 25

59. Extended Illustration
The present value of the cash inflows are calculated. 43 27

60. Extended Illustration
The present value of the relining is calculated.
Present value of $1
factor for 3 years at 10%. 45 30

61. Extended Illustration
The present value of the salvage value of the equipment is calculated.
Present value of $1
factor for 5 years at 10%. 47 32

62. Extended Illustration
This proposal should be accepted because the present value of the after tax cash inflows exceeds the present value of the after tax cash outflows by $92,836.
We should accept the contract because the present
value of the cash inflows exceeds the present value
of the cash outflows by $92,836. The project has a positive net present value. 48 33

63. Extended Illustration
General decision rule . . .
In general, if the net present value of a proposed project is positive, it should be accepted. If negative the proposal should be rejected. If zero, the project will return the hurdle rate of the investment. 50 35

64. Learning Objective 7
Learning objective seven. Discuss the difficulty of ranking investment proposals, and use the profitability index.

65. Ranking Investment Projects
We can invest in either of these projects. Use a 10% discount rate to determine the net present value of the cash flows.
Suppose a company has several potential investment projects, all of which have positive net present values. If a project has a positive net present value, this means that the return projected for the project exceeds the company’s cost of capital. In this case, every project with a positive NPV should be accepted. In spite of the theoretical validity of this argument, practice often does not reflect this viewpoint. In practice, managers often attempt to rank investment projects with positive net present values. Then only a limited number of the higher-ranking proposals are accepted.
The reasons for this common practice are not clear. If a discount rate is used that accurately reflects the firm’s cost of capital, then any project with a positive NPV will earn a return greater than the cost of obtaining capital to fund it. One possible explanation for the practice of ranking investment projects is a limited supply of scarce resources, such as managerial talent. Thus, a form of capital rationing takes place, not because of a limited supply of investment capital, but because of limitations on other resources. A manager may feel that he or she simply cannot devote sufficient attention to all of the desirable projects. The solution, then, is to select only some of the positive-NPV proposals, which implies a ranking.
Shown here is an example of two proposals, project a, and project b. 12 10

66. Ranking Investment Projects
We can invest in either of these projects. Use a 10% discount rate to determine the net present value of the cash flows.
The total cash flows are the same,
but the pattern of the flows is
different.
In this example, the total cash flows for each proposal is the same in total, but the timing of the cash flows occur differently. 10 13

67. Ranking Investment Projects
Let’s calculate the present value of the cash flows associated with Project A.
Since the cash flows are uneven, we must calculate the present value of each cash flow individually. 14

68. Ranking Investment Projects
Let’s calculate the present value of the cash flows associated with Project A.
Using a table or calculator to determine the present value factor, we multiply that times the first cash flow, and get the present value of that cash flow.
(1.10)-1 = rounded 16

69. Ranking Investment Projects
Let’s calculate the present value of the cash flows associated with Project A.
We repeat the process for the second cash flow.
(1.10)-2 = rounded 18

70. Ranking Investment Projects
Let’s calculate the present value of the cash flows associated with Project A.
After calculating the present value of the third cash flow, we add them up, subtracting the initial cost of the project. The net present value of project a is $1,020, and returns greater than the discount rate.
This project has a positive net present value which means
the project’s return is greater than the discount rate. 20

71. Ranking Investment Projects
Here is the net present value of the cash flows associated with Project B.
We repeat the process for project b. The net present value of the project is negative, indicating that the proposal will not return at least the discount rate.
Project B has a negative net present value which means
the project’s return is less than the discount rate. 21

72. Internal Rate of Return (IRR)
The interest rate that equates the present value of inflows and outflows from an investment project.
The internal rate of return is the interest rate that equates the present value of the inflows and outflows from an investment. 60

73. Internal Rate of Return (IRR)
When the cash flows from a project are constant, the present value of an annuity factor can be used to approximate the rate of return.
A project cost $90,119, and will yield net cash inflows of $25,000 at the end of each of the next five years.
A project will yield $25,000 worth of net cash inflows for the next five years and cost $90,119.
Let’s determine the IRR for this project! 61

74. Internal Rate of Return (IRR)
Required Investment
Annual net cash flow
PV factor =
$90,119
$25,000
PV factor =
PV factor =
3.605 rounded
We divide the cost of the investment by the annual net cash flow to get a present value factor. We then enter the tables across the five year line to find the factor that is closest to our calculation. Looking above the factor that was found, the internal rate of return is 12%.
The present value of an annuity factor of 3.605,
is an internal rate of return of 12%. 64

75. Learning Objective 8
Learning objective eight. Use the payback method and accounting-rate-of-return method to evaluate capital investment projects.

76. Alternative Methods for Making Investment Decisions
Payback Method
Payback
period
Initial investment
Annual after-tax cash inflow =
A company can purchase a machine for $20,000 that
will provide annual cash inflows of $4,000 for 7 years.
The payback period of an investment proposal is the amount of time it will take for the after-tax cash inflows from the project to accumulate to an amount that covers the original investment. The formula on the slide defines an investment project’s payback period.
In this example, the amount of the initial investment will be recovered in five years.
Payback
period
$20,000
$4,000 = =
5 years 22 11

77. Payback: Pro and Con Fails to consider the time value of money.
Does not consider a project’s cash flows beyond the payback period.
The payback method makes it appear as though an investment might recover its initial investment more quickly, but the method fails to consider the time value of money.
Another shortcoming of the payback method is that it fails to consider an investment project’s profitability beyond the payback period.

78. Payback: Pro and Con
Provides a tool for roughly screening investments.
For some firms, it may be essential that an investment recoup its initial cash outflows as quickly as possible.
Despite the shortcomings, the payback method is used widely in practice, for two legitimate reasons.
First, the payback method provides a tool for roughly screening investment proposals. If a project does not meet some minimal criterion for the payback period, management may wish to reject the proposal regardless of potential large cash flows predicted well into the future.
Second, a young firm may experience a shortage of cash. For such a company, it may be crucial to select investment projects that recoup their initial investment quickly. A cash-poor firm may not be able to wait for the big payoff of a project with a long payback period. Even in these cases, it is wise not to rely on the payback method alone. If the payback method is used, it should be in conjunction with a discounted-cash-flow analysis.

79. Accounting-Rate-of-Return Method
Discounted-cash-flow method focuses on cash flows and the time value of money.
Accounting-rate-of-return method focuses on the incremental accounting income that results from a project.
Discounted-cash-flow methods of investment analysis focus on cash flows and incorporate the time value of money. The accounting-rate-of-return method focuses on the incremental accounting income that results from a project. Accounting income is based on accrual accounting procedures. Revenue is recognized during the period of sale, not necessarily when the cash is received; expenses are recognized during the period they are incurred, not necessarily when they are paid in cash. 23 12

80. Accounting-Rate-of-Return Method
The following formula is used to calculate the accounting rate of return:
Accounting
rate of
return =
Average Average
incremental incremental expenses,
revenues including depreciation -
Initial investment
The formula shown on the slide is used to compute the accounting rate of return on an investment project.

81. Accounting-Rate-of-Return Method
Meyers Company wants to install an espresso bar in its restaurant.
The espresso bar:
Cost $140,000 and has a 10-year life.
Will generate incremental revenues of $100,000 and incremental expenses of $80,000 including depreciation.
What is the accounting rate of return on the investment project?
Meyers is considering installing an espresso bar. It will cost $140,000 and have a ten year life, generating revenues of $100,000 and incremental expenses of $80,000.

82. Accounting-Rate-of-Return Method
$100, $80,000
$140,000 =
= 14.3%
The accounting rate of return method is not recommended
for a variety of reasons, the most important of which
is that it ignores the time value of money.
The accounting rate of return is 14.3%. Like the payback method, the accounting rate-of-return method is a simple way of screening investment proposals. Some managers use this method because they believe it parallels financial accounting statements, which also are based on accrual accounting. However, like the payback method, the accounting-rate-of-return method does not consider the time value of money.

83. Capital Budgeting Practices
Percent of managers who believe each technique is important.
Despite their pros and cons, the percentage of managers who believe each technique is important is shown on the slide.

84. Learning Objective 9
Learning objective nine. Describe the impact of activity-based costing and advanced manufacturing technology on capital-budgeting decisions.

85. Estimating Cash Flows: The Role of Activity-Based Costing
ABC systems generally improve the ability of an analyst to estimate the cash flows associated with a proposed project.
The manufacturing industry is changing dramatically as firms adopt the just-in-time philosophy, collect cost information using activity based costing and move toward computer-integrated-manufacturing systems.
Many firms have found that JIT and CIM, coupled with a revised managerial accounting system, have provided a competitive edge in the marketplace. In many cases, however, managers have been frustrated when an NPV analysis projects a negative net present value for a proposed investment in a CIM system. Managers often believe intuitively that such an investment is justified, but they are stymied when the NPV analysis points to rejection of the proposal.
What is the problem here? Are managers overly optimistic about the advantages of CIM? Or is the NPV approach inappropriate for such an investment decision? Most likely neither of these conjectures is true. Managers often are right when their intuition tells them that the company would benefit from advanced manufacturing technology. And it is difficult to find fault with the NPV investment decision model. It is economically and mathematically sound. The problem lies in the difficulties of applying the NPV approach in a CIM investment decision.

86. Justification of Investments in Advanced Manufacturing Systems
Time
horizons
are too
short
Hurdle
rates are
too high
Bias
towards
incremental
projects
Some of the problems in evaluating advanced manufacturing systems are shown here on the slide.
Hurdle rates that are too high. Sometimes managers have a tendency to set hurdle rates that are too high in a CIM investment analysis. They tend to forget that the purpose of discounting in the NPV model is to account for the time value of money. The appropriate hurdle rate for any investment decision is the investment opportunity rate for alternative investment projects of equivalent risk. In many cases managers tend to overstate this rate.
Another common mistake is to evaluate a CIM investment proposal with too short a time horizon. The acquisition cost of a CIM system can be enormous, and the benefits may be realized over a lengthy period of time.
Most firms require that large investments be authorized by managers at higher levels than are required for smaller investments. One result of this sensible practice is an incentive for lower-level managers to request relatively small, incremental improvements in the manufacturing process rather than a large, comprehensive improvement, such as a move to CIM. In many cases, a series of such incremental improvements will not bring about the benefits that could be attained with a full commitment to advanced manufacturing technology.
Managers often have greater uncertainty about the cash flows that will result when an advanced manufacturing system is implemented. This increased uncertainty is due to the complexity of the machinery and the firm’s inexperience with such advanced technology.
The benefits to the firm from JIT and CIM systems are extensive. Some are easy to estimate, such as lower inventory levels, less floor space, and improved product quality. Others that can be even more significant are often difficult to quantify. Some of these benefits are greater flexibility in the production process, a flexible manufacturing system cell often can produce runs of several distinct products in the same day, flexible manufacturing systems also allow engineering changes to be made more easily as products are adapted to changing customer preferences.
Shorter cycle times and reduced lead times are possible with an FMS. This enables the firm to fill customer orders more quickly. Reduction of non-value-added costs often results when JIT and FMS systems are adopted. Part of the philosophy of these systems is to encourage employees to seek out activities that can be made more efficient or eliminated. Reduced inventory levels result in savings on working capital investment, less storage space, and reduced obsolescence. Lower floor-space requirements in a flexible manufacturing system require less space than several stand-alone machines. Product quality becomes higher and more constant because of advanced manufacturing systems.
Benefits
difficult to
quantify
Greater
cash flow
uncertainty

87. Learning Objective 10
Learning objective ten. Explain the impact of inflation on a capital-budgeting analysis.

88. Inflation Effects Nominal Dollars Real dollars
Most countries have experienced inflation to some degree over the past 30 years. Inflation is defined as a decline in the general purchasing power of a monetary unit, such as a dollar, across time. Since capital budgeting decisions involve cash flows over several time periods, it is worthwhile to examine the impact of inflation in capital-budgeting analyses.
Inflation can be incorporated in a discounted-cash-flow analysis in either of two ways. Both approaches yield correct results, but the analyst must be careful to be consistent in applying either approach. The two approaches are distinguished by the use of either nominal or real interest rates and dollars.
The real interest rate is the underlying interest rate, which includes compensation to investors for the time value of money and the risk of an investment. The nominal interest rate includes the real interest rate, plus an additional premium to compensate investors for inflation.
Either capital-budgeting approach will provide the correct conclusion, as long as it is applied consistently. Use either nominal dollars and a nominal discount rate or real dollars and a real discount rate. A common error in capital budgeting is to convert the after-tax cash flows to real dollars, but then use the nominal discount rate. This faulty analysis creates a bias against acceptance of worthwhile projects. 60

89. End of Chapter 16
An investment of time in this chapter will bring returns for the rest of your life!