1. Capital Expenditure Decisions
Chapter 16
Capital Expenditure Decisions
Chapter 16: Capital Expenditure Decisions
McGraw-Hill/Irwin
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Learning Objective 16-1 – Use the net-present-value method and the internal-rate-of-return method to evaluate an investment proposal.
Learning Objective Use the net-present-value method and the internal-rate-of-return method to evaluate an investment proposal.
16-2

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 774 through 780 of the text before continuing. (LO 16-1)
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4. Net-Present-Value Method
1. Prepare a table showing cash flows for each year, 2. Calculate the present value of each cash flow using a discount rate, 3. Compute net present value, 4. If the net present value (NPV) is zero or 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. (LO 16-1)
16-4

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. (LO 16-1)
16-5

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. (LO 16-1)
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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. (LO 16-1)
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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.
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.
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.
In addition, when the contract is completed, we will sell the equipment. The present value of the salvage value is $3,105.
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. (LO 16-1)
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.
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9. 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. (LO 16-1)
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10. 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 in cash operating costs.
This machine will last ten years. (LO 16-1)
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11. 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. (LO 16-1)
$104, 320
$20,000 =
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12. 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. (LO 16-1)
$104,320
$20,000 =
16-12

13. 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. (LO 16-1)
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14. Learning Objective 16-2 – Compare the net-present-value and internal-rate-of-return methods, and state the assumptions underlying each method.
Learning Objective Compare the net-present-value and internal-rate-of-return methods, and state the assumptions underlying each method.
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15. Comparing the NPV and IRR Methods (page 693)
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.
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.
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. (LO 16-2)
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16. 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.
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. (LO 16-2)
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17. 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. (LO 16-2)
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18. Choosing the Hurdle Rate
Minimum acceptable rate of return
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. (LO 16-2)
Read page 690 and 692.
16-18

19. Learning Objective 16-3 – Use both the total-cost approach and the incremental-cost approach to evaluate an investment proposal.
Learning Objective Use both the total-cost approach and the incremental-cost approach to evaluate an investment proposal.
16-19

20. 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. (LO 16-3)
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21. 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 cash flow data in the slide to determine if any of the data can be ignored as irrelevant. Notice that salvage values and datalink services 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 datalink service will cost $20,000 annually, regardless of which system is acquired. If the only purpose of the NPV analysis is to determine which computer system is the least-cost alternative, then salvage values and datalink services can be ignored as irrelevant, since they will affect both alternatives’ NPVs equally. (LO 16-3)
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22. Total-Cost Approach (page 697)
MAINFRAME ($) 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 OF PRESENT VALUES = ($1,575,705)
PERSONAL COMPUTER ($) 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 OF PRESENT VALUES = ($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. (LO 16-3)
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23. 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. (LO 16-3)
Mountainview should purchase the personal computer system for a cost savings of $327,820.
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24. Incremental-Cost Approach (page 698)
Today Year Year Year Year Year 5
Acquisition cost computer (100,000)
Acquisition cost software ,000
System update ,000
Salvage value ,000
Operating costs (100,000) (100,000) (100,000) (100,000) (100,000)
Time sharing revenue , , , , , ,000
Total cash flow ( 65,000) ( 80,000) ( 80,000) ( 80,000) ( 80,000) ( 60,000)
X Discount factor X X X X X X
Present value ( 65,000) ( 71,440) ( 63,760) ( 42,720) ( 50,880) ( 34,020)
SUM OF PRESENT VALUES = ($ 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. (LO 16-3)
16-24

25. 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 will always yield equivalent conclusions.
Choosing between them is a matter of personal preference. (LO 16-3)
Different methods, Same results.
16-25

26. 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. (LO 16-3)
16-26

27. 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 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. (LO 16-3)
16-27

28. Learning Objective 16-4 – Determine the after-tax cash flows in an investment analysis.
16-28

29. 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. (LO 16-4)
16-29 26 18

30. 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, 2017
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 for 2017 are $315,000.
Some expenses, depreciation being one of them, require no cash flows, yet they reduce the amount of taxable net income. (LO 16-4)
The tax rate is 40%, so income taxes are
$525,000 × 40% = $ 210,000
Not all expenses require cash outflows. The most common example is depreciation.
16-30

31. Learning Objective 16-5 – Use the Modified Accelerated Cost Recovery System to determine an asset’s depreciation schedule for tax purposes.
Page 703
Learning Objective Use the Modified Accelerated Cost Recovery System to determine an asset’s depreciation schedule for tax purposes.
16-31

32. Modified Accelerated Cost Recovery System (MACRS)
Tax depreciation is usually computed using MACRS. Here are the depreciation rates 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. (LO 16-5)
16-32 30

33. Learning Objective 16-6 – Evaluate an investment proposal using a discounted-cash-flow analysis, giving full consideration to income-tax issues.
Learning Objective Evaluate an investment proposal using a discounted-cash-flow analysis, giving full consideration to income-tax issues.
16-33

34. Investment in Working Capital
Current assets minus current liabilities
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. (LO 16-6)
16-34 2 2

35. Learning Objective 16-7 – Discuss the difficulty of ranking investment proposals, and use the profitability index.
Learning Objective Discuss the difficulty of ranking investment proposals, and use the profitability index.
16-35

36. 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.
In this example, the total cash flows for each proposal is the same in total, but the timing of the cash flows occur differently. (LO 16-7)
The total cash flows are the same, but the pattern of the flows is different.
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37. 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.
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.
We repeat the process for the second cash flow.
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, which signals a greater return than the discount rate. (LO 16-7)
This project has a positive net present value which means
the project’s return is greater than the discount rate.
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38. 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. (LO 16-7)
Project B has a negative net present value which means
the project’s return is less than the discount rate.
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39. Learning Objective 16-8 – Use the payback method and accounting rate-of-return method to evaluate capital investment projects. (both ignore the time value of money)
Learning Objective Use the payback method and accounting-rate-of-return method to evaluate capital investment projects.
16-39

40. 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. (LO 16-8)
Payback
period
$20,000
$4,000 = =
5 years
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41. Payback: Pro and Con
1. Provides a tool for roughly screening investments.
2. For some firms, it may be essential that an investment recoup its initial cash outflows as quickly as possible.
1. Fails to consider the time value of money.
2. 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.
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. (LO 16-8)
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42. 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. (LO 16-8)
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43. 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 &
income taxes -
Initial investment
The formula shown on the slide is used to compute the accounting rate of return on an investment project. (LO 16-8)
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44. 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 incremental revenues of $100,000 and incremental expenses of $80,000. (LO 16-8)
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45. 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. (LO 16-8)
16-45

46. Practice
Exercise 16-37

47. Learning Objective 16-9 – Describe the impact of activity-based costing and advanced manufacturing technology on capital-budgeting decisions.
Learning Objective Describe the impact of activity-based costing and advanced manufacturing technology on capital-budgeting decisions.
16-47

48. 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. (LO 16-9)
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49. Justification of Investments in Advanced Manufacturing Systems
Time
horizons
are too
short
Hurdle
rates are
too high
Bias
towards
incremental
projects
Benefits
difficult to
quantify
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. (LO 16-9)
Greater
cash flow
uncertainty
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50. Learning Objective 16-10 – Explain the impact of inflation on a capital-budgeting analysis.
Learning Objective Explain the impact of inflation on a capital-budgeting analysis (Appendix B).
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51. Nominal Dollars Real dollars
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. (LO 16-10)
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52. End Chapter 16
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