1. Planning for Capital Investments Chapter 10

2. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-2 Capital Investment Decisions The purchase of long-term operational assets are called capital investments. The capital investment decision is essentially a decision to exchange current cash outflows for the promise of receiving future cash inflows. The capital investment decision is essentially a decision to exchange current cash outflows for the promise of receiving future cash inflows. Purchase asset Produce added revenue

3. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-3 Typical Capital Budgeting Decisions Capital budgeting tends to fall into two broad categories...  Screening decisions. Does a proposed project meet some present standard of acceptance?  Preference decisions. Selecting from among several competing courses of action.

4. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-4 Time Value of Money A dollar received in the future is of less value than a dollar received today.  A dollar received today could be deposited and earn interest.  Inflation diminishes the buying power of a dollar.  There is an element of risk associated with receiving future dollars.

5. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-5 Determining the Minimum Rate of Return The company’s cost of capital represents the minimum acceptable rate of return on investments.

6. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-6 Converting Future Cash Inflows Into Their Equivalent Present Value Assume that EZ desires to earn a 12% rate of return on all investments. How much money should EZ be willing to invest today to receive $200,000 in one year?

7. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-7 Converting Future Cash Inflows Into Their Equivalent Present Value Investment + (.12 × Investment) = Future Cash Inflow 1.12 Investment = $200,000 Investment = $178,571* * rounded to the nearest dollar.

8. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-8 Present Value Table for Single Amount Cash Inflows Part of Table 1 in Appendix A $200,000 x 0.892857 = $178,571

9. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-9 Present Value Table for Annuities annuity An investment that involves a series of identical cash flows at the end of each year is called an annuity. 123456 $100$100$100$100$100$100

10. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-10 Time Value of Money Lacey Co. purchased a tract of land on which a $60,000 payment will be due each year for the next five years. What is the present value of this stream of cash payments when the discount rate is 12%?

11. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-11 Time Value of Money We could solve the problem like this... Look at Table 2 in Appendix A for the Present Value of an Annuity of $1 Table $60,000 × 3.604776 = $216,287

12. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-12 Net Present Value Carver Hospital is considering the purchase of an attachment for its X-ray machine that will cost $3,170. The attachment will be usable for four years, after which time it will have no salvage value. It will increase net cash inflows by $1,000 per year in the X-ray department. The hospital’s board of directors has instructed that no investments are to be made unless they have an annual return of at least 10%. Will we be allowed to invest in the attachment?

13. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-13 Net Present Value Present value of an annuity of $1 table Present value of an annuity of $1 table

14. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-14 Net Present Value Because the net present value is equal to zero, the attachment investment provides exactly a 10% return. Because the net present value is equal to zero, the attachment investment provides exactly a 10% return.

15. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-15 Net Present Value General decision rule...

16. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-16 Internal Rate of Return The rate that equates the present value of the cash inflows and outflows. The rate produces a zero net present value. The internal rate of return is compared to the desired rate of return to see if a project is acceptable.

17. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-17 Internal Rate of Return Decker Company 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.

18. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-18 Internal Rate of Return Future cash flows are the same every year in this example, so we can calculate the internal rate of return as follows: Investment required Investment required Net Annual Cash Flows Net Annual Cash Flows Factor of the internal rate of return = $104, 320 $20,000 = 5.216

19. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-19 Internal Rate of Return Find the 10-period row, move across until you find the factor 5.216. Look at the top of the column and you find a rate of 14%. Using the present value of an annuity of $1 table...

20. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-20 Internal Rate of Return Decker Company 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. The internal rate of return on this project is 14%. If the internal rate of return is equal to or greater than the company’s required rate of return, the project is acceptable.

21. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-21 Cash Inflows CostSavingsSalvagevalueIncrementalrevenues Release of workingcapital

22. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-22 Cash Outflows Initialinvestment Increase in operatingexpenses Workingcapital

23. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-23 Comparing Alternative Investment Opportunities Let’s look at how we use present value to make business decisions.

24. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-24 Net Present Value Lester Company has been offered a five-year contract to provide component parts for a large manufacturer.

25. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-25 Net Present Value At the end of five years the working capital will be released and may be used elsewhere by Lester. Lester Company uses a discount rate of 10%. Should the contract be accepted?

26. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-26 Net Present Value Annual net cash inflows from operations

27. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-27 Net Present Value

28. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-28 Net Present Value Present value of an annuity of $1 factor for 5 years at 10%. Present value of an annuity of $1 factor for 5 years at 10%.

29. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-29 Net Present Value Present value of $1 factor for 3 years at 10%. Present value of $1 factor for 3 years at 10%.

30. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-30 Net Present Value Present value of $1 factor for 5 years at 10%.

31. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-31 Net Present Value positive We should accept the contract because the present value of the cash inflows exceeds the present value of the cash outflows by $85,921. The project has a positive net present value.

32. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-32 Net Present Value White Co. is trying to decide whether to remodel an old car wash or remove it and install a new one. The company uses a discount rate of 10%.

33. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-33 Net Present Value The new washer costs $300,000 and will produce revenues for 10 years. The brushes have to be replaced at the end of 6 years at a cost of $50,000. The old washer has a current salvage value of $40,000. The estimated salvage value of the new washer will be $7,000 at the end of 10 years. Remodeling the old washer costs $175,000 and the brushes must be replaced at the end of 6 years at a cost of $80,000. Should White replace the washer?

34. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-34 Net Present Value If we install the new washer, the investment will yield a positive net present value of $83,149.

35. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-35 Net Present Value Now let’s see what happens if we remodel the existing washer.

36. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-36 Net Present Value If we remodel the existing washer, we will produce a positive net present value of $56,348.

37. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-37 The Total-Cost Approach Both projects yield a positive net present value so we need to develop a present value index. PV Index PV Cash Inflows PV Cash Outflows =

38. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-38 Net Present Value PV Index of remodeled washer == $276,506 $220,158 1.256 PV Index of new washer == $411,373 $328,224 1.253 The index indicates a decision slightly in favor of the decision to remodel the exiting washer. The index indicates a decision slightly in favor of the decision to remodel the exiting washer.

39. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-39 Tax Considerations The effects of income taxes on cash flows must be considered in capital budgeting decisions when an organization is subject to income taxes. 1040

40. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-40 Tax Considerations Although amortization is not a cash flow, it does have an impact on the amount of income taxes that a company will pay. Amortization deductions shield revenues from taxation and thereby reduce tax payments. Let’s look at an example of a amortization tax shield.

41. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-41 Tax Considerations Art and Music Companies are identical except that Art has a $60,000 annual amortization expense:

42. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-42 Tax Considerations As a result of the amortization deduction, Art has less net income than Music. But the difference is not $60,000.

43. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-43 Tax Considerations Let’s look more closely at the difference in net income. $60,000 × (1 –.30) = $42,000 We can compute the difference in net income as follows:

44. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-44 Tax Considerations The tax savings provided by the amortization tax shield is determined like this: Amortization Tax Shield =.30 × $60,000 = $18,000 Tax rate Amortization deduction × Amortization $60,000 Less: tax savings 18,000 Difference in income $42,000 Amortization $60,000 Less: tax savings 18,000 Difference in income $42,000

45. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-45 Techniques That Ignore Time Value of Money Other methods of making capital budgeting decisions include...  The Payback Method.  Unadjusted Rate of Return.

46. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-46 Payback Method payback period The payback period is the length of time that it takes for a project to recover its initial cost out of the cash receipts that it generates. Payback period = Net Cost of Investment Net Cost of Investment Annual Net Cash Inflow Annual Net Cash Inflow

47. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-47 Payback Method Management at The Daily Grind wants to install an espresso bar in its restaurant. The espresso bar:  Cost $140,000 and has a 10-year life.  Will generate net annual cash inflows of $35,000. Management requires a payback period of 5 years or less on all investments. Compute the payback period for the espresso bar?

48. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-48 Payback Method Payback period = $140,000 $140,000 $35,000 $35,000 Payback period = 4.0 years Given management’s decision criterion of a 5-year payback period, The Daily Grind should consider investing in the espresso bar. Payback period = Net Cost of Investment Net Cost of Investment Annual Net Cash Inflow Annual Net Cash Inflow

49. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-49 Provides no measurement of profitability of differentalternatives Interpreting Payback Ignores the time value of money Short-comings of the Payback Period.

50. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-50 Unadjusted Rate of Return accounting income Does not focus on cash flows -- rather it focuses on accounting income. The following formula is used to calculate the simple rate of return: Unadjusted rate of return = Average Incremental Increase in Annual Net Income Net Cost of Original Investment

51. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-51 Unadjusted Rate of Return Management of The Daily Grind 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 $65,000 including depreciation. What is the unadjusted rate of return on the investment project?

52. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-52 Unadjusted Rate of Return Unadjusted rate of return $100,000 - $65,000 $100,000 - $65,000 $140,000 $140,000 = 25% = 25%= The unadjusted 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.

53. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-53 Real-World Reporting Practices

54. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-54 Postaudits A postaudit is a follow-up after the project has been approved to see whether or not expected results are actually realized.

55. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 10-55 End of Chapter 10