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## Capital Expenditure Decisions

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**16**Chapter Sixteen Capital Expenditure Decisions**Discounted-Cash-Flow Analysis**Plant expansion Equipment selection Equipment replacement Cost reduction Lease or buy**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.**Net-Present-Value Method**Mattson Co. has been offered a five year contract to provide component parts for a large manufacturer.**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?**Net-Present-Value Method**Annual net cash inflows from operations**Net-Present-Value Method**Present value of an annuity of $1 factor for 5 years at 10%.**Net-Present-Value Method**Present value of $1 factor for 3 years at 10%.**Net-Present-Value Method**Present value of $1 factor for 5 years at 10%.**Net-Present-Value Method**Mattson should accept the contract because the present value of the cash inflows exceeds the present value of the cash outflows by $85,955. The project has apositivenet present value.**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.**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.**Internal-Rate-of-Return Method**Future cash flows are the same every year in this example, so we can calculate the internal rate of return as follows: Investment required Net annual cash flows = Present value factor $104, 320 $20,000 =5.216**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 5.216. Look at the top of the column and you find a rate of 14% which is the internal rate of return. $104, 320 $20,000 = 5.216**Internal-Rate-of-Return Method**Here’s the proof . . .**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. Net Present Value The cost of capital is used as the actual discount rate. Any project with a negative net present value is rejected. Comparing the NPV and IRR Methods**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.**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.**Choosing the Hurdle Rate**• The discount rate generally is associated with the company’scost of capital. • The cost of capital involves a blending of the costs of allsources of investment funds, both debt and equity.**Tax Return**Form 1120 Depreciable Assets Both the NPV and IRR methods focus on cash flows, and periodic depreciation charges are not cash flows . . . Depreciation is tax deductible and . . . Reduces cash outflows for taxes.**Comparing Two Investment Projects**To compare competing investment projects we can use the following net present value approaches: • Total-Cost Approach. • Incremental-Cost Approach.**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 30,000 ================================================ 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 25,000 -**Total-Cost Approach**MAINFRAME ($)TodayYear 1Year 2Year 3Year 4Year 5 Acquisition cost computer (400,000) Acquisition cost software ( 40,000) System update ( 40,000) Salvage value 50,000 Operating costs (335,000) (335,000) (335,000) (335,000) (335,000) (335,000) Time sharing revenue 20,000 20,000 20,000 20,000 20,00020,000 Total cash flow 440,000 (315,000) (315,000) (355,000) (315,000) (265,000) X Discount factor X 1.000 X .893 X .797X .712X .636X .567 Present value (440,000) (281,295) (251,055) (252,760) (200,340) (150,255) SUM = ($1,575,705) PERSONAL COMPUTER ($)TodayYear 1Year 2Year 3Year 4Year 5 Acquisition cost computer (300,000) Acquisition cost software ( 75,000) System update ( 60,000) Salvage value 50,000 Operating costs (235,000) (235,000) (235,000) (235,000) (235,000) (235,000) Time sharing revenue -0- -0- -0- -0- -0- -0- _ Total cash flow 375,000 (235,000) (235,000) (295,000) (235,000) (205,000) X Discount factor X 1.000 X .893 X .797X .712X .636X .567 Present value (375,000) (209,855) (187,295) (210,040) (149,460) (116,235) SUM = ($1,247,885)**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) Mountainview should purchase the personal computer system for a cost savings of $327,820.**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) 35,000 Update new system ( 40,000) ( 60,000) 20,000 Salvage value new system 50,000 30,000 20,000 =========================================================== 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) 0 Revenue from time-share 20,000 - 20,000**Incremental-Cost Approach**INCREMENTAL ($) TodayYear 1Year 2Year 3Year 4Year 5 Acquisition cost computer (100,000) Acquisition cost software 35,000 System update 20,000 Salvage value 20,000 Operating costs (100,000) (100,000) (100,000) (100,000) (100,000) Time sharing revenue 20,000 20,000 20,000 20,000 20,00020,000 Total cash flow ( 65,000) ( 80,000) ( 80,000) ( 80,000) ( 80,000) ( 60,000) X Discount factor X 1.000 X .893 X .797X .712X .636X .567 Present value ( 65,000) ( 71,440) ( 63,760) ( 42,720) ( 50,880) ( 34,020) SUM = ($ 327,820)**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) Different methods, Same results.**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.**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.**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**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 525,000 Income taxes (210,000) Net Income 315,000 The tax rate is 40%, so income taxes are $525,000 × 40% = $ 210,000**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.**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 60,000 Income taxes (24,000) Net Income 36,000_ The tax rate is 40%, so income taxes are $60,000 × 40% = $ 24,000**A short cut works like this:**Increase in income × ( 1 - tax rate) $60,000 × ( 1 - .4) = $36,000 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 60,000 Income taxes (24,000) Net Income 36,000_**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, 2007. One-half year depreciation is taken in 2007.**Depreciation**Tax Shield Noncash Expenses Here is a complete depreciation schedule for High Country. Depreciation Tax Reduced Tax Year Expense Rate Payment _ 1 $ 5,000 40% $ 2,000 2 10,000 40% 4,000 3 10,000 40% 4,000 4 10,000 40% 4,000 5 5,000 40% 2,000 40,000 16,000**Net Present Value Analysis**Calculation of the present value of proposal cash flows. INCREMENTAL ($) TodayYear 1Year 2Year 3Year 4Year 5 Acquisition cost $( 40,000) Cash flows from proposal $ 18,000 $ 36,000 $ 36,000 $ 36,000 $ 18,000 Depreciation shield 2,000 4,000 4,000 4,000 2,000 Total cash flow ( 40,000) 20,000 40,000 40,000 40,000 20,000 X Discount factor X 1.000 X .893 X .797X .712X .636X .567 Present value ( 40,000) 17,860 31,880 28,480 25,440 11,340 SUM = $ 75,000 The sum of the present values from this proposal is a positive $75,000**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.**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.**$5,600 × (1.10)^-1**$20,000 × 28% $100,000 × 20% Modified Accelerated Cost Recovery System (MACRS) Calculation of the present value of the depreciation tax shield.**$20,000 × (1.10)^-1**Modified Accelerated Cost Recovery System (MACRS) Calculation of the present value proposal cash flows.**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.**Investment in Working Capital**Some investment proposals require additional outlays for working capital such as increases in cash, accounts receivable, and inventory.