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Capital Investment Decisions

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  1. CHAPTER Capital Investment Decisions

  2. Objectives 1.Explain what a capital investment decision is, and distinguish between independent and mutually exclusive capital investment decisions. 2. Compute the payback period and accounting rate of return for a proposed investment, and explain their roles in capital investment decisions. 3. Use net present value analysis for capital investment decisions involving independent projects. After studying this chapter, you should be able to:

  3. Objectives 4. Use the internal rate of return to assess the acceptability of independent projects. 5. Discuss the role and value of postaudits. 6. Explain why NPV is better than IRR for capital investment decisions involving mutually exclusive projects. 7. Convert gross cash flows to after-tax cash flows. 8. Describe capital investment in the advanced manufacturing environment.

  4. Capital investment decisions are concerned with the process of planning, setting goals and priorities, arranging financing, and using certain criteria to select long-term assets.

  5. Payback Method Original investment Annual cash flow • Payback period = The cash flows is assume to occur evenly.

  6. Payback Method Unrecovered Investment Year (Beginning of year) Annual Cash Flow 1 $100,000 $30,000 2 70,000 40,000 3 30,000 50,000 4 ---- 60,000 5 ---- 70,000 $30,000 was needed in Year 3 to recover the investment

  7. Payback Method Deficiency • Ignores the time value of money • Ignores the performance of the investment beyond the payback period

  8. Payback Method The payback period provides information to managers that can be used as follows: • To help control the risks associated with the uncertainty of future cash flows. • To help minimize the impact of an investment on a firm’s liquidity problems. • To help control the risk of obsolescence. • To help control the effect of the investment on performance measures.

  9. Accounting Rate Of Return (ARR) • ARR = Average income ÷ Original investment or • Average investment Average annual net cash flows, less average depreciation Average investment = (I + S)/2 I = the original investment S = salvage value Assume that the investment is uniformly consumed

  10. Accounting Rate Of Return (ARR) Example:Suppose that some new equipment requires an initial outlay of $80,000 and promises total cash flows of $120,000 over the next five years (the life of the machine). What is the ARR? Answer:The average cash flow is $24,000 ($120,000 ÷ 5) and the average depreciation is $16,000 ($80,000 ÷ 5). ARR = ($24,000 – $16,000) ÷ $80,000 = $8,000 ÷ $80,000 = 10%

  11. Accounting Rate Of Return (ARR) Reasons for Using ARR • A screening measure to ensure that new investment will not adversely affect net income • To ensure a favorable effect on net income so that bonuses can be earned (increased)

  12. Accounting Rate Of Return (ARR) • The major deficiency of the accounting rate of return is that it ignores the time value of money.

  13. The Net Present Value Method • NPV = P – I • where: • P = the present value of the project’s future cash inflows • I = the present value of the project’s cost (usually the initial outlay) • Net present value is the difference between the present value of the cash inflows and outflows associated with a project.

  14. The Net Present Value Method • Brannon Company has developed new earphones for portable CD and tape players that are expected to generate an annual revenue of $300,000. Necessary production equipment would cost $320,000 and can be sold in five years for $40,000.

  15. The Net Present Value Method In addition, working capital is expected to increase by $40,000 and is expected to be recovered at the end of five years. Annual operating expenses are expected to be $180,000. The required rate of return is 12 percent.

  16. STEP 1. CASH-FLOW IDENTIFICATION YEAR ITEM CASH FLOW 0 Equipment $-320,000 Working capital - 40,000 Total $-360,000 1-4 Revenues $300,000 Operating expenses -180,000 Total $120,000 5 Revenues $300,000 Operating expenses -180,000 Salvage 40,000 Recovery of working capital 40,000 Total $200,000

  17. STEP 2A. NPV ANALYSIS YEAR CASH FLOW DISCOUNT FACTOR PRESENT VALUE 0 $-360,000 1.000 $-360,000 1 120,000 0.893 107,160 2 120,000 0.797 95,640 3 120,000 0.712 85,440 4 120,000 0.636 76,320 5 200,000 0.567 113,400 Net present value $117,960 STEP 2B. NPV ANALYSIS YEAR CASH FLOW DISCOUNT FACTOR PRESENT VALUE 0 $-360,000 1.000 $-360,000 1-4 120,000 3.307 364,400 5 200,000 0.567 113,400 Net present value $117,840 Present Value of $1 Present Value of an Annuity of $1 Present Value of $1

  18. Decision Criteria for NPV The Net Present Value Method • If NPV = 0, this indicates: • 1. The initial investment has been recovered • 2. The required rate of return has been recovered • Thus, break even has been achieved and we are indifferent about the project.

  19. Decision Criteria for NPV The Net Present Value Method • If the NPV > 0 this indicates: • 1. The initial investment has been recovered • 2. The required rate of return has been recovered • 3. A return in excess of 1. and 2. has been received • Thus, the earphones should be manufactured.

  20. Reinvestment Assumption The Net Present Value Method • The NVP model assumes that all cash flows generated by a project are immediately reinvested to earn the required rate of return throughout the life of the project.

  21. Internal Rate of Return • Theinternal rate of return (IRR)is the discount rate that sets the project’s NPV at zero. Thus, P = I for the IRR. • Example: A project requires a $10,000 investment and will return $12,000 after one year. What is the IRR? • $12,000/(1 + i) = $10,000 • 1 + i = 1.2 • i = 0.20

  22. Internal Rate of Return • If the IRR > Cost of Capital, the project should be accepted. • If the IRR = Cost of Capital, acceptance or rejection is equal. • If the IRR < Cost of Capital, the project should be rejected. Decision Criteria:

  23. NPV Compared With IRR • There are two major differences between net present value and the internal rate of return: • NPV assumes cash inflows are reinvested at the required rate of return whereas the IRR method assumes that the inflows are reinvested at the internal rate of return. • NPV measures the profitability of a project in absolute dollars, whereas the IRR method measures it as a percentage.

  24. NPV Compared With IRR Bintley Corporation Example Design A Design B Annual revenue $179,460 $239,280 Annual operating costs 119,460 169,280 Equipment (purchased before Year 1) 180,000 210,000 Project life 5 years 5 years

  25. NPV Compared With IRR CASH-FLOW PATTERN Year Design A Design B 0 $-180,000 $-210,000 1 60,000 70,000 2 60,000 70,000 3 60,000 70,000 4 60,000 70,000 5 60,000 70,000 DESIGN A: NPV ANALYSIS Year Cash Flow Discount Factor Present Value 0 $-180,000 1.000 $-180,000 1-5 60,000 3.605 216,300 Net present value $ 36,300

  26. NPV Compared With IRR IRR ANALYSIS Initial Investment Discount factor = Annual cash flow $180,000 60,000 = = 3.000 From Exhibit 18B-2, df = 3,000 for five years; IRR = 20% = 3,000 DESIGN B: NPV ANALYSIS Year Cash Flow Discount Factor Present Value 0 $-210,000 1.000 $-210,000 1-5 70,000 3.605 252,350 Net present value $ 42,350

  27. NPV Compared With IRR IRR ANALYSIS Initial Investment Discount factor = Annual cash flow $210,000 70,000 = = 3.000 From Exhibit 18B-2, df = 3,000 for five years; IRR = 20% = 3,000

  28. Adjusting Forecast for Inflation WITHOUT INFLATIONARY ADJUSTMENT Year Cash Flow Discount Factor Present Value 0 $-5,000,000 1.000 $-5,000,000 1-2 2,900,000 1.528 4,431,200 Net present value $- 568,800 WITH INFLATIONARY ADJUSTMENT Year Cash Flow Discount Factor Present Value 0 $-5,000,000 1.000 $-5,000,000 1 3,335,000 0.833 2,778,055 2 3,835,250 0.694 2,661,664 Net present value $ 439,719

  29. After-Tax Operating Cash FlowsThe Income Approach • After-tax cash flow = After-tax net income + Noncash expenses • Example: • Revenues $1,000,000 • Less: Operating expenses* 600,000 • Income before taxes $ 400,000 • Less: Income taxes 136,000 • Net income $ 264,000 • *$100,000 is depreciation • After-tax cash flow = $264,000 + $100,000 • = $364,000

  30. After-Tax Operating Cash FlowsDecomposition Approach • After-tax cash revenues = (1 – Tax rate) x Cash revenues • After-tax cash expense = (1 – Tax rate) x Cash expenses • Tax savings (noncash expenses) = (Tax rate) x Noncash expenses • Total operating cash is equal to the after-tax cash revenues, less the after-tax cash expenses, plus the tax savings on noncash expenses.

  31. After-Tax Operating Cash FlowsDecomposition Approach Example: Revenues = $1,000,000, cash expenses = $500,000, and depreciation = $100,000. Tax rate = 34%. After-tax cash revenues (1 – .34) ($1,000,000) = $660,000 Less: After-tax cash expense (1 – .34)($500,000)= -330,000 Add: Tax savings (noncash exp.) .34 ($100,000) = 34,000 Total $364,000

  32. DepreciationTax-Shielding Effect • Depreciation is a noncash expense and is not a cash flow. Depreciation, however SHIELDS revenues from being taxed and, thus, creates a cash inflow equal to the tax savings. • Assume initially that tax laws DO NOT allow depreciation to be deducted to arrive at taxable income. If a company had before-tax operating cash flows of $300,000 and depreciation of $100,000, we have the statement found on Slide 33.

  33. DepreciationTax-Shielding Effect Net operating cash flows $300,000 Less: Depreciation 0 Taxable income $300,000 Less: Income taxes (@ 34%) 102,000 Net income $198,000

  34. DepreciationTax-Shielding Effect • Net operating cash flows $300,000 • Less: Depreciation 100,000 Taxable income $200,000 • Less: Income taxes (@ 34%) -68,000 • Net income $132,000 Now assume that the tax laws allow a deduction for depreciation:

  35. DepreciationTax-Shielding Effect Notice that the taxes saved are $34,000 ($102,000 – $68,000). Thus, the firm has additional cash available of $34,000. This savings can be computed by multiplying the tax rate by the amount of depreciation claimed: .34 x $100,000 = $34,000

  36. MACRS Depreciation Rates • The tax laws classify most assets into the following three classes (class = Allowable years): • ClassTypes of Assets • 3 Most small tools • 5 Cars, light trucks, computer equipment • 7 Machinery, office equipment • Assets in any of the three classes can be depreciated using either straight-line or MACRS (Modified Accelerated Cost Recovery System) with a half-year convention.

  37. MACRS Depreciation Rates • Half the depreciation for the first year can be claimed regardless of when the asset is actually placed in service. • The other half year of depreciation is claimed in the year following the end of the asset’s class life. • If the asset is disposed of before the end of its class life, only half of the depreciation for that year can be claimed.

  38. Example—S/L Depreciation An automobile is purchased on March 1, 2003 at a cost of $20,000. The firm elects the straight-line method for tax purposes. Automobiles are five-year assets (to refer to a chart, click on the car below; to return to this slide, click on the hammer). The annual depreciation is $4,000 ($20,000 ÷ 5). However, due to the half-year convention, only $2,000 can be deducted in 2003.

  39. Example—S/L Depreciation Year Depreciation Deduction 2003 $2,000 (half-year amount) 2004 4,000 2005 4,000 2006 4,000 2007 4,000 2008 2,000 (half-year amount) Assume that the asset is disposed of in April 2005. Only $2,000 of depreciation can be claimed, so the book value would be $12,000 ($20,000 – $8,000).

  40. MACRS Depreciation Rates for Five-Year Assets Year Percentage of Cost Allowed 1 20.00% 2 32.00 3 19.20 4 11.52 5 11.52 6 5.76 Example—MACRS Method

  41. Example—S/L Depreciation Tax Tax Discount Present Year Depreciation Rate Savings Factor Value 1 $2,000 0.40 $ 800.00 0.909 $ 727.20 2 4,000 0.40 1,600.00 0.826 1,321.60 3 4,000 0.40 1,600.00 0.751 1,201.60 4 4,000 0.40 1,600.00 0.683 1,092.80 5 4,000 0.40 1,600.00 0.621 993.60 6 2,000 0.40 1,600.00 0.564 451.20 Net present value $5,788.00

  42. Example—MACRS Method Tax Tax Discount Present Year Depreciation Rate Savings Factor Value 1 $4,000 0.40 $1,600.00 0.909 $1,454.40 2 6,400 0.40 2,560.00 0.826 2,114.56 3 3,840 0.40 1,536.00 0.751 1,153.54 4 2,304 0.40 921.60 0.683 629.45 5 2,304 0.40 921.60 0.621 572.31 6 1,152 0.40 460.80 0.564 259.89 Net present value $6,184.15

  43. Present value ($4,000,000 x 5.65) $22,600,000 Investment 18,000,000 Net present value $ 4,600,000 How Estimates of Operating Cash Flows Differ A company is evaluating a potential investment in a flexible manufacturing system (FMS). The choice is to continue producing with its traditional equipment, expected to last 10 years, or to switch to the new system, which is also expected to have a useful life of 10 years. The company’s discount rate is 12 percent.

  44. How Estimates of Operating Cash Flows Differ FMS STATUS QUO Investment (current outlay): Direct costs $10,000,000 --- Software, engineering 8,000,000 --- Total current outlay $18,000,000 Net after-tax cash flows $ 5,000,000 $1,000,000 Less: After-tax cash flows for status quo 1,000,000 n/a Incremental benefit $ 4,000,000 n/a

  45. FMS STATUS QUO INCREMENTAL BENEFIT EXPLAINED Direct benefits: Direct labor $1,500,000 Scrap reduction 500,000 Setups 200,000 $2,200,000 Intangible benefits (quality savings): Rework $ 200,000 Warranties 400,000 Maintenance of competitive position 1,000,000 1,600,000 Indirect benefits: Production scheduling $ 110,000 Payroll 90,000 200,000 Total $4,000,000

  46. Future Value: Time Value of Money • Let: • F = future value • i = the interest rate • P = the present value or original outlay • n = the number or periods • Future value can be expressed by the following formula: • F = P(1 + i)n

  47. Future Value: Time Value of Money • Assume the investment is $1,000. The interest rate is 8%. What is the future value if the money is invested for one year? Two? Three?

  48. Future Value: Time Value of Money • F = $1,000(1.08) = $1,080.00 (after one year) • F = $1,000(1.08)2 = $1,166.40 (after two years) • F = $1,000(1.08)3 = $1,259.71 (after three years)

  49. Present Value • P = F/(1 + i)n • The discount factor, 1/(1 + i), is computed for various combinations of I and n. • Example: Compute the present value of $300 to be received three years from now. The interest rate is 12%. • Answer: From Exhibit 18B-1, the discount factor is 0.712. Thus, the present value (P) is: • P = F(df) • = $300 x 0.712 • = $213.60

  50. Present Value • Answer: • Discount Present Year Cash Factor Value • 1 $100 0.893 $ 89.30 • 2 100 0.797 79.70 • 3 100 0.712 71.20 • 2.402* $240.20 Example: Calculate the present value of a $100 per year annuity, to be received for the next three years. The interest rate is 12%. * Notice that it is possible to multiply the sum of the individual discount factors (.40) by $100 to obtain the same answer. See Exhibit 18 B-2 for these sums which can be used as discount factors for uniform series.