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## Capital Equipment Planning

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**Capital Equipment Planning**Kevin Hirst Brigham Young University**Overview**• Capital equipment planning defined • How is it used? • Capital budgeting techniques • Examples and Real World Exercise • Summary • Reading List • Exercise Solution**What Is Capital Equipment Planning?**• Planning for the purchase or replacement of capital equipment • Reasons for purchase or replacement include obsolescence, desire for increased capacity, and introduction of a new product or process • Planning is put into action through capital budgeting and cash flow analysis**Capital Equipment Planning—Why?**• Equipment is becoming obsolete • Purchase additional equipment to increase productivity • Need new equipment for a new product or process • Find best investment from several capital equipment options**Capital Equipment Planning—How?**• Capital budgeting techniques are used to determine best investment • Obsolescence planning can be used to plan for the replacement of old or obsolete equipment**Capital Budgeting**• Determining which capital investment projects to do • Best capital budgeting techniques: • Consider the time-value of money • Include all incremental cash flows • Incorporate the required rate of return for the project**Capital Budgeting Techniques**• Payback Period • Net Present Value (NPV) • Internal Rate of Return (IRR)**Payback Period**• The time it takes to for an investment to pay for itself or recoup the initial outlay • When positive cash flows are equal: Initial Investment Payback = Annual Cash Flow Example: A machine that costs $50,000 will earn $20,000 a year. What is the payback period? $50,000 Payback = = 2.5 years, or 2 years 6 months $20,000**Payback Period**• When cash flows are not equal, subtract the cash inflows from the initial investment until it reaches zero Example: A machine that costs $50,000 will earn $15,000 in year 1, $25,000 in year 2, and $30,000 in year 3. What is the payback period? Payback occurs between year 2 and 3. To figure this out, divide remainder ($10,000) by the cash flow in year 3 ($30,000) $10,000 = .33 + 2 years = 2.33 years, or $30,000 2 years 4 months**Payback Period**Pros • Easy to calculate • Easy to understand Cons • Doesn’t take into account the time- value of money • Doesn’t consider cash flows after payback period**Net Present Value**• The sum of the present values of all the annual net cash flows minus the initial investment n t = 1 Σ CFt NPV = - initial investment (1+ r)t**Net Present Value**• Decision criteria: • If NPV > 0, the investment is acceptable • If NPV < 0, the investment is not acceptable**Net Present Value**Example: A machine that costs $50,000 will produce cash flows of $25,000 in year 1, $20,000 in year 2, and $10,000 in year 3. Assume a 12% required rate of return. What is the NPV? Should we purchase the machine? NPV = PV of Cash Flows – Initial Investment = 45,383.11 – 50,000 = - 4,616.89 Because NPV < 0, we should NOT purchase this machine. Discount each cash flow**Net Present Value**Pros • Incorporates time-value of money • Considers all cash flows • Clear decision criteria • Shows the amount of wealth that could be created from investment Cons • Can’t easily compare two projects if they differ in size (comparing apples to oranges)**Internal Rate of Return**• The rate of return that an investment earns • More specifically, the rate of return that makes the present value of the annual cash flows equal to the initial investment • No way to calculate IRR by hand (besides trial and error). Excel and financial calculators have built-in functions to solve for IRR.**Internal Rate of Return**• Decision criteria: • If IRR >= required rate of return, a.k.a. the hurdle rate, the investment is acceptable • If IRR < required rate of return, the investment is not acceptable**Internal Rate of Return**Example: A machine that costs $50,000 will produce cash flows of $25,000 in year 1, $20,000 in year 2, and $10,000 in year 3. Assume a 12% required rate of return. What is the IRR? Is this machine acceptable? IRR = 5.73% Because IRR < 12% (the hurdle rate), we should NOT invest in this machine.**Internal Rate of Return**Pros • Incorporates time-value of money • Considers all cash flows • Clear decision criteria • Can compare IRRs of different investments regardless of size Cons • Assumes that cash can be reinvested at the IRR, which could be unrealistic if the IRR is very high • Can exist multiple IRRs if there is more than one negative net cash flow**NPV vs. IRR**• Traditionally, IRR has been most the popular capital budgeting technique among Fortune 1000 firms. • Over the years, NPV use has grown and is now the most popular technique among the Fortune 1000 firms. • This is largely due to professors that have been stressing to MBA students over the years that NPV is a better technique than IRR**Real World Exercise**Lumberjack Inc. wants to purchase a wood-cutting machine to increase production. It is considering two different machines, the Cutter 500 and the Saw-tooth 3000. The Cutter costs $600,000 and would increase production by 60,000 pieces a year. The machine would be depreciated straight-line over 6 years with no salvage value. The Saw-tooth costs $1,000,000 and would increase production by 110,000 pieces a year. The machine would be depreciated straight-line over 6 years with no salvage value. The sales price per unit is $5 and the variable cost per unit is $1.50. Fixed costs to run either machine are $30,000 per year. Lumberjack’s tax rate is 35% and the cost of capital (required rate of return) is 14%. Using the capital budgeting techniques, which machine is the better investment?**Real World Exercise**This chart summarizes this information in the exercise. Using this information, calculate the payback period, NPV, and IRR. Then determine which machine is the better investment.**Summary**• Capital equipment planning is important for knowing when to purchase new equipment or replace old or obsolete equipment • Capital budgeting techniques are helpful in finding profitable capital equipment investments**Reading List**• Mayes, Timothy R. and Todd M. Shank. Financial Analysis with Microsoft Excel 2002. Minnesota: South-Western, 2004. • Keown, Martin, Petty, and Scott. Financial Management: Principles and Applications. New Jersey: Prentice Hall, 2000. • Ryan, Patricia A. and Glenn P. Capital Budgeting Practices of the Fortune 1000: How Have Things Changed? Journal of Business and Management, Vol. 8, No. 4, Oct 2002.**Reading List**• Cheng, C.S. Agnes, D. Kite, and R. Radtke. The Applicability and Usage of NPV and IRR Capital Budgeting Techniques. Managerial Finance, Vol. 20, No. 7, 1994. • Bozarth, Cecil C. and Robert B. Handfield. Introduction to Operations and Supply Chain Management. New Jersey: Prentice Hall, 2006. • MacEwen, Bruce. IRR vs. NPV and What You Need to Know. URL: http://www.bmacewen.com/blog/archives/ 2004/09/irr_vs_npv_and.html**Exercise Solution**Cutter 500 Payback = 600,000 / 152,000 = 3.95 years NPV = (133,333 + 116,959 + 102,596 + 89,996 + 78,944 + 69,249) – 600,000 = -8,923 IRR = 13.5%**Exercise Solution**Saw-tooth 3000 Payback = 1,000,000 / 289,083 = 3.46 years NPV = (253,582 + 222,440 + 195,123 + 171,161 + 150,141 + 131,702) – 1,000,000 = 124,149 IRR = 18.4%**Exercise Solution**Because the Saw-tooth 3000 has a shorter payback period, higher net present value, and higher internal rate of return than the Cutter 500, Lumberjack Inc. should invest in the Saw-tooth 3000.