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.