Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin
Capital Expenditure
Decisions
Chapter 16
Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin
Learning
Objective
1
Discounted-Cash-Flow Analysis
1-3
Cost reduction
Plant expansion
Equipment selection
Lease or buy
Equipment replacement
Net-Present-Value Method
1-4

o Prepare a table showing cash flows for each year,
o Calculate the present value of each cash flow using a
discount rate,
o Compute net present value,
o If the net present value (NPV) is positive, accept the
investment proposal. Otherwise, reject it.

Net-Present-Value Method
1-5
Mattson Co. has been offered a five year contract to
provide component parts for a large manufacturer.
Cost and revenue information
Cost of special equipment $160,000
Working capital required 100,000
Relining equipment in 3 years 30,000
Salvage value of equipment in 5 years 5,000
Annual cash revenue and costs:
Sales revenue from parts 750,000
Cost of parts sold 400,000
Salaries, shipping, etc. 270,000
Net-Present-Value Method
1-6
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
1-7
Annual net cash inflows from operations
Sales revenue 750,000 $
Cost of parts sold 400,000
Gross margin 350,000
Less out-of-pocket costs 270,000
Annual net cash inflows 80,000 $
Net-Present-Value Method
1-8
Years
Cash
Flows
10%
Factor
Present
Value
Investment in equipment Now $(160,000) 1.000 (160,000) $
Working capital needed Now (100,000) 1.000 (100,000)
Annual net cash inflows 1-5 80,000 3.791 303,280
Relining of equipment 3 (30,000) 0.751 (22,530)
Salvage value of equip. 5 5,000 0.621 3,105
Working capital released 5 100,000 0.621 62,100
Net present value 85,955 $
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 a positive net present value.
Internal-Rate-of-Return Method
1-9
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
1-10
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
1-11
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
1-12
$104, 320
$20,000
= 5.216
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.
Internal-Rate-of-Return Method
1-13
Heres the proof . . .
Year Amount
14%
Factor
Present
Value
Investment required Now (104,320) $ 1.000 (104,320)
Annual cost savings 1-10 20,000 5.216 104,320
Net present value - $
Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin
Learning
Objective
2
Comparing the NPV and IRR
Methods
1-15
Internal Rate of Return
The cost of capital is
compared to the
internal rate of return
on a project.
To be acceptable, a
projects 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
1-16
The net present value
method has the following
advantages over the
internal rate of return
method . . .
Easier to use.
Easier to adjust for risk.
Assumptions Underlying
Discounted-Cash-Flow Analysis
1-17
All cash flows are
treated as though
they occur at year end.
Cash flows are
treated as if
they are known
with certainty.
Cash inflows are
immediately
reinvested at
the required
rate of return.
Assumes a
perfect
capital
market.
Choosing the Hurdle Rate
1-18
The discount rate generally
is associated with the
companys cost of capital.
The cost of capital involves
a blending of the costs of all
sources of investment
funds, both debt and equity.
Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin
Learning
Objective
3
Comparing Two Investment
Projects
1-20
To compare competing investment projects
we can use the following net present value
approaches:
Total-Cost Approach.
Incremental-Cost Approach.
Total-Cost Approach
1-21
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
1-22
MAINFRAME ($) Today Year 1 Year 2 Year 3 Year 4 Year 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 20,000 20,000
Total cash flow 440,000 (315,000) (315,000) (355,000) (315,000) (265,000)
X Discount factor X 1.000 X .893 X .797 X .712 X .636 X .567
Present value (440,000) (281,295) (251,055) (252,760) (200,340) (150,255)
SUM = ($1,575,705)
PERSONAL COMPUTER ($) Today Year 1 Year 2 Year 3 Year 4 Year 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 .797 X .712 X .636 X .567
Present value (375,000) (209,855) (187,295) (210,040) (149,460) (116,235)
SUM = ($1,247,885)
Total-Cost Approach
1-23
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
$327,820.
Incremental-Cost Approach
1-24
INCREMENTAL ($)
Today Year 1 Year 2 Year 3 Year 4 Year 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 20,000 20,000
Total cash flow ( 65,000) ( 80,000) ( 80,000) ( 80,000) ( 80,000) ( 60,000)
X Discount factor X 1.000 X .893 X .797 X .712 X .636 X .567
Present value ( 65,000) ( 71,440) ( 63,760) ( 42,720) ( 50,880) ( 34,020)
SUM = ($ 327,820)
Total-Incremental Cost
Comparison
1-25
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 Accountants Role
1-26
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 . . .
1. increase the hurdle rate,
2. use sensitivity analysis.
Postaudit of Investment Projects
1-27
A postaudit is a follow-up after the project has
been approved to see whether or not
expected results are actually realized.
Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin
Learning
Objective
4
Income Taxes and Capital
Budgeting
1-29
Cash flows from an investment proposal affect
the companys profit and its income tax
liability.
Income = Revenue - Expenses + Gains - Losses
After-Tax Cash Flows
1-30
The tax rate is 40%, so income taxes are
$525,000 40% = $ 210,000
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
Not all expenses require cash outflows. The most common example is depreciation.


Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin
Learning
Objective
5
Modified Accelerated Cost
Recovery System (MACRS)
1-32
Tax depreciation is usually computed using
MACRS. Here are the depreciation rate for 3,
5, and 7-year class life assets.
Year 3-year 5-year 7-year
1 33.33% 20.00% 14.29%
2 44.45% 32.00% 24.49%
3 14.81% 19.20% 17.49%
4 7.41% 11.52% 12.49%
5 11.52% 8.93%
6 5.76% 8.92%
7 8.93%
8 4.46%
Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin
Learning
Objective
6
Investment in Working Capital
1-34
Some investment proposals require additional
outlays for working capital such as
increases in cash, accounts receivable, and
inventory.
Current assets 100,000 $
Less: current liabilities (65,000)
Working capital 35,000 $
Extended Illustration
1-35
For a complete present value analysis for an
investment decision facing High Country
Department Stores, Inc., see the textbook.
High Country
Department
Stores
Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin
Learning
Objective
7
Ranking Investment Projects
1-37
We can invest in either of these projects.
Use a 10% discount rate to determine
the net present value of the cash flows.
Project A Project B
Immediate cash outlay 100,000 $ 100,000 $
Cash inflows:
Year 1 50,000 $ 30,000 $
Year 2 40,000 40,000
Year 3 30,000 50,000
Total inflows 120,000 $ 120,000 $
The total cash flows are the same, but the pattern of
the flows is different.
Ranking Investment Projects
1-38
Lets calculate the present value of the cash
flows associated with Project A.
This project has a positive net present value which means
the projects return is greater than the discount rate.
Project A PV Factor PV
Immediate cash outlay (100,000) $ 1.000 (100,000) $
Cash inflows:
Year 1 50,000 $ 0.909 45,450
Year 2 40,000 0.826 33,040
Year 3 30,000 0.751 22,530
Net present value 1,020 $
Ranking Investment Projects
1-39
Here is the net present value of the cash flows
associated with Project B.
Project B PV Factor PV
Immediate cash outlay (100,000) $ 1.000 (100,000) $
Cash inflows:
Year 1 30,000 $ 0.909 27,270
Year 2 40,000 0.826 33,040
Year 3 50,000 0.751 37,550
Net present value (2,140) $
Project B has a negative net present value which means
the projects return is less than the discount rate.
Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin
Learning
Objective
8
Alternative Methods for Making
Investment Decisions
1-41
Payback Method
Payback
period
Initial investment
Annual after-tax cash inflow
=
Payback
period
=
$20,000
$4,000
= 5 years
A company can purchase a machine for $20,000 that
will provide annual cash inflows of $4,000 for 7 years.
Payback: Pro and Con
1-42
1. Fails to consider
the time value of
money.
2. Does not consider
a projects cash
flows beyond the
payback period.
1. Provides a tool for
roughly screening
investments.
2. For some firms, it
may be essential
that an investment
recoup its initial
cash outflows as
quickly as
possible.
Accounting-Rate-of-Return
Method
1-43
Discounted-cash-flow method focuses on
cash flows and the time value of money.


Accounting-rate-of-return method focuses on
the incremental accounting income that
results from a project.
Accounting-Rate-of-Return
Method
1-44
The following formula is used to calculate the
accounting rate of return:
Accounting
rate of
return
=
Average Average
incremental incremental expenses,
revenues including depreciation &
income taxes
-
Initial investment
Accounting-Rate-of-Return
Method
1-45
Meyers Company 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 $80,000 including
depreciation.

What is the accounting rate of return on the
investment project?
Accounting-Rate-of-Return
Method
1-46
The accounting 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.
Accounting
rate of return
$100,000 - $80,000
$140,000
= 14.3% =
Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin
Learning
Objective
9
Estimating Cash Flows:
The Role of Activity-Based Costing
1-48
ABC systems generally improve the ability of
an analyst to estimate the cash flows
associated with a proposed project.
Justification of Investments in Advanced
Manufacturing Systems
1-49
Hurdle
rates are
too high
Time
horizons
are too
short
Bias
towards
incremental
projects
Greater
cash flow
uncertainty
Benefits
difficult to
quantify
Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin
Learning
Objective
10
Inflation Effects
1-51
Nominal Dollars
Real dollars
End of Chapter 16
1-52