Cost Management

Measuring, Monitoring, and Motivating Performance

Chapter 12 Strategic Investment Decisions

Prepared by Gail Kaciuba Midwestern State University
Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1e

© John Wiley & Sons, 2005

Slide # 1

Chapter 12: Strategic Investment Decisions

Learning objectives
• • • • • • • • Q1: How are strategic investment decisions made? Q2: What cash flows are relevant for strategic investment decisions? Q3: How is net present value (NPV) analysis performed and interpreted? Q4: What are the uncertainties and limitations of NPV analysis? Q5: What alternative methods (IRR, payback, and accrual accounting rate of return) are used for long-term decision making? Q6: What additional issues should be considered for strategic investment decisions? Q7: How do income taxes affect strategic investment decision cash flows? Q8: How are the real and nominal methods used to address inflation in NPV analysis (Appendix 12A)
Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1e Slide # 2

© John Wiley & Sons, 2005

Q1: Process for Making Strategic Investment Decisions

• The process used to compare and analyze long-term investment projects is called capital budgeting. • The capital budgeting process includes the following stages:
• • • • • • Identify decision alternatives. Identify relevant cash flows. Apply the appropriate quantitative techniques. Perform sensitivity analysis. Identify and analyze qualitative factors. Consider quantitative and qualitative factors and make a decision.
Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management, 1e Slide # 3

© John Wiley & Sons, 2005

1e Slide # 4 .Q1: Capital Budgeting Quantitative Techniques • Methods that consider the time value of money: • Net present value (NPV) method • Internal rate of return (IRR) method • Methods that do not consider the time value of money: • Payback method • Accounting rate of return method © John Wiley & Sons. 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management.

1e Slide # 5 . 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management. • Examples of relevant cash outflows include: • Initial investment outlay • Future operating costs • Project closing and cleanup costs • Examples of relevant cash inflows include: • Future revenues • Decreased operating costs • Salvage value of assets at project’s end © John Wiley & Sons.Q2: Relevant Cash Flows in Capital Budgeting • Relevant cash flows occur in the future and are different across the alternatives.

it is acceptable © John Wiley & Sons. where 1 r  t t • t = year of the project’s life in which cash flow occurs • n = life of the project • r = discount.Q3: Net Present Value (NPV) Analysis • The NPV of a project is the sum of the project’s discounted cash flows: NPV =  n t=0 Expected cash flow . 1e Slide # 6 . or hurdle rate • If a project’s NPV > 0. 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management.

1e Slide # 7 . • After screening. acceptable projects may be ranked according to their profitability index. © John Wiley & Sons. Profitability index = Present value of benefits Present value of costs • The profitability index allows for rankings of projects of various sizes. 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management.Q3: NPV Analysis and Project Ranking • NPV analysis is often used to screen projects as to whether they are acceptable.

200 467.000 x PV of $1 factor of 0. the NPV > 0. 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management.470 © John Wiley & Sons. Compute the NPV of the Lindie Lane building.000 NPV $17.270 Sale of building: $400.000 x PV annuity factor of 5.000 and the net annual cash inflows are expected to be $45. Is it an acceptable investment? PV of cash inflows: Annuity of cash inflows: $45.Q3: NPV Example Joseph Leasing is considering an investment in a new apartment building.583 233.000.206 $234. Assume all cash inflows occur at the end of each year. Joseph expects to be able to sell Lindie Lane building for $400. so the investment is acceptable Slide # 8 . Joseph demands a minimum required rate of return of 8% on all investments. 1e Yes.000 for 7 years.470 PV of cash outflows: Initial investment 450. The Lindie Lane building will cost $450. At the end of the 7th year.

463 Yes. Is it an acceptable investment? PV of cash inflows: Annuity of cash inflows: $6. so the investment is acceptable © John Wiley & Sons.000. The cost is $65.800 x PV annuity factor of 6. Compute the NPV of the trailer investment.000 and the expected net cash inflows are $6.000 x PV of $1 factor of 0.463 65.Q3: NPV Example Joseph Leasing is also looking at the purchase of a lot with a double-wide trailer on it. 1e Slide # 9 . At the end of the 10th year. 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management.800 per year for 10 years.000 $1.835 66. the NPV > 0.628 20.463 PV of cash outflows: Initial investment NPV $45.710 Sale of lot and trailer: $45. Joseph expects to be able to sell the lot and trailer for $45.

2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management.0388 1. 1e Slide # 10 .463 = 65.000 1.000 66. If Joseph has sufficient capital.Q3: NPV Example Compare the two investments for Joseph using the profitability index.0225 The Lindie Lane yields a slightly greater PV for each invested dollar than does the trailer.470 = 450. and describe to him what the index means. © John Wiley & Sons. he should invest in both unless he has alternatives that have even greater profitability indices. Which investment (or both) should he make? Profitability index Lindie Lane building: PV of cash inflows PV of cash outflows Trailer: PV of cash inflows PV of cash outflows 467.

1e Slide # 11 . 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management.Q4: Limitations of NPV Analysis • The uncertainty about future cash flows increases the further the cash flow is in the future. • Individuals providing information about the future cash flows are likely to have a vested interest in the project’s acceptance. © John Wiley & Sons. but NPV analysis uses only one discount rate for all future periods.

© John Wiley & Sons. Initial investment = PV of an annuity factor Annual cash inflow • Then the discount rate is found by locating the column for the PV factor. 1e Slide # 12 . the IRR can be determined by computing the PV of an annuity factor and solving for the interest rate. 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management. given n. • For projects with equal annual cash inflows where the only cash outlay is the initial investment.Q5: Internal Rate of Return (IRR) Method • The IRR method computes the discount rate required to set the NPV to zero.

Assume the cost savings are realized at the end of the year. 2005 Slide # 13 . investments.650 value of an annuity table. Compute the IRR for the proposed machine. using n = $17.700 each year for 10 years. so the IRR = 12%.65 factor in the present $100. The machine is not expected to have any salvage value at the end of its life. Since the machine’s IRR exceeds Graham’s minimum rate of return.700 10 years and note that it is found in the 12% column. 1e © John Wiley & Sons.000 and the machine is expected to generate cost savings of $17. Should Graham purchase the machine? Locate the 5. Graham requires a 10% rate of return on all new investments. but of course should still be compared to other. The cost is $100.000 = 5. Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management.Q5: IRR Example Graham Enterprises is considering the purchase of a new machine. potentially better. the machine is an acceptable investment.

Q5: Payback Method • The payback method computes the number of years before the initial investment is recovered. the payback period is computed as: Payback period in years = Initial investment Annual cash inflow • For projects where annual cash inflows are not equal. 1e Slide # 14 . the payback period is computed by merely counting the years required before the initial investment is recovered. • If cash inflows are the same each year and the project has only one initial outlay. 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management. © John Wiley & Sons.

• It ignores cash flows that occur after the payback period.Q5: Payback Method • The payback method is widely used because of its simplicity. • However. 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management. the payback method is flawed because: • It ignores the time value of money. the payback method should be used in conjunction with the NPV or IRR methods to help assess project risk. • If used at all. © John Wiley & Sons. 1e Slide # 15 .

© John Wiley & Sons.700 each year for 10 years. 1e Slide # 16 .000 = 5. 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management.650 years $17. The machine is not expected to have any salvage value at the end of its life. $100.Q5: Payback Method Example Graham Enterprises is considering the purchase of a new machine. The cost is $100.000 and the machine is expected to generate cost savings of $17. Compute the payback period for the proposed machine.700 Notice that the payback period is the same as the PV factor computed in the IRR example.

is considering the purchase of a new machine.000 $50. 4 $80. The 1 $10. and $40. Compute the payback period for each and comment on your findings.000 is 3 $30. 2005 Slide # 17 . Time Cash Flow period Machine A Machine B The payback period for 0 ($100.000 ½ of year 4’s cash inflow).000) Machine B is 2 years. There are two alternatives.Q5: Payback Method Example Cophil.000 covered after 3 years. 1e © John Wiley & Sons.000 $50. Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management.000) ($100.000 5 $80.000 preferable to Machine A. but ignores the large cash inflows of Machine A that occur after the payback period.000 The payback method shows Machine B to be 6 $80. and the cash flow information is given below.000 is 3.000 payback period for Machine A 2 $20. Inc.5 years ($60.

© John Wiley & Sons.Q5: Accrual Accounting Rate of Return Method • The accrual accounting rate of return computes the project’s rate of return using operating income in place of cash flows. 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management. Accrual accounting rate of return = Operating income Annual cash inflow • This method is widely used because the financial accounting information is readily available. but is is flawed because it ignores the time value of money. 1e Slide # 18 .

000 = $12.000/5 years) Effect on annual operating income Accrual accounting rate of return © John Wiley & Sons.000 per year.000 $100. 2005 20.000 Annual depreciation expense ($100. The machine is expected to generate cost savings of $32. Ignoring income tax effects. compute the accrual accounting rate of return for this investment.000 and it is expected to last 5 years and have no salvage value. 1e Slide # 19 .000 $12.Q5: Accrual Accounting Rate of Return Method Example Blanche Manufacturing is considering the purchase of a new machine. Annual cost savings $32. The cost is $100.000 = 12% Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management.

Q6: Additional Considerations in Strategic Investment Decisions • Qualitative issues that may arise in capital budgeting include: • the effects of the decision on the company’s reputation. 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management. • the effects on the company’s community. • After a capital budgeting decision is made. 1e Slide # 20 . a post-investment audit should be performed to assess the decision process. and • the effects on employees. • the effects on the quality of the company’s products and services. © John Wiley & Sons.

Q7: Income Tax Considerations • All cash flows should first be converted to an after-tax amount. • The tax savings that result from the depreciation deduction is called the depreciation tax shield. 1e Slide # 21 . © John Wiley & Sons. 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management.

Colby’s tax rate is 30% and its discount rate is 10%. 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management.000 = $44. Compute the IRR of this machine.000 and it is expected to last 6 years and have no salvage value.$180. The machine is expected to generate cost savings of $50. suppose that Colby uses straight-line depreciation for both books and taxes.$180.000 = $11.000 NPV = $44.000 9. Cash inflows after taxes [$50.355 .000 $44. The cost is $180.620 © John Wiley & Sons.000 x (1 – 30%)] Tax savings from depreciation [$30.000 x PV factor of an annuity .000 x 30%] Net after-tax annual cash inflows $35.Q7: Capital Budgeting and Income Tax Considerations (NPV) Example Colby Products is considering the purchase of a new machine. For simplification.000 x 4. 1e Slide # 22 .000 per year.

The machine is expected to generate cost savings of $50. Compute the IRR of this machine. © John Wiley & Sons. For simplification.000 x (1 – 30%)] Tax savings from depreciation [$30.000 x 30%] Net after-tax annual cash inflows $180.000 = PV of an annuity factor = 4. The cost is $180. suppose that Colby uses straight-line depreciation for both books and taxes.091 Locate the 4.000 9.000 $35.000 $44. Cash inflows after taxes [$50. 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management.091 factor in the present value of an annuity table. 1e Slide # 23 .Q7: Capital Budgeting and Income Tax Considerations (IRR) Example Colby Products is considering the purchase of a new machine. so the IRR is just over 12%.000 and it is expected to last 6 years and have no salvage value. Colby’s tax rate is 30% and its discount rate is 10%. using n = 6 years and note that it is found between the 12% & 13% columns.000 $44.000 per year.

Colby’s tax rate is 30% and its discount rate is 10%. Cash inflows after taxes [$50.000 $44.000 = Payback period = 4. The machine is expected to generate cost savings of $50.000 and it is expected to last 6 years and have no salvage value.000 $44. Compute the payback period of this machine. For simplification. 1e Slide # 24 .91 years. suppose that Colby uses straight-line depreciation for both books and taxes.000 x 30%] Net after-tax annual cash inflows $35. The cost is $180.000 x (1 – 30%)] Tax savings from depreciation [$30. © John Wiley & Sons. 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management.000 9.000 $180.000 per year.Q7: Capital Budgeting and Income Tax Considerations (Payback) Example Colby Products is considering the purchase of a new machine.

44% accrual accounting ROR © John Wiley & Sons. The cost is $180. Colby’s tax rate is 30% and its discount rate is 10%. 1e Slide # 25 .Q7: Capital Budgeting and Income Tax Considerations (Accrual Accounting ROR) Example Colby Products is considering the purchase of a new machine. 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management.000 x 30%] Net after-tax annual increase in operating income $44.000 9. For simplification.000 $44.000 per year.000 x (1 – 30%)] Tax savings from depreciation [$30. The machine is expected to generate cost savings of $50. Cash inflows after taxes [$50.000 $180.000 $35. suppose that Colby uses straight-line depreciation for both books and taxes.000 = 24. Compute the accrual accounting rate of return of this machine.000 and it is expected to last 6 years and have no salvage value.

© John Wiley & Sons. it is known as inflation. 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management. • The nominal rate of interest is the rate that investors demand when inflation is taken into consideration in their decisions.Q8: Inflation and NPV Analysis • When the purchasing power of the dollar declines over time. 1e Slide # 26 . • The real rate of interest does not consider changes in the purchasing power of a dollar.

• The risk premium increases for riskier investments. 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management.Q8: Inflation and NPV Analysis • The risk-free rate is the rate of interest that is paid on long-term government bonds. • The risk premium is the additional rate of return investors demand to compensate them for taking risk. • The real rate of interest is the nominal rate plus the risk premium demanded for that investment. © John Wiley & Sons. 1e Slide # 27 .

Q8: Nominal and Real Methods of NPV Analysis • The real and nominal rates of interest are related as follows: Nominal rate of = interest (1 + real rate) x (1 + inflation rate) -1 • Nominal future cash flows are real cash flows inflated to future dollars: Nominal cash flow = Real cash flow x (1 + i)t. 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management. 1e Slide # 28 . where i = rate of inflation. and t = the number of time periods in the future the cash flow occurs © John Wiley & Sons.

• In the nominal method of NPV analysis. © John Wiley & Sons. 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management. future cash flows are state in real dollars (without considering changes in the purchasing power of the dollar) and a real rate of interest is used as the discount rate.Q8: Nominal and Real Methods of NPV Analysis • In the real method of NPV analysis. future cash flows and the terminal project value must be inflated to future dollars and a nominal rate of interest is used as the discount rate. 1e Slide # 29 .

Multiply the real value of the depreciation deduction times the tax rate.Calculate the annual depreciation deduction for tax purposes. using the real rate of interest. 3. © John Wiley & Sons. 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management.Q8: Real Method of NPV Analysis • The depreciation tax shield is calculated in 3 steps: 1. • Calculate the NPV for the incremental cash flows. 2. 1e Slide # 30 .Convert each year’s depreciation deduction from year zero dollars to real dollars by dividing by (1 + inflation rate)t. including the tax savings from depreciation.

the risk-free rate is 3%.76% $23. Compute the depreciation tax shield in real dollars for this machine.Q8: Real Method of NPV Analysis Example Stiles.000. and Stiles believes that a risk premium of 5% for this machine is appropriate. The machine qualifies as 5-year MACRS property for tax purposes. Inc. 19.76% 5.00% 2 32.040 $23.138 $6.52% $46.431 $123.76% of asset cost. The cost is $400. is considering the purchase of a new machine.529 $36.370 $21.711 4 4 11.571 $42.000 $128.521 6 6 5.02)t MACRS rate Depreciation deduction (nominal) Depreciation deduction (real)* Tax savings (real) © John Wiley & Sons. 11. which means that the depreciation deduction is taken over 6 years at 20%. 2005 1 20.736 $12.080 $42.521 $12.571 $12.000 $78.459 $6.2%.52% $46. 32%.800 $72.00% 3 19. 11.030 $23.52%.000 and it is expected to last 6 years and have a salvage value of $80.459 $20.771 $12. respectively.909 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management.52% 11.080 $46.138 Slide # 31 $80. the expected inflation rate is 2%. 1e .736 $41. Stiles’ tax rate is 30%.52% 11. and 5.20% $76.040 $20.080 $46.771 5 5 11. *this is the nominal depreciation over (1.52%.080 $41.

000 $80. 1e Slide # 32 . so the $24.000 is already in real dollars.Q8: Real Method of NPV Analysis Example Compute the tax on the gain on the sale of the machine. so they were not in real dollars and needed to be deflated. depreciation deductions taken in years 2 – 6 are based on an investment stated in year 1 dollars.000 $400. On the prior slide. © John Wiley & Sons. Asset cost Depreciation taken Tax basis of asset Proceeds from sale of asset Gain on sale Tax rate Taxes on gain $400.000 30% $24.000 Note that the tax will be paid in the same year as the disposal. 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management.000 $0 $80. in real dollars.

• Calculate the gain on asset disposal as the historical cost compared to the nominal depreciation deduction. © John Wiley & Sons. 1e Slide # 33 .Q8: Nominal Method of NPV Analysis • Incremental cash inflows and the terminal cash flow must be adjusted (inflated) for inflation. • The nominal and real methods yield the same NPV when the inflation rate is constant over the investment’s life. 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management.

the risk-free rate is 3%. 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management. 32%. respectively.912 MACRS rate Depreciation deduction Tax savings 20.824 6 5.52%. Compute the depreciation tax shield in nominal dollars for this machine.52% $46.76% $23.52%. 1e Slide # 34 .040 $6.52% $46. 19. which means that the depreciation deduction is taken over 6 years at 20%. the expected inflation rate is 2%. Inc.080 $13. is considering the purchase of a new machine.Q8: Nominal Method of NPV Analysis Example Stiles.000 $80. The machine qualifies as 5-year MACRS property for tax purposes. 1 2 32.824 5 11.040 4 11.20% $76.2%.800 $23.000.000 © John Wiley & Sons.080 $13. Stiles’ tax rate is 30%.000 $128. The cost is $400.00% $38. and Stiles believes that a risk premium of 5% for this machine is appropriate. and 5. 11.76% of asset cost. 11.00% $24.400 3 19.000 and it is expected to last 6 years and have a salvage value of $80.

093 $0 $90. in nominal dollars.000 © John Wiley & Sons.028 = (1.12616 $90. 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management. 1e Slide # 35 .02)6 $400.000 1.000 cost less depreciation taken of $400.093 30% $27. Disposal value Inflation factor Inflated disposal value Tax basis of asset Gain on sale Tax rate Taxes on gain $80.Q8: Nominal Method of NPV Analysis Example Compute the tax on the gain on the sale of the machine.

74805 $50.000 $453. Compute the NPV of the machine using the nominal method.195 $117.424 3 $60.102) ($19.67905 $40.672 4 $60.245 6 $60.000 $64.675 $38.912 0.817) ($27.286 0. 1e Slide # 36 . Time period Cash inflows Inflated cash inflows Taxes on cash inflows Taxes on gain Depreciation tax savings $24.90777 $60.305 ($18.484) ($19.Q8: Nominal Method of NPV Analysis Example Suppose the machine generates cost savings of $60.097 0.000 $66.61643 $37.000 ($78.093 $120.108) Total $360. inflated © John Wiley & Sons.000 per year for 6 years.028) ($27.258 $13.824 0.000 $67.040 $67.057 $90.000 $386.028) $60.000 $62.271) ($115.82405 $67.611 0.000 Net cash inflows PV factor (nominal) PV of annual net cash flow Initial outlay NPV $66.840 0.276 Terminal cash flow.624 $321.200 2 $60.946 5 $60.360) ($18.727) ($19.892 $400.824 $59.093 $6.576 $13.106 1 $60.000 $63.400 $82.55957 $65.000 $61.570 $90.652 $23. 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcott’s Cost Management.873) ($20.

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