18 -1

Capital Investment
Decisions
 18 -2

Objectives
Objectives
1. Explain what a capital investment decision is,
After
After studying
studying this
this
and distinguish between independent and
chapter,
chapter, you
you should
should
mutually exclusive capital investment decisions.
be
be able
able to:
to: and accounting rate
2. Compute the payback period
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.
 18 -3

Objectives
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.
 18 -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.
 18 -5

Payback Method

Payback period =
Original investment
Annual cash flow

The
The cash
cash flows
flows isis assume
assume
to
to occur
occur evenly.
evenly.
 18 -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 ----
$30,000 was needed
70,000
$30,000 was needed
in
inYear
Year33to
torecover
recover
the
theinvestment
investment
 18 -7

Payback Method
Deficiency
Deficiency
 Ignores the time value of
money
 Ignores the performance of the
investment beyond the
payback period
 18 -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.
 18 -9

Accounting
Accounting Rate
Rate Of
Of Return
Return (ARR)
(ARR)
ARR = Average income ÷ Original investment or
Average investment

Average
Average annual
annual net
net
cash
cash flows,
flows, less
less Average
Average investment
investment
average
average == ((II ++ SS)/2
)/2
depreciation
depreciation
II==the
theoriginal
originalinvestment
investment
SS==salvage
salvagevalue
value
Assume
Assumethatthatthe
theinvestment
investment
isisuniformly
uniformlyconsumed
consumed
 18 -10

Accounting
Accounting Rate
Rate Of
Of Return
Return (ARR)
(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%
 18 -11

Accounting
Accounting Rate
Rate Of
Of Return
Return (ARR)
(ARR)
Reasons
Reasons for
for Using
Using ARR
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)
 18 -12

Accounting
Accounting Rate
Rate Of
Of Return
Return (ARR)
(ARR)
The major deficiency of the accounting rate of
return is that it ignores the time value of money.
 18 -13

The
The Net
Net Present
Present Value
Value Method
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.
 18 -14

The
The Net
Net Present
Present Value
Value Method
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.
 18 -15

The
The Net
Net Present
Present Value
Value Method
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.
 18 -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
 18 -17

STEP 2A. NPV ANALYSIS

YEAR CASH FLOW DISCOUNT FACTOR PRESENT VALUE
0 $-360,000 1.000 $-360,000
1 Present
120,000 0.893 107,160
2 Value of $1
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
Present Value 1.000 $-360,000
1-4 120,000
of an Annuity 3.037 364,440
Present Value
5 200,000
of 0.567 113,400
of $1
$1
Net present value $117,840
 18 -18

The
The Net
Net Present
Present Value
Value Method
Method
Decision Criteria for NPV

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.
 18 -19

The
The Net
Net Present
Present Value
Value Method
Method
Decision Criteria for NPV
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.

 18 -20

The
The Net
Net Present
Present Value
Value Method
Method
Reinvestment Assumption
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.
 18 -21

Internal
Internal Rate
Rate of
of Return
Return
The internal 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
 18 -22

Internal
Internal Rate
Rate of
of Return
Return
Decision Criteria:
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.
 18 -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.
 18 -24
NPV Compared With IRR
Bintley
Bintley Corporation
Corporation Example
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
 18 -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
 18 -26
NPV Compared With IRR
IRR ANALYSIS

Initial Investment
Discount factor =
Annual cash flow
$180,000
= = 3.000
60,000
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
 18 -27
NPV Compared With IRR
IRR ANALYSIS

Initial Investment
Discount factor =
Annual cash flow
$210,000
= = 3.000
70,000
From Exhibit 18B-2, df = 3,000 for five years; IRR = 20%
= 3,000
 18 -28

Adjusting
Adjusting Forecast
Forecast for
for Inflation
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
 18 -29
After-Tax Operating Cash Flows
The 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
 18 -30
After-Tax Operating Cash Flows
Decomposition 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.
 18 -31
After-Tax Operating Cash Flows
Decomposition 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
 18 -32

Depreciation
Depreciation
Tax-Shielding
Tax-Shielding Effect
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.
 18 -33

Depreciation
Depreciation
Tax-Shielding
Tax-Shielding Effect
Effect

Net operating cash flows $300,000

Less: Depreciation 0
Taxable income $300,000
Less: Income taxes (@ 34%) 102,000
Net income $198,000
 18 -34

Depreciation
Depreciation
Tax-Shielding
Tax-Shielding Effect
Effect
Now assume that the tax laws allow a deduction for
depreciation:
Net operating cash flows $300,000
Less: Depreciation 100,000
Taxable income $200,000
Less: Income taxes (@ 34%) -68,000
Net income $132,000
 18 -35

Depreciation
Depreciation
Tax-Shielding
Tax-Shielding Effect
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
 18 -36

MACRS
MACRS Depreciation
Depreciation Rates
Rates
The tax laws classify most assets into the following three classes
(class = Allowable years):
Class Types 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.
 18 -37

MACRS
MACRS Depreciation
Depreciation Rates
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.
 18 -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.
 18 -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).
 18 -40

Example—MACRS Method
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
 18 -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
 18 -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
 18 -43
How
How Estimates
Estimates of
of Operating
Operating
Cash
Cash Flows
Flows Differ
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.
Present value ($4,000,000 x 5.65) $22,600,000
Investment 18,000,000
Net present value $ 4,600,000
 18 -44
How
How Estimates
Estimates of
of Operating
Operating
Cash
Cash Flows
Flows Differ
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
 18 -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
 18 -46

Future
Future Value:
Value: Time
Time
Value
Value of
of Money
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
 18 -47

Future
Future Value:
Value: Time
Time
Value
Value of
of Money
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?
 18 -48

Future
Future Value:
Value: Time
Time
Value
Value of
of Money
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)
 18 -49

Present
Present Value
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
 18 -50

Present
Present Value
Value
Example: Calculate the present value of a $100 per year
annuity, to be received for the next three years. The interest rate
is 12%.
Answer:
Discount Present Year Cash Factor Value
1 $1000.893 $ 89.30
2 1000.797 79.70
3 1000.712 71.20
2.402*$240.20

* 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.
 18 -51
Homework

 Exercise 13.3

 Exercise 13.5

 Exercise 13.6

 Exercise 13.7
 18 -52

Chapter Eighteen

The
The End
End