Chapter 5 - Capital Investment

Chapter 19
Capital investment
Hansen/Mowen, Cornerstones of Cost Management, 4 th Edition. © 2018 Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Learning Objectives (1 of 2)
1. Describe the difference between independent and mutually exclusive capital
investment decisions
2. Explain the roles of the payback period and accounting rate of return in
capital investment decisions
3. Calculate the net present value (NPV) for independent projects
4. Compute the internal rate of return (I RR) for independent projects
Hansen/Mowen, Cornerstones of Cost Management, 4 th Edition. © 2018 Cengage. All Rights Reserved. May not
be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Learning Objectives (2 of 2)
5. Tell why NPV is better than IRR for choosing among mutually exclusive
projects
6. Convert gross cash flows to after-tax cash flows
7. Describe capital investment for advanced technology and environmental
impact settings
Capital Investment Decisions
• Concerned with the process of:
o Planning and setting goals and priorities
o Arranging financing
o Using certain criteria to select long-term assets
• Affect the future development of the firm
o Concerned with investments in long-term capital assets
Capital budgeting
• Process of making capital investment decisions
• Types of capital budgeting projects
o Independent projects: Do not affect the cash flows of another project if
accepted or rejected
o Mutually exclusive projects: Preclude the acceptance of all other completing
projects if accepted
Making Capital Investment Decisions
• Managers must:
o Estimate the quantity and timing of cash flows
o Assess the risk of the investment
o Consider the impact of the project on the firm’s profits
• Models that guide managers in accepting or rejecting potential investments
o Nondiscounting models: Ignore the time value of money
o Discounting models: Explicitly consider the time value of money
NONdiscounting methods - Payback Period (1 of 3)
• Time required for a firm to recover its original investment
• When cash flows of a project are assumed to be even, payback period can
be computed using the following formula
o Payback period = Original investment
Annual cash flow
o If cash flows are uneven, payback period is computed by adding annual cash
flows until the time the original investment is recovered
• Approaches
o Setting a maximum payback period for all projects and rejecting any project that
exceeds this level
o Choosing among competing alternatives
• Deficiency - Ignores a project’s total profitability and the time value of money
• Provides information to managers that can help:
o Control risks associated with the uncertainty of future cash flows
o Minimize the impact of an investment on a firm’s liquidity problems
o Control the risk of obsolescence
o Control the effect of the investment on performance measures
Nondiscounting Methods - Accounting Rate of Return
(ARR)
• Measures the return on a project in terms of income, as opposed to using a
project’s cash flow
o ARR = Average income
Original investment
Income for each year of the project
• Average income =
Number of years
• Deficiency - Ignores the time value of money
Net Present Value Method (NPV) (1 of 3)
• Discounted cash flows: Future cash flows expressed in terms of their
present value
• NPV: Difference between the present value of the cash inflows and outflows
associated with a project: NPV = P − I
o P = Present value of the project’s future cash inflows
o I = Present value of the project’s cost
• Measures the profitability of an investment
o If positive, it measures the increase in wealth
• Required rate of return should be defined in order to use NPV
o Required rate of return (discount rate or hurdle rate): Minimum acceptable rate
of return
o Corresponds to the cost of capital
• Cost of capital: Weighted average of the costs from various sources
• If NPV > 0, investment is profitable and therefore acceptable
• If NPV = 0, decision maker will find acceptance or rejection of the investment
equal
• If NPV < 0, investment should be rejected
Internal Rate of Return (IRR) (1 of 2)
• Interest rate that sets the present value of a project’s cash inflows equal to
the present value of the project’s cost
o
• I = Present value of the project’s cost
• CFt = Cash inflow to be received in period t
• t = 1, . . . , n
• i = Required rate of return
o df = Investment
Annual cash flow
• df = Discount factor
Internal Rate of Return (IRR) (2 of 2)
• If the IRR is greater than cost of capital, the project should be accepted
• If the IRR is equal to cost of capital, acceptance or rejection is equal
• If the IRR is less than cost of capital, the project should be rejected
NPV versus IRR: Mutually Exclusive Projects (1 of 2)
• NPV assumes each cash inflow is reinvested at the required rate of return
o Measures the profitability in absolute terms
o Provides the correct signal for choosing among mutually exclusive investments
• Measures the impact that competing projects have on the value of the firm
• IRR assumes that each cash inflow is reinvested at the computed I RR
o Measures profitability in relative terms
NPV versus IRR: Mutually Exclusive Projects (2 of 2)
o Measures the rate of return of funds that are invested internally accurately as a
relative measure of profitability
• Independent project is acceptable if NPV is positive
o For mutually exclusive projects, the project with the largest N PV is chosen
• Steps involved in selecting the best project
o Assess the cash flow pattern for each project
o Compute the NPV for each project
o Identify the project with the greatest NPV
Computing After-Tax Cash Flows
• Steps required to compute cash flows
o Forecasting revenues, expenses, and capital outlays
o Adjusting gross cash flows for inflation and tax effects
• To analyze tax effects, cash flows are broken down into the following
categories:
o Initial cash outflows needed to acquire the assets of the project
o Cash flows produced over the life of the project
o Cash flows from the final disposal of the project
After-Tax Cash Flows: Year Zero (1 of 3)
• Net cash outflow in year zero
o Difference between the initial cost of the project and any cash inflows directly
associated with it
• Gross cost of the project includes:
o Cost of land and equipment
o Taxes on gains from the sale of assets
o Increases in working capital
• Cash inflows include tax savings from the sale of assets, cash from the sale
of assets, and other tax benefits such as tax credits
• Current tax law
o All costs relating to the acquisition of assets other than land must be capitalized
and written off over the useful life of the assets
• Write-off is achieved through depreciation
• No depreciation is computed at the point of acquisition
• Gains on the sale of assets produce additional taxes
o Reduce the cash proceeds received from the sale of old assets
• Losses are noncash expenses that reduce taxable income, producing tax
savings
• Cash proceeds from the sale of an old asset are increased by the amount of
the tax savings
After-Tax Operating Cash Flows: Life of the Project (1 of 2)
• Source of cash flows is from operations

o Operating cash inflows can be assessed from the project’s income statement
• After-tax cash flow = After-tax net income + Noncash expenses
o CF = NI + NC
o Noncash expenses generate cash flows by reducing taxes
After-Tax Operating Cash Flows: Life of the Project (2 of 2)
• Income approach to determine operating cash flows

o Can be decomposed to assess the after-tax, cash flow effects of each
individual item on the income statement
• CF = [(1 − Tax rate) × Revenues] − [(1 − Tax rate) × Cash expenses] + (Tax rate ×
Noncash expenses)
Calculating After-Tax Cash Flows (1 of 3)
• A company plans to make a new product that requires new equipment
costing $1,600,000
o Both the product and equipment have a life of four years
o The equipment will be depreciated on a straight-line basis, with no expected
salvage value
• Annual income statement for the product
o Using the income approach, calculate the after-tax cash flows
o Using the decomposition approach, calculate the after-tax cash flows for each
item of the income statement
Revenues $1,200,000
Less: Cash operating expenses (500,000)
Depreciation (400,000)
Income before income taxes $ 300,000
Less: Income taxes (@ 40%) 120,000
Net income $ 180,000
• Solution:
o Income approach
• CF = NI + NC = $180,000 + $400,000 = $580,000
o Decomposition approach
(1- t) × Revenue = (1-0.40) × $1,200,000 $ 720,000

(1 - t) × Cash expenses = (1-0.40) × $(500,000) (300,000)
t × Depreciation = 0.40 × $400,000 160,000
Operating cash flow $ 580,000
Personal Property
• All depreciable business assets other than real estate
• For calculating depreciation, assets are divided into classes
o Seven-year assets: Most equipment, machinery, and office furniture
o Five-year assets: Light trucks, automobiles, and computer equipment
o Three-year assets: Most small tools
Modified accelerated cost recovery system (MACRS)
Depreciation
• Double-declining-balance method used to compute annual depreciation
o No consideration of salvage value is required
• Half-year convention applies to this method
o Half-year convention: Assumes that a newly acquired asset is in service for
one-half of its first taxable year of service
• When the asset reaches the end of its life, the other half-year of depreciation can be
claimed in the following year
Exhibit 19.5 – MACRS Depreciation Rates
Year Three-Year Assets Five-Year Assets Seven-Year Assets

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
MACRS Depreciation - After-Tax Cash Flows: Final
Disposal
• Sources of cash at the end of the life of the project
o Release of working capital
o Preparation, removal, and sale of the equipment (salvage value effects)
• Any working capital committed to a project is released at this point
o Release of working capital is a cash inflow with no tax consequences
Capital Investment: Advanced Technology And
Environmental Considerations (1 of 2)
• Advanced manufacturing technology can improve quality, increase flexibility
and reliability, and decrease lead times
o Helps increase customer satisfaction and market share
• Pollution prevention (P2) projects look to:
o Redesign complex products and processes
o Invest in new technologies
Capital Investment: Advanced Technology And
Environmental Considerations (2 of 2)
• Differ from the traditional approach in the following ways:
o How investment is defined
o How operating cash flows are estimated
o How salvage value is treated
o How the discount rate is chosen
How Investment and Estimates of Operating Cash
Flows Differ
• Greater attention must be paid to the investment outlays because peripheral
items can require substantial resources
• Many environmental costs are hidden within other costs
o More effort is required to measure intangible and indirect benefits in order to
estimate the potential value of investments more accurately
Salvage Value
• Sensitivity analysis is used to deal with uncertainty related to estimating
terminal or salvage value
o Sensitivity analysis changes the assumptions on which the capital investment
analysis relies and assesses the effect on the cash flow pattern
Discount Rates
• In theory, if future cash flows are known with certainty, the correct discount
rate is a firm’s cost of capital
• In practice, future cash flows are uncertain
o Managers choose a discount rate higher than the cost of capital to deal with the
uncertainty

Chapter 5 - Capital Investment

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Chapter 19

• Source of cash flows is from operations

• Income approach to determine operating cash flows

(1- t) × Revenue = (1-0.40) × $1,200,000 $ 720,000

Year Three-Year Assets Five-Year Assets Seven-Year Assets

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