Module 02: Discussion 1 of 2

edina

Hilton_MA_12e_Chap016_PPT.pptx

Home >Business & Finance homework help >Management homework help >Module 02: Discussion 1 of 2

Capital Expenditure Decisions

16-1

Chapter 16

Chapter 16: Capital Expenditure Decisions

Learning Objective 16-1 – Use the net-present-value method and the internal-rate-of-return method to evaluate an investment proposal.

16-2

Learning Objective 16-1. Use the net-present-value method and the internal-rate-of-return method to evaluate an investment proposal.

Discounted-Cash-Flow Analysis

16-3

Decisions involving cash inflows and outflows beyond the current year are called capital-budgeting decisions.

Discounted-cash-flow analysis accounts for the time value of money in such decisions.

Managers in all organizations periodically face major decisions that involve cash flows over several years. Decisions involving the acquisition of machinery, vehicles, buildings, or land are examples of such decisions. Other examples include decisions involving significant changes in a production process or adding a major new line of products or services to the organization’s activities.

Decisions involving cash inflows and outflows beyond the current year are called capital-budgeting decisions.

Discounted-cash-flow analysis accounts for the time value of money. It is a mistake to add cash flows occurring at different points in time. The proper approach is to use discounted-cash-flow analysis, which takes into account the timing of the cash flows. There are two widely used methods of discounted-cash-flow analysis: the net-present-value method and the internal-rate-of-return method.

(LO 16-1)

Net-Present-Value Method

1. Prepare a table showing cash flows for each year,

2. Calculate the present value of each cash flow using a discount rate,

3. Compute net present value,

4. If the net present value (NPV) is zero or positive, accept the investment proposal. Otherwise, reject it.

16-4

These four steps constitute a net-present-value analysis of an investment proposal:

1. Prepare a table showing the cash flows during each year of the proposed investment.

2. Compute the present value of each cash flow, using a discount rate that reflects the cost of acquiring investment capital. This discount rate is often called the hurdle rate or minimum desired rate of return.

3. Compute the net present value, which is the sum of the present values of the cash flows.

4. If the net present value (NPV) is equal to or greater than zero, accept the investment proposal. Otherwise, reject it. (LO 16-1)

Net-Present-Value Method (2/5)

Mattson Co. has been offered a five year contract to provide component parts for a large manufacturer.

16-5

Here a table has been prepared by Mattson’s accountant showing the cash flows during each year of a proposed investment to provide component parts to another manufacturer. The proposal requires special equipment that would need to be purchased if the proposal is accepted, associated cash revenue and expense items are also included. (LO 16-1)

Net-Present-Value Method (3/5)

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?

16-6

Other information available is that the working capital required to accept the proposal will be returned at the end of the contract, and Mattson requires a minimum of a ten percent hurdle rate.

We need to decide whether we should accept or reject the proposal. (LO 16-1)

Net-Present-Value Method (4/5)

Annual net cash inflows from operations

16-7

First, we calculate the net annual cash inflows to Mattson.

Mattson would have net cash inflows of $80,000 per year for the next five years if the proposal is accepted. (LO 16-1)

Net-Present-Value Method (5/5)

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.

16-8

Two costs that would be incurred immediately if the proposal is accepted are the investment in equipment and the immediate need for working capital. The present value of those expenditures are the same, because we would purchase the equipment today and need the working capital today.

The annual net cash inflows would be received over a five-year period, so we must bring that value back to the present, in order to compare apples to apples. The present value of the net cash inflows is $303,280.

We will also need to reline the equipment in three years at a cost of $30,000. The present value of this amount is $22,530.

In addition, when the contract is completed, we will sell the equipment. The present value of the salvage value is $3,105.

We then add together all of the present values. A positive net present value means that the value of accepting the proposal exceeds the negatives, and that the return on this investment is at least as high as the hurdle rate. Considering the net present value method only, this proposal should be accepted by Mattson. (LO 16-1)

Internal-Rate-of-Return Method

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.

16-9

An alternative discounted-cash-flow method for analyzing investment proposals is the internal-rate-of-return method.

An asset’s internal rate of return, or time-adjusted rate of return is the true economic return earned by the asset over its life.

Another way of stating the definition is that an asset’s internal rate of return, IRR, is the discount rate that would be required in a net-present-value analysis in order for the asset’s net present value to be exactly zero. (LO 16-1)

Internal-Rate-of-Return Method (2/5)

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.

16-10

A new machine will cost $104,320 and will save Black Company $20,000 per year in cash operating costs.

This machine will last ten years. (LO 16-1)

Internal-Rate-of-Return Method (3/5)

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

16-11

The IRR is calculated by taking the amount of the investment and dividing it by the net annual cash inflows.

This gives us a present value factor to enter into the tables with. (LO 16-1)

Internal-Rate-of-Return Method (4/5)

$104,320

$20,000

= 5.216

The present value factor (5.216) is located on Table IV in Appendix A. 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.

16-12

We look in a present value table across the ten-year line until we find the number that is closest to our calculated factor.

We find our 5.216 factor under the 14% column.

This is the internal rate of return. (LO 16-1)

Internal-Rate-of-Return Method (5/5)

Here’s the proof . . .

16-13

To prove that 14% is the rate of return, we work backwards and calculate the net present value to be zero.

The decision rule in the internal-rate-of-return method is to accept an investment proposal if its internal rate of return is greater than the organization’s cost of capital, or hurdle rate. (LO 16-1)

Learning Objective 16-2 – Compare the net-present-value and internal-rate-of-return methods, and state the assumptions underlying each method.

16-14

Learning Objective 16-2. Compare the net-present-value and internal-rate-of-return methods, and state the assumptions underlying each method.

Comparing the NPV and IRR Methods

Net Present Value

The cost of capital is used as the actual discount rate.

Any project with a negative net present value is rejected.

Internal Rate of Return

The cost of capital is compared to the internal rate of return on a project.

To be acceptable, a project’s rate of return must be greater than the cost of capital.

16-15

Calculation of the net present value is relatively simple.

The cost of capital is used as the actual discount rate and any negative value is rejected because it does not return the hurdle rate.

The internal rate of return, once calculated is compared to the hurdle rate.

If the return is greater than the cost of capital, the project is acceptable. (LO 16-2)

Comparing the NPV and IRR Methods (2/2)

The net-present-value method has the following advantages over the internal-rate-of-return method:

Easier to use.

Easier to adjust for risk.

16-16

The net-present-value method exhibits two potential advantages over the internal-rate-of-return method. First, if the investment analysis is carried out by hand, it is easier to compute a project’s NPV than its IRR. For example, if the cash flows are uneven across time, trial and error must be used to find the IRR. This advantage of the NPV approach is not as important, however, when a computer is used.

A second potential advantage of the NPV method is that the analyst can adjust for risk considerations. For some investment proposals, the further into the future that a cash flow occurs, the less certain the analyst can be about the amount of the cash flow. Thus, the later a projected cash flow occurs, the riskier it may be. It is possible to adjust a net-present-value analysis for such risk factors by using a higher discount rate for later cash flows than earlier cash flows. It is not possible to include such a risk adjustment in the internal-rate-of-return method, because the analysis solves for only a single discount rate, the project’s IRR. (LO 16-2)

Assumptions Underlying Discounted-Cash-Flow Analysis

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.

16-17

Some assumptions are made in discounted cash flow analyses.

In the present-value calculations used in the NPV and IRR methods, all cash flows are treated as though they occur at year-end. Most annual operating-cost savings actually would occur uniformly throughout each year. The additional computational complexity that would be required to reflect the exact timing of all cash flows would complicate an investment analysis considerably. The error introduced by the year-end cash-flow assumption generally is not large enough to cause any concern.

Discounted-cash-flow analyses treat the cash flows associated with an investment project as though they were known with certainty. Although methods of capital budgeting under uncertainty have been developed, they are not used widely in practice. Most decision makers do not feel that the additional benefits in improved decisions are worth the additional complexity involved. As mentioned above, however, risk adjustments can be made in an NPV analysis to partially account for uncertainty about the cash flows.

Both the NPV and IRR methods assume that each cash inflow is immediately reinvested in another project that earns a return for the organization. In the NPV method, each cash inflow is assumed to be reinvested at the same rate used to compute the project’s NPV, the organization’s hurdle rate. In the IRR method, each cash inflow is assumed to be reinvested at the same rate as the project’s internal rate of return.

A discounted-cash-flow analysis assumes a perfect capital market. This implies that money can be borrowed or lent at an interest rate equal to the hurdle rate used in the analysis. (LO 16-2)

Choosing the Hurdle Rate

The discount rate generally is associated with the company’s cost of capital.

The cost of capital involves a blending of the costs of all sources of investment funds, both debt and equity.

16-18

The choice of a hurdle rate is a complex problem in finance.

The hurdle rate is determined by management based on the investment opportunity rate.

This is the rate of return the organization can earn on its best alternative investments of equivalent risk.

In general, the greater a project’s risk is, the higher the hurdle rate should be. (LO 16-2)

Learning Objective 16-3 – Use both the total-cost approach and the incremental-cost approach to evaluate an investment proposal.

16-19

Learning Objective 16-3. Use both the total-cost approach and the incremental-cost approach to evaluate an investment proposal.

Comparing Two Investment Projects

To compare competing investment projects, we can use the following net present value approaches:

Total-Cost Approach

Incremental-Cost Approach

16-20

The total-cost approach uses all of the relevant costs of each proposal and are included in the analysis.

The incremental-cost approach is where just the difference in the cost of each relevant item under the two alternative systems is included in the analysis. (LO 16-3)

Total-Cost Approach

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 20,000 -

16-21

The computing system used by the city of Mountainview is outdated. The city council has voted to purchase a new computing system to be funded through municipal bonds. The mayor has asked the city’s controller to make a recommendation as to which of two computing systems should be purchased.

The two systems are equivalent in their ability to meet the city’s needs and in their ease of use. The mainframe system consists of one large mainframe computer with remote terminals and printers located throughout the city offices. The personal computer system consists of a much smaller mainframe computer, a few remote terminals, and a dozen personal computers, which will be networked to the small mainframe.

Mountainview’s accountant has prepared the above schedule of net costs.

Before we begin the steps of the net-present-value method, let’s examine the cash flow data in the slide to determine if any of the data can be ignored as irrelevant. Notice that salvage values and datalink services do not differ between the two alternatives. Regardless of which new computing system is purchased, certain components of the old system can be sold now for $25,000. Moreover, the datalink service will cost $20,000 annually, regardless of which system is acquired. If the only purpose of the NPV analysis is to determine which computer system is the least-cost alternative, then salvage values and datalink services can be ignored as irrelevant, since they will affect both alternatives’ NPVs equally. (LO 16-3)

Total-Cost Approach (2/3)

MAINFRAME ($) Time 0 Time 1 Time 2 Time 3 Time 4 Time 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)

Time sharing revenue 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)

× Discount factor × 1.000 × .893 × .797 × .712 × .636 × .567

Present value (440,000) (281,295) (251,055) (252,760) (200,340) (150,255)

SUM OF PRESENT VALUES = $(1,575,705)

PERSONAL COMPUTER ($)

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)

Time sharing revenue -0- -0- -0- -0- -0- _

Total cash flow 375,000 (235,000) (235,000) (295,000) (235,000) (205,000)

× Discount factor × 1.000 × .893 × .797 × .712 × .636 × .567

Present value (375,000) (209,855) (187,295) (210,040) (149,460) (116,235)

SUM OF PRESENT VALUES = $(1,247,885)

16-22

The slide shown here displays a net-present-value analysis of the two alternative computing systems.

The exhibit uses the total-cost approach, in which all of the relevant costs of each computing system are included in the analysis.

Then the net present value of the cost of the mainframe system is compared with that of the personal computer system. (LO 16-3)

Total-Cost Approach (3/3)

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.

16-23

Since the NPV of the costs is lower with the personal computer system, that will be the controller’s recommendation to the Mountainview City Council.

A decision such as Mountainview’s computing-system choice, in which the objective is to select the alternative with the lowest cost, is called a least-cost decision.

Rather than maximizing the NPV of cash inflows minus cash outflows, the objective is to minimize the NPV of the costs to be incurred. (LO 16-3)

Incremental-Cost Approach

INCREMENTAL ($)

Time 0 Time 1 Time 2 Time 3 Time 4 Time 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

Total cash flow ( 65,000) ( 80,000) ( 80,000) ( 80,000) ( 80,000) ( 60,000)

× Discount factor × 1.000 × .893 × .797 × .712 × .636 × .567

Present value ( 65,000) ( 71,440) ( 63,760) ( 42,720) ( 50,880) ( 34,020)

SUM OF PRESENT VALUES = $(327,820)

16-24

The slide shown here displays the incremental net-present-value analysis of the city’s two alternative computing systems.

The result of this analysis is that the NPV of the costs of the mainframe system exceeds that of the personal computer system by $327,820. (LO 16-3)

Total-Incremental Cost Comparison

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!!

16-25

The total-cost and incremental-cost approaches will always yield equivalent conclusions.

Choosing between them is a matter of personal preference. (LO 16-3)

Managerial Accountant’s Role

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 . . .

increase the hurdle rate,

use sensitivity analysis.

16-26

To use discounted-cash-flow analysis in deciding about investment projects, managers need accurate cash-flow projections. This is where the managerial accountant plays an important role. The accountant often is asked to predict cash flows related to operating-cost savings, additional working-capital requirements, or incremental costs and revenues. Such predictions are difficult in a world of uncertainty. The managerial accountant often draws upon historical accounting data to help in making cost predictions. Knowledge of market conditions, economic trends, and the likely reactions of competitors can also be important in projecting cash flows. (LO 16-3)

Postaudit of Investment Projects

A postaudit is a follow-up after the project has been approved to see whether or not expected results are actually realized.

16-27

The discounted-cash-flow approach to evaluating investment proposals requires cash flow projections. The desirability of a proposal depends heavily on those projections. If they are highly inaccurate, they may lead the organization to accept undesirable projects or to reject projects that should be pursued. Because of the importance of the capital-budgeting process, most organizations systematically follow up on projects to see how they turn out. This procedure is called a postaudit or reappraisal.

In a postaudit, the managerial accountant gathers information about the actual cash flows generated by a project. Then the project’s actual net present value or internal rate of return is computed. Finally, the projections made for the project are compared with the actual results. If the project has not lived up to expectations, an investigation may be warranted to determine what went awry.

Sometimes a postaudit will reveal shortcomings in the cash-flow projection process. In such cases, action may be taken to improve future cash-flow predictions. Two types of errors can occur in discounted-cash-flow analyses; undesirable projects may be accepted and desirable projects may be rejected. The postaudit is a tool for following up on accepted projects.

Thus, a postaudit helps to detect only the first kind of error, not the second. As in any performance-evaluation process, a postaudit should not be used punitively.

The focus of a postaudit should provide information to the capital-budgeting staff, the project manager, and the management team. (LO 16-3)

Learning Objective 16-4 – Determine the after-tax cash flows in an investment analysis.

16-28

Learning Objective 16-4. Determine the after-tax cash flows in an investment analysis.

Income Taxes and Capital Budgeting

Cash flows from an investment proposal affect the company’s profit and its income tax liability.

Income = Revenue − Expenses + Gains − Losses

16-29

When a business makes a profit, it usually must pay income taxes, just as individuals do.

Since many of the cash flows associated with an investment proposal affect the company’s profit, they also affect the firm’s income-tax liability.

Any aspect of an investment project that affects any of the items in this equation generally will affect the company’s income-tax payments.

These income-tax payments are cash flows, and they must be considered in any discounted-cash-flow analysis.

In some cases, tax considerations are so crucial in a capital-investment decision that they dominate all other aspects of the analysis. (LO 16-4)

After-Tax Cash Flows

Suppose High Country’s management is considering the purchase of an additional delivery truck.

High Country will consider the after-tax cash flows from the incremental sales revenue and expenses in order to assist in their decision making.

16-30

The first step in a discounted-cash-flow analysis for a profit-seeking enterprise is to determine the after-tax cash flows associated with the investment projects under consideration. An after-tax cash flow is the cash flow expected after all tax implications have been taken into account. Each financial aspect of a project must be examined carefully to determine its potential tax impact.

High Country Department Stores, Inc., operates two department stores in the city of Mountainview. The firm has a large downtown store and a smaller branch store in the suburbs. The company is quite profitable, and management is considering several capital projects that will enhance the firm’s future profit potential.

Some expenses, depreciation being one of them, require no cash flows, yet they reduce the amount of taxable net income. (LO 16-4)

After-Tax Cash Flows (2/3)

Incremental sales revenue, net of cost of goods sold (cash inflow)	$ 50,000
Incremental income tax (cash outflow), $50,000 × 30%	(15,000)
After-tax cash flow (net inflow after taxes)	$ 35,000

A quick method for computing the after-tax cash inflow from incremental sales is:

16-31

The sales manager estimates that a new truck will allow the company to increase annual sales revenue by $110,000. High Country’s additional annual sales revenue will result in an increase of $60,000 per year in cost of goods sold. The net incremental cash inflow resulting from the sales increase is $50,000 per year ($110,000 − $60,000).

What is High Country’s after-tax cash flow from the incremental sales revenue, net of cost of goods sold? Notice the firm’s incremental cash inflow from the additional sales is only $35,000 once tax effect is taken into consideration.

(LO 16-4)

After-Tax Cash Flows (3/3)

Incremental expense (cash outflow)	$(30,000)
Reduction in income tax (reduced cash outflow), $30,000 × 30%	9,000
After-tax cash flow (net outflow after taxes)	$(21,000)

A quick method for computing the after-tax cash inflow from incremental expenses is:

16-32

What are the tax implications of cash expenses? Suppose the addition of the delivery truck under consideration by High Country’s management will involve hiring an additional part-time employee, whose annual compensation and fringe benefits will amount to $30,000.

Although the incremental employee compensation is $30,000, this expense is tax-deductible. Thus, the firm’s income-tax payment will be reduced by $9,000. As a result, the after-tax cash outflow from the additional compensation is $21,000.

(LO 16-4)

Not all expenses represent cash outflows. The most common example of a noncash expense is depreciation expense.

Non-Cash Expenses

The annual depreciation expense provides a reduction in income-tax expense equal to the firm’s tax rate times the depreciation deduction. This is called a depreciation tax shield.

In a discounted-cash-flow analysis, we will discount the related cash flows which occurs over a period of years, to find their present value.

16-33

Not all expenses represent cash outflows. The most common example of a noncash expense is depreciation expense.

The annual depreciation expense provides a reduction in income-tax expense equal to the firm’s tax rate times the depreciation deduction. This is called a depreciation tax shield.

In a discounted-cash-flow analysis, we will discount the cash flows related to depreciation which occurs over a period of years to find their present value. (LO 16-4)

Learning Objective 16-5 – Use the Modified Accelerated Cost Recovery System to determine an asset’s depreciation schedule for tax purposes.

16-34

Learning Objective 16-5. Use the Modified Accelerated Cost Recovery System to determine an asset’s depreciation schedule for tax purposes.

Modified Accelerated Cost Recovery System (MACRS)

Under prior Tax Reform Acts most depreciable assets have been depreciated under the Modified Accelerated Cost Recovery System, or MACRS.

Tax Cuts and Jobs Act (TCJA) came into effect on January 1, 2018, and additional changes were made in how companies calculate depreciation for tax purposes.

In particular, under the TCJA, many assets could be depreciated much more quickly than they could before the TCJA.

16-35

Depreciation expense, although it is not a cash flow in and of itself, does cause a reduced cash outflow for income taxes, because depreciation expense reduces taxable income.

One aspect of the tax law that often has changed during major tax reforms is the set of rules determining how depreciation is calculated. This set of rules is complex.

Under the Tax Reform Acts of 1986, 1989, and 1993 most depreciable assets have been depreciated for tax purposes in accordance with the Modified Accelerated Cost Recovery System, or MACRS.

Much more recently, the Tax Cuts and Jobs Act (TCJA) came into effect on January 1, 2018, and additional changes were made in how companies calculate depreciation for tax purposes.

In particular, under the TCJA, many assets could be depreciated much more quickly than they could before the TCJA.

Assets already in service before the TCJA took effect in 2018 must continue to follow the tax rules in place before the TCJA, which generally will be MACRS.

(2) Although the TCJA provides for considerably accelerated depreciation deductions, there are circumstances where a taxpayer may opt out of the TCJA and instead follow the pre-TCJA rules (i.e., MACRS).

(3) “For assets that do not qualify for the special provisions in the TCJA, taxpayers must fall back to the standard depreciation methods used prior to the TCJA.” (This generally is MACRS.)

(4) The advantageous depreciation provisions under the TCJA are temporary, and they will be phased out for assets placed in service after 2022. (Most other provisions in the TCJA—for example, a lower corporate tax rate—are permanent.)

(LO 16-5)

Modified Accelerated Cost Recovery System (MACRS) (2/3)

16-36

Under the Modified Accelerated Cost Recovery System, or MACRS, every asset is placed in one of several classes, depending on the asset’s expected useful life. The number of years of depreciation specified by the tax code is not the same as an asset’s useful life. Thus, each asset’s useful life is used only to place the asset in its appropriate MACRS class. Then the tax code specifies the appropriate number of years of depreciation. The table above summarizes the rates for 3, 5, 7, and 10 year property. (LO 16-5)

Modified Accelerated Cost Recovery System (MACRS) (3/3)

Depreciation Methods

Half-Year Convention

No Salvage Values

Optional Straight-Line Depreciation

Income-Tax Complexities

16-37

Assets in the 3-year, 5-year, 7-year, and 10-year MACRS property classes are depreciated using the double-declining-balance (DDB) method. Assets in the 15-year and 20-year MACRS property classes are depreciated using the 150%-declining-balance method. Assets in the 27.5-year and 39-year MACRS property classes are depreciated using the straight-line method.

An asset may be purchased at any time during the tax year. MACRS assumes that, on average, assets will be placed in service halfway through the tax year. Thus, the tax code allows only a half-year’s depreciation during the tax year in which an asset is placed in service. The other half of the first year’s depreciation is picked up in the second tax year in which the asset is in service.

Under MACRS, an asset’s estimated salvage value is not subtracted in computing the asset’s depreciation basis.

The tax law permits a business to depreciate any asset using the straight-line method if desired.

The U.S. tax code is a complex document with a multitude of provisions. It is not possible to cover all of these provisions in this text, so it is wise to consult a tax expert regarding the complexities that may apply in a particular investment decision. Since the tax code is changed frequently by Congress, a tax rule that applied last year may not apply this year. (LO 16-5)

Learning Objective 16-6 – Evaluate an investment proposal using a discounted-cash-flow analysis, giving full consideration to income-tax issues.

16-38

Learning Objective 16-6. Evaluate an investment proposal using a discounted-cash-flow analysis, giving full consideration to income-tax issues.

Gains and Losses

The tax effects of gains and losses on disposal of assets can be an important feature of an investment decision.

16-39

When a business sells an asset, there often is a gain or loss on the sale. Since gains and losses are included in income, the business’s income taxes generally are affected. Capital investment decisions frequently involve the disposal of assets, and sometimes gains or losses are recorded on those sales. Thus, the tax effects of gains and losses on disposal of assets can be an important feature of an investment decision. (LO 16-6)

Investment in Working Capital

Some investment proposals require additional outlays for working capital, such as increases in cash, accounts receivable, and inventory.

16-40

Some investment proposals require additional outlays for working capital.

Working capital, defined as the excess of current assets over current liabilities, often increases as the result of higher balances in accounts receivable or inventory necessary to support a project.

Such increases are uses of cash and should be included in a discounted cash-flow analysis. (LO 16-6)

Investment in Working Capital (2/3)

16-41

To illustrate, suppose the city of Mountainview has offered High Country Department Stores a contract to sell special T-shirts and mementos commemorating the city’s bicentennial. The contract covers the three-year period leading up to the bicentennial celebration. The cash flows associated with the proposal are displayed above. Notice that the sales proposal would require a $2,000 outlay for additional working capital throughout the three-year period. The increased working capital is largely due to a higher balance in merchandise inventory. (LO 16-6)

Investment in Working Capital (3/3)

16-42

Panel B of the exhibit shows the analysis of the discounted cash flows. Notice that the time 0 cash investment in working capital is included as a $2,000 cash outflow. Since the increase in working capital is not released until the end of year 3, that $2,000 inflow is discounted. The city’s proposal has a positive net present value, so it should be accepted. (LO 16-6)

Learning Objective 16-7 – Discuss the difficulty of ranking investment proposals, and use the profitability index.

16-43

Learning Objective 16-7. Discuss the difficulty of ranking investment proposals, and use the profitability index.

Ranking Investment Projects

We can invest in either of these projects. Use a 10% discount rate to determine the net present value of the cash flows.

The total cash flows are the same, but the pattern of the flows is different.

16-44

Suppose a company has several potential investment projects, all of which have positive net present values. If a project has a positive net present value, this means that the return projected for the project exceeds the company’s cost of capital. In this case, every project with a positive NPV should be accepted. In spite of the theoretical validity of this argument, practice often does not reflect this viewpoint. In practice, managers often attempt to rank investment projects with positive net present values. Then only a limited number of the higher-ranking proposals are accepted.

The reasons for this common practice are not clear. If a discount rate is used that accurately reflects the firm’s cost of capital, then any project with a positive NPV will earn a return greater than the cost of obtaining capital to fund it. One possible explanation for the practice of ranking investment projects is a limited supply of scarce resources, such as managerial talent. Thus, a form of capital rationing takes place, not because of a limited supply of investment capital, but because of limitations on other resources. A manager may feel that he or she simply cannot devote sufficient attention to all of the desirable projects. The solution, then, is to select only some of the positive-NPV proposals, which implies a ranking.

Shown here is an example of two proposals, Project A and Project B.

In this example, the total cash flows for each proposal is the same in total, but the timing of the cash flows occur differently. (LO 16-7)

Ranking Investment Projects (2/3)

Let’s calculate the present value of the cash flows associated with Project A.

This project has a positive net present value which means

the project’s return is greater than the discount rate.

16-45

Since the cash flows are uneven, we must calculate the present value of each cash flow individually.

Using a table or calculator to determine the present value factor, we multiply that times the first cash flow, and get the present value of that cash flow.

We repeat the process for the second cash flow.

After calculating the present value of the third cash flow, we add them up, subtracting the initial cost of the project.

The net present value of project A is $1,020, which signals a greater return than the discount rate. (LO 16-7)

Ranking Investment Projects (3/3)

Here is the net present value of the cash flows associated with Project B.

Project B has a negative net present value which means

the project’s return is less than the discount rate.

16-46

We repeat the process for Project B.

The net present value of the project is negative, indicating that the proposal will not return at least the discount rate. (LO 16-7)

Learning Objective 16-8 – Use the payback method and accounting-rate-of-return method to evaluate capital investment projects.

16-47

Learning Objective 16-8. Use the payback method and accounting-rate-of-return method to evaluate capital investment projects.

Alternative Methods for Making Investment Decisions

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.

16-48

The payback period of an investment proposal is the amount of time it will take for the after-tax cash inflows from the project to accumulate to an amount that covers the original investment.

The formula on the slide defines an investment project’s payback period.

In this example, the amount of the initial investment will be recovered in five years. (LO 16-8)

Payback: Pro and Con

1. Fails to consider the time value of money.

2. Does not consider a project’s 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.

16-49

The payback method makes it appear as though an investment might recover its initial investment more quickly, but the method fails to consider the time value of money.

Another shortcoming of the payback method is that it fails to consider an investment project’s profitability beyond the payback period.

Despite the shortcomings, the payback method is used widely in practice, for two legitimate reasons.

First, the payback method provides a tool for roughly screening investment proposals. If a project does not meet some minimal criterion for the payback period, management may wish to reject the proposal regardless of potential large cash flows predicted well into the future.

Second, a young firm may experience a shortage of cash. For such a company, it may be crucial to select investment projects that recoup their initial investment quickly. A cash-poor firm may not be able to wait for the big payoff of a project with a long payback period. Even in these cases, it is wise not to rely on the payback method alone. If the payback method is used, it should be in conjunction with a discounted-cash-flow analysis. (LO 16-8)

Accounting-Rate-of-Return Method

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.

16-50

Discounted-cash-flow methods of investment analysis focus on cash flows and incorporate the time value of money.

The accounting-rate-of-return method focuses on the incremental accounting income that results from a project.

Accounting income is based on accrual accounting procedures.

Revenue is recognized during the period of sale, not necessarily when the cash is received; expenses are recognized during the period they are incurred, not necessarily when they are paid in cash. (LO 16-8)

Accounting-Rate-of-Return Method (2/4)

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

16-51

The formula shown on the slide is used to compute the accounting rate of return on an investment project. (LO 16-8)

Accounting-Rate-of-Return Method (3/4)

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?

16-52

Meyers is considering installing an espresso bar.

It will cost $140,000 and have a ten-year life, generating incremental revenues of $100,000 and incremental expenses of $80,000. (LO 16-8)

Accounting-Rate-of-Return Method (4/4)

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%

16-53

The accounting rate of return is 14.3%.

Like the payback method, the accounting rate-of-return method is a simple way of screening investment proposals.

Some managers use this method because they believe it parallels financial accounting statements, which also are based on accrual accounting.

However, like the payback method, the accounting-rate-of-return method does not consider the time value of money. (LO 16-8)

Learning Objective 16-9 (Appendix B) – Explain the impact of inflation on a capital-budgeting analysis.

16-54

Learning Objective 16-9 (Appendix B). Explain the impact of inflation on a capital-budgeting analysis. (LO 16-9 & Appendix B)

Inflation Effects

Nominal Dollars

Real dollars

16-55

Most countries have experienced inflation to some degree over the past 30 years. Inflation is defined as a decline in the general purchasing power of a monetary unit, such as a dollar, across time. Since capital budgeting decisions involve cash flows over several time periods, it is worthwhile to examine the impact of inflation in capital-budgeting analyses. (LO 16-9 & Appendix B)

Inflation Effects (2/2)

Two Capital-Budgeting Approaches under Inflation

A correct capital-budgeting analysis may be done using either of the following approaches.

Use cash flows measured in nominal dollars and a nominal interest rate to determine the nominal discount rate.

Use cash flows measured in real dollars and a real interest rate to determine the real discount rate.

16-56

A cash flow measured in nominal dollars is the actual cash flow we observe. A cash flow measured in real dollars reflects an adjustment for the dollar’s purchasing power. The real interest rate is the underlying interest rate, which includes compensation to investors for the time value of money and the risk of an investment. The nominal interest rate includes the real interest rate, plus an additional premium to compensate investors for inflation.

Either capital-budgeting approach will provide the correct conclusion, as long as it is applied consistently. Use either nominal dollars and a nominal discount rate or real dollars and a real discount rate. A common error in capital budgeting is to convert the after-tax cash flows to real dollars, but then use the nominal discount rate. This faulty analysis creates a bias against acceptance of worthwhile projects. (LO 16-9 & Appendix B)

End Chapter 16

16-57

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

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 years5,000

Annual cash revenue and costs:

Sales revenue from parts 750,000

Cost of parts sold 400,000

Salaries, shipping, etc. 270,000

Sheet1


	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

Page &P

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

Sheet1


	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

Page &P

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$

Years

Cash

Flows

10%

Factor

Present

Value

Investment in equipmentNow $ (160,000)1.000 (160,000)$

Working capital neededNow(100,000) 1.000 (100,000)

Annual net cash inflows1-580,000 3.791 303,280

Relining of equipment3 (30,000) 0.751 (22,530)

Salvage value of equip.5 5,000 0.621 3,105

Working capital released5 100,000 0.621 62,100

Net present value 85,955$

Sheet1


	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

Page &P

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 -$

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 -$

Sheet1


	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				$ - 0

Page &P

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$

Project AProject B

Immediate cash outlay100,000$ 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$

)Sheet1


	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

Page &P

)Sheet2

Page &P

)Sheet3

Page &P

)Sheet4

Page &P

)Sheet5

Page &P

Project A

PV Factor

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

]]]Sheet1


	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

Page &P

]]]Sheet2

Page &P

]]]Sheet3

Page &P

]]]Sheet4

Page &P

]]]Sheet5

Page &P

Project B

PV FactorPV

Immediate cash outlay(100,000)$ 1.000 (100,000)$

Cash inflows:

Year 130,000$ 0.909 27,270

Year 240,000 0.826 33,040

Year 350,000 0.751 37,550

Net present value(2,140)$

]Sheet1


	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)

Page &P

]Sheet2

Page &P

]Sheet3

Page &P

]Sheet4

Page &P

]Sheet5

Page &P