CHAPTER 27 LONGER-RUN DECISIONS: CAPITAL BUDGETING Changes from Eleventh Edition All changes to chapter 27 were minor. Approach Capital investment decisions are a special kind of alternative choice problem. They are analyzed in the same way as that used for the problems described in Chapter 26 with the e!ception that the timing of cash inflows and outflows must be taken into account. This one difference is an important one however. "n order to incorporate its effect in the analysis one must have a thorough understanding of the concept of present value. #ecause of the difficulty that students seem to have with the topic the discussion of present value in the first part of this chapter proceeds $uite slowly unless the Appendi! to Chapter % was previously assigned and discussed. &nce students understand the nature and use of this concept they should have relatively little difficulty with most other topics discussed in the chapter. 'uite early in the chapter the steps in analyzing a capital investment problem are set forth. As various aspects of the analysis are discussed it is a good idea to relate each of them to these steps and to keep the students continually aware of the purpose of the analysis namely to reach a decision on the acceptability of a proposed capital investment. The reason for the omission of depreciation is often difficult to understand. (tudents must appreciate that the procedure takes into account the recovery of the investment and that to include depreciation as a separate item of cost would be double counting. "n addition to the te!t discussion of this point it may be desirable to introduce additional illustrations. "t may also be desirable to relate this topic to the corresponding discussion in Chapter 26. (tudents have difficulty in understanding the depreciation ta! shield. They learned in Chapter 26 that noncash costs are to be disregarded but now they are told that noncash depreciation is to be counted and this seems contradictory. This point needs to be discussed in depth. (tudents should understand that the amount of depreciation does not directly enter the cash flow calculation. "t is the amount of income ta! that is the cash flow) depreciation is used only to calculate the amount of income ta!. The description and the e!amples have been stated and arranged in such a way that hopefully this point is emphasized. "n the latter part of the chapter several methods of investment analysis are described and compared. Although the net present*value method is described as being superior to the discounted cash*flow method not too much importance should be attached to this point. "n most real*life problems either method gives satisfactory results. Any method that uses present values is superior to all methods that disregard present values +e.g. payback unad,usted return- and it is a good idea to stress this point. +"n practice companies tend to use several methods simultaneously.Cases Sinclair Company is a carefully se$uenced set of assumptions about one proposed e$uipment ac$uisition each of which makes a separate point. Rock Creek Golf Club is a buy*or*lease case with ta! aspects. Phuket Beach Hotel: Valuing Mutually Exclui!e Capital Pro"ect asks students to build cash flow forecasts and then to rank mutually e!clusive pro,ects using various evaluation criteria. #ccounting: $ext an% Cae &'e ( )ntructor* Manual #nthony+Ha,kin+Merchant Problems Problem 27-1 Land Donated Land Sold Calculation of /et "ncome0 1reta! income before disposal..................................................................................................................................................... 3333333 3333333 Addition to +deduction from- ta!able income.............................................................................................................................. +33333333 1reta! income after disposal........................................................................................................................................................ 4%43333 33333 "ncome ta! 5 .3........................................................................................................................................................................ 486333 3333 Accounting income before disposal............................................................................................................................................. 3333333 3333333 9ess book value of land............................................................................................................................................................... 3333 1lus gain on sale of land.............................................................................................................................................................. : 33333 1reta! accounting income............................................................................................................................................................ 4443333 333333 9ess income ta! +above-.............................................................................................................................................................. 486333 3333 /et "ncome.................................................................................................................................................................................. 63333 6386333 Calculation of cash flow (aving in ta! .3 ! 3333...................................................................................................................................................... 333 Cash from sale............................................................................................................................................................................. 3333 9ess additional ta!....................................................................................................................................................................... : %%333 Additional cash............................................................................................................................................................................ 333 22333 (trangely enough the company is better off to donate the land rather than to sell it. /otes0 +- "t would also be correct to calculate the additional ta! at a capital gains rate of say 28 percent. +2- The cost of the land is disregarded in the ta! calculation. Actually the ta!able gain would probably be 3333 * 3333 ; 33333. +Problem 27-2: Plastic ec!cling Compan! a. Comparisons of Cash <lows and Ta!able "ncome0 "ear 1 2 # $ % &otal (traight*line +a-........................................................................................................................................................................ 6333 6333 6333 6333 6333 3333 =AC>(................................................................................................................................................................................... 6333 4633 833 833 833 3333 ?ifference in ta!able income................................................................................................................................................... 3 * 633 @ 633 @833 @833 3 ?ifference in ta! 5 .3............................................................................................................................................................ 3 * 3 @ 23 @ 633 @ 633 3 ?ifference in after*ta! income.................................................................................................................................................. 3 * 263 @ 63 @ 433 @ 433 3 ?ifference in cumulative cash flow +ta! postponed-............................................................................................................................................................ 3 3 233 633 3 b. The =AC>( method produces faster cash flows because of the ta! advantage in early years which decreases the funds spent for ta!es. +- 33338 years or 6333 per year +2- 3333 ! =AC>( allowance for given year. 2 B'--. McGra,/Hill+)r,in Chapter '. Problem 27-#: Corrine Compan! a. (99 &> >/T "f sell 273333 Cost............................................................................................................................................................................. Accumulated depreciation............................................................................................................................................ %3333 +2733338 years- ! 3 years #ook value................................................................................................................................................................... 43333 (elling price................................................................................................................................................................. 228333 9ong*term gain............................................................................................................................................................ 8333 Ta! 5 .3.................................................................................................................................................................... 3833 /et gain after ta!.......................................................................................................................................................... 4833 /et cash inflow ; 228333 * 3833......................................................................................................................... %833 "f rent >ent proceeds per year................................................................................................................................................ 72333 =aintenance etc......................................................................................................................................................... 27333 ?epreciation................................................................................................................................................................ %333 8333 /et rent income before ta!.......................................................................................................................................... 27333 Ta! 5 .3.................................................................................................................................................................... 3%33 /et rent after ta!......................................................................................................................................................... 6233 b. The cash flow of 8333 * 3%33 or 233 after ta! for five years is 7333 which is less than the after*ta! profit from a sale now. +The present value of 233 for 8 years at say 3D is 24682 even less than the 7333 and more accurate making the sale even more attractive.- #ut the value of the warehouse 8 years hence is not mentioned. "t might be sold at a large enough gain to offset the difference between rent proceeds and a sale now. >ent might increase or e!penses increase. vidence is weighted in favor of a sale now for after*ta! benefits. Problem 27-$ a. The investmentinflow ratio ; 3333 ÷ annual cash inflow ; 6.2 so if the investment is 3333 the annual cash inflow is 3333 ÷ 6.2 or 6. c. An investmentinflow ratio of 6.2 for 2 years from Table # is appro!imately a 2D internal rate of return. b. The investmentinflow ratio ; investment 6.-. c. ÷ 2333 ; 6. so the investment ; 22%3 +2333 ! The investmentinflow ratio from Table # for 7 years at 6D is .34. The investment is therefore 8333 annual cash inflow ! .34 ; 2348 the ma!imum price to pay. d. The investmentinflow ratio for % years at D from Table # is 64 which is the ma!imum investment per dollar of annual savings. #ccounting: $ext an% Cae &'e ( )ntructor* Manual #nthony+Ha,kin+Merchant Problem 27-%: 'ellington Corporation Calculation of 1ro,ect >eturns Pro(ect 2 8 +a33333 33333 3333 23333 83.333 )sef*l Life 6 years 8 2 28333 ÷ 3333 ÷ 8333 ÷ 3333 ÷ 2833 ÷ +nvestment, +nflo .a/ .3 . %.3 2.3 .3 ; .3 ; . ; %.3 ; 2.3 ; .3 et*rn .b/ D %D 4D 3D negative an0 st rd 2nd th 8th +b- >eturns for 1ro,ects * are from Table #. 1ro,ect Es return is zero since the nondiscounted inflows +3333 ! 2- e!actly e$ual the initial investment. 1ro,ect 8 over its entire life returns only 7833 of the initial 83333 investment so its return must be negative. Problem 27-: a3ton Compan! a. ?ifferential after*ta! cash flows +333 omitted-0 1445 1441 1442 (ales.............................................................................................................................................................................................. 333 633 %33 =aterial labor direct overhead..................................................................................................................................................... 33 783 83 Added rent +2833 ! -.............................................................................................................................................................. 83 83 83 ?epreciation.................................................................................................................................................................................. 83 33 83 ?ifferential cost............................................................................................................................................................................. 433 33 883 ?ifferential income....................................................................................................................................................................... 33 833 283 ?ifferential income ta!es +3D-.................................................................................................................................................... 3 233 33 ?ifferential net income.................................................................................................................................................................. 63 33 83 Add back depreciation................................................................................................................................................................... 83 33 83 ?ifferential cash flow from product.............................................................................................................................................. 83 633 33 (alvage value................................................................................................................................................................................ ** ** %3 /et differential cash flow.............................................................................................................................................................. 83 633 %3 Cash outlay for pro,ect0 1urchase price.............................................................................................................................. 433 =odifications............................................................................................................................... 3 "nstallation................................................................................................................................... 63 Testing......................................................................................................................................... 43 Total............................................................................................................................................. 3%3 9ess0 (alvage %3 ?epreciable #ase 433 b. The payback period is slightly less than two years since the initial investment is 3%3333 and the sum of the first two yearsE inflows is 3333. Thus if a two*year payback period is the decision criterion the pro,ect is acceptable. B'--. McGra,/Hill+)r,in c. Chapter '. 443 /et income............................................................................................................................ 833 44 /et income............................................................................................................................ 22833 442 /et income............................................................................................................................ 36833 82833 Average income............................................................................................................................. 7833 +Average investmentF...................................................................................................................... 83333 +2Accounting rate of return............................................................................................................... 22D +÷2Average "nvestment /et ?epreciation 433 +.6- ; 83 Cash outlay for e$uipment ; 3%3 623 ; 83 d. The pro,ect should be adopted if a 23D after*ta! rate of return is re$uired0 Present val*e of cash flos at 256: 4430 83333 ! 3.% ; 2%3 440 633333 ! 3.64 ; 633 4420 %3333 ! 3.874 ; 277423 483 The present value of 483 is greater than the initial outlay of 3%3333) therefore the pro,ect more than satisfies the 23D re$uirement. e. "f the student does not have access to a calculator or computer programmed to make ">> calculations the ">> must be estimated using a trial*and*error approach. The ">> is slightly in e!cess of 22D as shown by these calculations0 "ear 4430 440 4420 Cash lo 83333 633333 %3333 226 actor 3.%23 3.672 3.88 226 P898 %233 3233 26%3 3%8%%3 2$6 actor 3.%36 3.683 3.82 2$6 P898 363 43333 28823 3828%3 FThe initial investment +3%3333- is sometimes used in this calculation) this would make the accounting rate of return ; D. Cases ote on )se of Cases The same general line of attack can be used for several of the cases0 +- make a $uantitative calculation) +2- consider the non$uantitative factors) and +- reach a decision. "deally we think half the time should be spent on the first point and half the time on the last two but it never seems to work out that way. "nstead the problem is to get through the figures rapidly enough so that one has any time left to discuss the non$uantitative matters and the decision. "n order to do this we often cut off the discussion of specific problems in the figures by some such device as taking a vote using the figure of the person who seems to be making the best argument or even using our own figure. This must be done carefully and with appropriate cautions to the effect that we are not passing over the figures lightly but simply that we are not taking the time to consider all the aspects of the figures so that we can have some time to discuss the action. "t is unfortunate if the decision part of the problem is omitted. "f this is done. students may get the impression that the decision is of little importance whereas actually of course it is crucial. 8 #ccounting: $ext an% Cae &'e ( )ntructor* Manual #nthony+Ha,kin+Merchant There are several valid ways in which the figures may be put together. There are also several ways of arriving at the basic figures for investment and earnings. This may lead to confusion when students come to class with solutions prepared in accordance with different methods. &ne way of avoiding this is to specify a method when assigning the case. Ge prefer to let the students use whatever method they wish and e!pect them to be able to follow someone elseEs method as it unfolds in class. &ften after someone has started the class discussion with a valid method we ask everyone to continue to develop the data in accordance with that method and although they do not like to make the adaptation they usually can do it. The commentaries to several of the cases are more detailed than students reasonably can be e!pected to develop in class. Case 27-1: Sinclair Company ote: $hi cae i unchange% from the Ele!enth E%ition . Approach These problems are constructed so that each one builds on the preceding one and brings out a new point. "t often happens that in connection with the very first problem students raise $uestions that range all over the chapter. " ask them not to do this as the $uestions usually can be handled better later on in connection with the specific problems to which they apply. Also " prefer to get right to the problems rather than spending very much time on the te!t. " do go over the idea of present value and answer some $uestions but " think troublesome points are best handled in the conte!t of specific problems. "n introducing 1art A " may ask0 H"f you were going to buy a machine and had your choice of paying 8 now or a year for the ne!t five years which would you takeIJ /e!t H"f you had your choice of paying 8 now or per year for si! yearsIJ H<or seven yearsIJ This seems to help in clearing up the idea of contrasting the one*shot cost with the stream of earnings and the notion of the present value of a stream of payments. Comments on ;*estions . 2. PA& A "nvestment............................................................................................................................................................................ 283333 Annual savings..................................................................................................................................................................... 72333 1resent value of a year 8 years 8 percent..................................................................................................................... .82 Total present value of savings.............................................................................................................................................. 2 ?ecision0 /et present value ; *%686) therefore................................................................................................................. ?o not purchase (ame as $uestion . Moral0 #ook value makes no difference. The figures and decision are the same as in . /evertheless a profit center manager may not view the 8333 write*off as irrelevant even though it does represent a sunk cost. . "nvestment gross.................................................................................................................................................................. 283333 9ess salvage on old........................................................................................................................................................... 78333 /et investment............................................................................................................................................................... 78333 Annual earnings.................................................................................................................................................................... 72333 1resent value0 72333 F .82............................................................................................................................................. 2 ?ecision0 /et present value ; 66) therefore................................................................................................................ 1urchase Moral0 The resale value of the superseded machine reduces the amount of new funds re$uired which +in this case- changed the decision. 6 B'--. McGra,/Hill+)r,in . Chapter '. "nvestment............................................................................................................................................................... 283333 Annual earnings....................................................................................................................................................... 7833 1resent value 3 years 8D0 7833 F 8.34........................................................................................................ %%2 ?ecision0 /et present value ; *67%7) therefore................................................................................................... ?o not purchase Moral0 Although total earnings are appro!imately the same as in $uestion +78333 versus 63333- the present value is considerably different. "t is the pattern of earnings through time that counts not the total Hamount.J PA& "nvestment............................................................................................................................................................... 833333 Annual earnings....................................................................................................................................................... 63333 1resent value0 63333 F .82.............................................................................................................................. 8623 ?ecision0 /et present value ; 623) therefore.................................................................................................... 1urchase +"f =odel A has resale value the return would be even higher.2. The error arose when =odel A was purchased. Assuming the situation in A+- =odel A has an acceptable return if its economic life is 8 years. "t turns out that its economic life was only two years) conse$uently =odel A should not have been bought +although this is known only from hindsight-. . Moral0 ?onEt let past mistakes prevent you from making wise decisions now +i.e. sunk costs are irrelevant-. PA& C The 4% Ta! Act +and subse$uent acts- with AC>( provisions usually makes this kind of a computational nightmare for students because of the erratic HdepreciationJ +officially Hcost recoveryJamounts in years *8 and the absence of such amounts in later years. Ge have assumed that the AC>( allowances stay at 8D 26D 8D 2D 2D for 8*year assets. The cash flow pattern including a 8D +assumed to be time zero- "TC is0 1K of cash savings of 63333year for 8 years ; 63333 F .63 F .44............................................................. %2% Add0 1K of AC>( depreciation ta! shield for 833333 machine ; 7473 F .3................................................ 67%% 88386 ?educt0 1K of depreciation shield from old machine sacrificed +83333yr. for more years- ; 83333 F .3 F 2.877 +Table #-........................................................................... 883 /et present value of earnings................................................................................................................................... 4%476 (ince 4%476 is more than the net investment of 333 the decision is to purchase. AC>( Allowance Lear 1K factor ratio 78333 M .426 62383 2 3333 M .%87 3 78333 M .74 84883 63333 M .78 33 8 63333 M .6% 3%63 7473 7 #ccounting: $ext an% Cae &'e ( )ntructor* Manual . #nthony+Ha,kin+Merchant PA& D "nvestment............................................................................................................................................................................. 283333 1resent value of earnings Lears *0 74833 F 2.2% +Table #-............................................................................................................................... %44 Lears *80 63783 F .364F............................................................................................................................................. 642 Total 1K of earnings..................................................................................................................................................... 26 ?ecision0 ?o not purchase since /1K ; * 884. FThis is the difference between .82 and 2.2% 2. Although the total earnings for the 8*year period are the same in 1art ? as in A+- shifting more of the earnings to the early years and less to the later years increases the present value from 2 to 26. Moral0 The time pattern of earnings makes a difference. . "nvestment net of "TC.......................................................................................................................................................... 27833 1resent value of cash savings0 Lears *0 74833 F .63 + * ta! rate- F 2.877................................................................................................................. 2242 Lears *80 63783 F .63 F l.6...................................................................................................................................... 86 1resent value of AC>( depredation ta! shield0 23%4%8 F .3................................................................................................................................................................. %84 Total present value................................................................................................................................................................ 28%3 F.44 +8 yrs.- N 2.877 + yrs.- Moral0 The combination of ta!*shield benefits and a shift in earnings now makes the decision to purchase a good one +even without the 2833 "TC-. Case 27-2: Rock Creek Golf Club* ote: $hi cae i unchange% from the Ele!enth E%ition . Approach Ghereas many capital budgeting problems deal with comparative evaluation of alternative asset ac$uisitions this case involves analyzing two ways of financing a given asset ac$uisition. (ince Hlease* versus*buyJ is a common alternative choice problem in both business and nonbusiness organizations this case provides relevant e!perience for students. The class session can deal se$uentially with the assigned $uestions. 'uestion is the most difficult and sub,ect to studentsE omissions and differing assumptions. 'uestion is interesting but not crucial should class time become scarce. E<=++& A "ear 3 3 3 *8 *8 *8 * P*rchase Lease &ransaction +nflo >*tflo >*tflo +nflo F?isposal of old carts....................................................................................................................................................... %333 %333 FTa! effect of disposal .................................................................................................................................................... 2723 2723 1urchase cost.................................................................................................................................................................... %4633 n.a. FCart revenues2................................................................................................................................................................ 883 883 FCart e!penses................................................................................................................................................................ 3%%yr. 3%%yr. 9ease payments ............................................................................................................................................................... n.a. 233yr ?epreciation ta! shields 8.................................................................................................................................................. 4823 n.a. This teaching note was prepared by 1rofessor Oames (. >eece. Copyright B by Oames (. >eece. % B'--. McGra,/Hill+)r,in 2 8 8 3 *8 Chapter '. ?epreciation ta! shield........................................................................................................................................ 7372 n.a. ?epreciation ta! shield........................................................................................................................................ 2 n.a. ?epreciation ta! shield........................................................................................................................................ %2 n.a. ?epreciation ta! shield........................................................................................................................................ %2 n.a. 1roceeds from disposal........................................................................................................................................ 4633 n.a. Time Pero flow.................................................................................................................................................... %23 82%3 /1K of net streams.............................................................................................................................................. 82F 82F .44 ; 7734% .44; 243 <actor /1K..................................................................................................................................................................... 3.426 %%6 n.a. 2 &f........................................................................................................................................................................ 3.%87 636 n.a. ?epreciation........................................................................................................................................................ 3.74 64 n.a. Ta!....................................................................................................................................................................... 3.78 24 n.a. 8 (hield................................................................................................................................................................... 3.6% 267 n.a. 8 /1K of disposal proceeds.................................................................................................................................... 3.6% 68% n.a. /1K of ach Alternative.................................................................................................................................................... 2236% 24673 /1K Qsing 8.2%D ?iscount >ate...................................................................................................................................... 7788 4 >&ES &> E<=++& A: F"tems so marked can be eliminated from the analysis because they are the same for either alternative and because not ac$uiring the new carts has been e!cluded by the case as an alternative. . 233 F 3 carts F . ta! rate 2. %333 F + * .. 23 F 3 carts F + * .. 833 F 3 carts F + * .8. "ear 2 8 Depreciation &a3 Shield .#$6/ 2%333 4823 23%33 7372 2%3 2 463 %2 463 %2 %3333 ; %4633 * 4633 residual value Case 27-3: Phuket each !otel: "aluin# $utually %&clusi'e Capital Pro(ects* 4 #ccounting: $ext an% Cae &'e ( )ntructor* Manual #nthony+Ha,kin+Merchant ote0 $hi cae i unchange% from the Ele!enth E%ition0 S!nopsis 1huket #each Rotel has an opportunity to lease its under*utilised space to a karaoke pub and earn a rental income. Alternatively the hotel could develop the unused space and create its own pub. The general manager of the hotel must decide which of the two capital pro,ects to recommend to the hotel owners. The case presents sufficient information to build cashflow forecasts for each pro,ect and to rank the mutually e!clusive pro,ects using various evaluation criteria. &eaching >b(ectives This case may be used to e!pose students to a range of capital*budgeting issues0 • The principle of incremental analysis for identifying relevant cashflows for a pro,ect. • The treatment of sunk costs corporate overhead allocations opportunity costs e!ternalities and social costs in the identification of relevant cashflows. • The use of ?C< versus non*?C< techni$ues in evaluating capital budgeting pro,ects. • 1ossible conflict in pro,ect rankings on the basis of /1K and ">>. • The use of the e$uivalent*annuity criterion to solve the problem in ranking pro,ects of une$ual life. • "dentification of Hkey value driversJ for performing sensitivity analysis. S*ggested ;*estions . 1lease assess the economic benefits associated with each of the capital pro,ects. Ghat is the initial outlayI Ghat are the incremental cashflows over the life of the pro,ectI Ghat is an appropriate discount rate to use for discounting the cashflows of the pro,ectsI 2. >ank the pro,ects using various measures of investment attractiveness. ?o all the measures rank the pro,ects identicallyI Ghy or why notI Ghich criterion is the bestI . Are the pro,ects comparable based on the standard /1K measure given that they have une$ual livesI Ghat ad,ustment or alternative method is re$uired in comparing such pro,ectsI . Row sensitive is your ranking to changes in the discount rateI Ghat other Hkey value driversJ would affect the attractiveness of the pro,ectsI 1lease estimate the sensitivity of your result to a change in any of the key value drivers. 8. Ghich pro,ect should the hotel undertakeI Anal!sis )%entify the rele!ant cahflo, an% incremental cahflo, "n evaluating the pro,ects in this case we should focus on those cashflows that occur if and only if we accept the pro,ects. These cashflows called incremental cashflows represent the changes in the firmEs total cashflow that FMary Ho prepare% thi $eaching 1ote un%er the uper!iion of Prof0 Su Han Chan an% Prof0 2o 3ang a a gui%eline to teaching: 4Phuket Beach Hotel: Valuing Mutually Exclui!e Capital Pro"ect50 6 '--& by $he #ia Cae Reearch Centre7 $he 8ni!erity of Hong 2ong0 3 B'--. McGra,/Hill+)r,in Chapter '. occurs as a direct result of accepting the pro,ects. They include changes in e!isting revenues e!penses and ta!es caused by a pro,ectEs acceptance. The financial controller in this case stresses the importance of identifying future profits instead of cashflows. (tudents should note that accounting profits are not the relevant measure of benefits. )gnore unk cot A sunk cost is an outlay that has already been committed or that has already occurred hence is not affected by the decision under consideration. "n this case the overhead e!penses and salary e!penses of the e!cess labour can be considered as sunk costs. /ote that repairs and maintenance e!penses will increase if the karaoke pro,ects are accepted. "n this situation it is appropriate to include such incremental e!penses in the cashflow estimates for both pro,ects. Coni%er externalitie !ternalities represent the effects of a pro,ect on other parts of the firm. "n this case the possible reduction in room sales should be considered in the analysis for both pro,ects. The social effects of the pro,ects are difficult to $uantify) yet they should be taken into account if the detrimental effect on the hotel will affect the pro,ectsE future cashflows. Coni%er opportunity cot &pportunity costs are cashflows that could be generated from an asset the firm already owns provided it is not used for the pro,ect in $uestion. #ecause the two pro,ects in this case are mutually e!clusive the opportunity costs of one pro,ect are the cashflows that are forgone due to the re,ection of the other pro,ect. Pro(ect Eval*ation &echni?*es "n this case since it is technically impossible for the hotel to undertake both pro,ects on the same site the acceptance of one pro,ect implies the re,ection of the other. Thus the two pro,ects are mutually e!clusive and a ranking of the two pro,ects in terms of their economic attractiveness becomes necessary. The present capital budgeting system in 1huket #each Rotel ranks pro,ects according to payback period and average return on investment. Although these methods are simple to use they have a number of weaknesses that dis$ualify them as effective methods for ranking pro,ects. "n fact there are other pro,ect evaluation techni$ues that are more effective. The following table summarises the advantages and disadvantages of each of the pro,ect evaluation techni$ues. ) +on-,iscounte, Cashflo .echni/ues 0a Payback perio, +see noteAdvantages Disadvantages − "s simple and easy to understand − "gnores the time value of money − Can be used as a rough screening tool − "gnores cashflows beyond the payback period − (erves as a useful indicator of a pro,ectEs riskiness and li$uidity − (election of the ma!imum acceptable payback period is arbitrary 0b 'era#e return on in'estment +;Average annual cashflow after ta!es /et investmentAdvantages − "s simple and easy to understand − Can be used as a rough screening tool Disadvantages − "gnores time value of money #ccounting: $ext an% Cae &'e ( )ntructor* Manual #nthony+Ha,kin+Merchant /ote0 The discounted payback method is similar to the regular payback method e!cept that it discounts cashflows at the pro,ectsE cost of capital. "t considers the time value of money but it ignores cashflows occurring after the payback period. )) iscounte, Cashflo .echni/ues 0c )nternal rate of return 0)RR Advantages Disadvantages − Takes into account the time value of money − 1ossible e!istence of multiple ">>s − "s in general consistent with the firm goal of shareholder wealth ma!imisation − >e$uires more complicated calculations − >e$uires detailed long*term forecast of incremental costs and benefits − "mplicitly assumes that the intermediate cashflows from the pro,ect are reinvested at the ">> rather than at the opportunity cost of capital 0, Profitability )n,e& 0P) Advantages Disadvantages − "s consistent with the firm goal of shareholder wealth ma!imisation − Takes into account the time value of money and the scale of investment − >e$uires detailed long*term forecast of incremental costs and benefits 0e +et Present "alue 0+P" Advantages Disadvantages − "s consistent with the firm goal of shareholder wealth ma!imisation − Takes into account the time value of money − >e$uires detailed long*term forecast of incremental costs and benefits The information re$uired for estimating the weighted average cost of capital +GACC- for 1huket #each Rotel is provided in the case on page . @c 1@d .1 B t/ 2@e Ghere Sc ; corporate cost of capital w ; proportion of total financing that is debt w2 ; proportion of total financing that is common e$uity t ; ta! rate Sc ; 3.28 M 3. M + B3D- @ 3.78 M 3.2 ; 3.78D 2 B'--. McGra,/Hill+)r,in Chapter '. S*mmar! of es*lts <or detailed computations and assumptions please refer to E3hibits &-1 and 2. Lease >ption Planet @arao0e P*b *ild >ption each @arao0e P*b Pa!bac0 2.6 years .% years Disco*nted pa!bac0 .3 years .48 years Average ret*rn on investment 4D 3D + 2D 7D P+ .2 .22 P9 6837 baht 73 baht E?*ivalent ann*it! .EA/ 82436 baht %788 baht The above summary shows that ranking conflicts have arisen. The first four measures favour the lease option while the 1" and /1K measures favour the build option. The last measure e$uivalent annuity which solves the une$ual life problem also favours the build option. +1lease refer to the earlier e!hibit on the pros and cons of using each measure.The graph below illustrates the classic Hcross*overJ problem in which conflict in pro,ect rankings arises on the basis of the /1K and ">> criteria. The standard approach to this problem is to rely on the ranking by /1K because the implicit reinvestment*rate assumption in the /1K method is more reasonable than that in the ">> method. +P" Profiles of the 4ease an, uil, 5ption The graph shows that the /1K profiles of the two pro,ects cross over when the discount rate used is 6D. The ranking conflict between /1K and ">> disappears at discount rates above 6D. /ote that the build optionEs net present value profile has the steeper slope indicating that a given change in discount rate has a larger effect on its net present value. The build option has a greater sensitivity because it offers rising cashflows in the later years. "ts cashflows in the later years have a relatively smaller present value at higher discount rates. Sensitivit! Anal!sis (mall changes in key variables might affect the economic attractiveness of the proposed pro,ects. (tudents should therefore test the sensitivity of the ranking to changes in key value drivers. (ome of the key value drivers in this case are listed below0* − 1atronage factor − Amount of upfront investment − Cost of capital %/ui'alent nnuity 0in baht Sensiti'ity nalysis: patrona#e factor Patronage factor see !hibits T/* U 2V Lease >ption EA .baht/ *ild >ption EA .baht/ Decision 5 26483 26 #uild 582% 68%2% 734443 #uild 1 The e$uivalent annuity approach compares pro,ects with une$ual lives. (ee note 2 in !hibit T/* for detailed computations. #ccounting: $ext an% Cae &'e ( )ntructor* Manual #nthony+Ha,kin+Merchant 58% .base/ 9'7-; <.79=9 Buil% 587% +88266- +843- >e,ect both 1 +8%%- +877- >e,ect both Sensiti'ity nalysis: upfront in'estment 6 increase in *pfront investment Lease >ption EA .baht/ *ild >ption EA .baht/ Decision 56 .base/ 9'7-; <.79=9 Buil% %6 83 876%3 #uild 156 44 27%6 9ease 256 83%2 +42- 9ease #56 +%3- +46- >e,ect both Sensiti'ity nalysis: cost of capital Cost of capital Lease >ption EA .baht/ *ild >ption EA .baht/ Decision 6 66676 22887 #uild 1587%6 .base/ 9'7-; <.79=9 Buil% 126 686 72 #uild 1$6 6237 8322 #uild 16 2872 %27 9ease 16 8387 +%%%4- 9ease 256 27 +64- 9ease 226 +672- +6%8- >e,ect both %/ui'alent nnuity 0in baht Sensiti'ity nalysis: cost of capital 6 patrona#e factor .he uil, 5ption Cost of capital Patronage actor 6 1587%6 126 1$6 16 16 5 7386 26 %8 2%64 28788 22%8 582% 7686 734443 64342 668736 6743 63472 58% 22887 %788 72 8322 %27 +%%%4- 587% +83- +843- +8832%- +87866- +636- +62783- 1 +2822- +877- +72%4- +46%- +223446- +26- B'--. McGra,/Hill+)r,in Chapter '. .he 4ease 5ption Cost of capital Patronage actor 6 1587%6 126 1$6 16 16 5 274224 26483 2864 288 23 22286 582% 672482 68%2% 6872 63%64 624%62 6%736 58% 66676 82436 686 6237 2872 8387 587% +8463- +88266- +88%68- +86%88- +87%7- +8%%842- 1 +8%77- +8%%- +6%%- +77- +%28%7- +422- ifference in %/ui'alent nnuity 0in baht uil, - 4ease8 Cost of capital Patronage actor 6 1587%6 126 1$6 16 16 5 437 6%%6 8742 3%63 28 8474 582% 784 8862 6% 2%7 %3% +%4%- 58% 88%% 64 2746 %%8 +7%- +246- 587% %6% 778 %22 +723%- +2242- +%434- 1 2388 74 +%8- +22- +%34- +8%7- E<=++& &-1 &=E LEASE >P&+>: PLAE& @AA>@E P) AAL"S+S > >PEA&+ CAS=L>' 1ro,ect life years >enovation cost 773333 baht Ta! rate 3D Cost of capital 3.78D "ncrease in repairs U maintenance 3333 baht 1atronage factor 3.8 1atronage factor ?ecrease in net room revenue 3 3D 3.28 6.28D 3.8 2.83D 3.78 %.78D 28D 8 #ccounting: $ext an% Cae &'e ( )ntructor* Manual #nthony+Ha,kin+Merchant +<igures in baht e!cept where otherwise stated"ear 5 1 2 # $ /et room revenueF 233333 6333 7333 %333 >eduction in net room revenue 683333 6%333 76728 %88833 1 2 # $ >ental income 233333 233333 22333 22333 9ess0 ?epreciation e!pense +42833- +42833- +42833- +42833- "ncrease in repairs U maintenance +3333- +3333- +3333- +3333- >eduction in net room revenue +683333- +6%333- +76728- +%88833- Additional operating income %7833 8833 7278 %333 9ess0 ta!es +86283- +683- +87- +28233- /&1AT 283 3%83 2366 8%%33 Add0 ?epreciation 42833 42833 42833 42833 "ear 5 9ess0 Capital e!penditure +773333- &perating cashflow +773333- 2783 33683 6 2833 ?iscounted operating cashflow +773333- 24228 287 2386 6734 1ote: &0 #!erage return on in!etment i calculate% a the a!erage of the cahflo, o!er the life of the pro"ect %i!i%e% by the upfront in!etment0 '0 $he e>ui!alent annuity i that le!el annual payment o!er the life of the in!etment that yiel% a preent !alue "ut e>ual to the net preent !alue of the entire cahflo, tream0 $he annuity i %etermine% by ol!ing for 4#5: # ? ;+ @ k-n N Vk n ; number of periods k ; discount rate 1PV+PV)@# n0k where 1K"<A F 1et room re!enue ? Room re!enue / Room operating expene Pa!bac0 2.6 Lears Disco*nted pa!bac0 .3 Lears Average ret*rn on investment 4D + 2D Profitabilit! +nde3 .2 P9 6837 #aht EA 82436 #aht 6 B'--. McGra,/Hill+)r,in Chapter '. E<=++& &-2 &=E )+LD >P&+>: EAC= @AA>@E P) AAL"S+S > >PEA&+ CAS=L>' 1ro,ect life 6 years Qpfront investment * renovation %33333 baht * e$uipment 433333 baht Ta! rate 3D cost of capital 3.78D (ales growth rate 8D <ood and beverage cost 28D of sales (alary 6D of sales &ther operating e!pense 22D of sales "ncrease in repairs and maintenance 3333 baht Annual capital e!penditure e$uals depreciation 1atronage factor 3.8 1atronage factor ?ecrease in net room revenue 3 3D 3.28 6.28D 3.8 2.83D 3.78 %.78D 28D 7 +<igures in baht e!cept where otherwise stated- "ear 5 1 2 # $ % /et room revenue 233333 6333 7333 %333 83333 8333 >eduction in net room revenue 683333 6%333 76728 %88833 %42833 4378 "ear 5 1 2 # $ % (ales 672333 438633 883%%3 83%2 867%%8 84627%7 9ess0 <ood and beverage cost +6%333- +22633- +2%7723- +8236- +47- +43647- &ther operating e!penses +327%3- +37422- +4- +%4%8- +246- +%- "ncrease in repairs and maintenance +3333- +3333- +3333- +3333- +3333- +3333- ?epreciation +2%- +2%- +2%- +2%- +2%- +2%- >eduction in net room revenue +683333- +6%333- +76728- +%88833- +%42833- +4378- Additional operating income 82%27 6268 66483% 776 %2488 46864 9ess0 ta!es +84%%- +%7343- +233%82- +282%4- +27%6- +2%347- /&1AT 72474 68 6%686 8322 87676% 68884% Add0 ?epreciation 9ess0 Capital e!penditure 2% 2% 2% 2% 2% 2% 6862 74%7% 784%4 7%8678 %6332 4%42 +2%- +2%- +2%- +2%- +2%- +2%- Qpfront investment +733333- * * * * * * &perating cashflow +733333- 72474 68 6%686 8322 87676% 68884% ?iscounted operating cashflow +733333- 6778 884 833 436 668 882% Pa!bac0 .% Lears Disco*nted pa!bac0 .48 Lears Average ret*rn on investment 3D + 7D Profitabilit! +nde3 .22 P9 73 #aht EA %788 #aht
