Chapter Fourteen
Capital Investment Decisions
COPYRIGHT © 2012 Nelson Education Ltd.
Learning Objectives
1.
2.
3.
4.
5.
6.
7.
Explain the meaning of capital investment decisions, and distinguish
between independent and mutually exclusive capital investment
decisions
Compute the payback period and accounting rate of return for a
proposed investment, and explain their roles in capital investment
decisions
Use net present value analysis for capital investment decisions
involving independent projects
Use the internal rate of return to assess the acceptability of
independent projects
Incorporate the tax shield into capital expenditure analysis
Explain the role and value of postaudits
Explain why net present value is better than internal rate of return for
capital investment decisions involving mutually exclusive projects
14-2
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OBJECTIVE 1
Explain the meaning of capital
investment decisions, and
distinguish between independent
and mutually exclusive capital
investment decisions
Capital Investment Decisions
• Long range decisions involving opportunities
to invest in new assets or projects
• Among the most important decisions made by
managers
• Place large amounts of resources at risk for
long periods of time
• Affect firm’s future development
• Decision making process is called “capital
budgeting”
14-4
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Capital Budgeting
• Managers must decide whether or not a
capital investment will:
– Earn back its original outlay and provide a
reasonable return
• To make a capital investment decision,
managers must:
– Make estimates of the quantity and timing of aftertax cash flows
– Assess the risk of the investment
– Consider the impact of the project on the firm’s
profits
14-5
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Capital Budgeting
• Two types:
– Independent projects (“Mutually exclusive
projects”)
• If accepted or rejected, do not affect the cash
flows of other projects
– Competing projects
• Acceptance of one alternative precludes the
acceptance of another
14-6
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Making Capital Investment
Decisions
• Managers must:
– Set goals
– Set priorities for capital investments
– Establish basic criteria for acceptance or rejection of
proposed investments
• Two types of methods:
– Nondiscounting models
• Do not consider time value of money
• Two methods: Payback period & Accounting rate of return
– Discounting models
• Use time value of money
• Two methods: Net Present Value and Internal Rate of Return
14-7
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OBJECTIVE 2
Compute the payback period
and accounting rate of return
for a proposed investment, and
explain their roles in capital
investment decisions
Payback Period
• Time required for a firm to recover its
original investment
• If investment generates even cash flows
– Formula:
Payback
period
=
Original investment / Annual cash flow
• If investment generates uneven cash flows
– Formula:
• Add cash flows until original investment is recovered
14-9
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Analyzing Payback Periods
• Set a maximum payback period
• Rough measure of risk
• Firms with riskier cash flows could require
shorter payback periods than normal
• Firms with liquidity problems need quicker
paybacks
• Shortest payback period is preferred
14-10
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Uses of Payback Method
• Information can be used to help:
– Control risks associated with uncertainty of future
cash flows
– Minimize impact of an investment on a firm’s
liquidity problems
– Control risk of obsolescence
– Control effect of investment on performance
measures
14-11
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Example: Cornerstone 14-1
HOW TO Calculate Payback
Information:
• A new car wash facility requires an investment of
$100,000 and either has:
– Even cash flows of $50,000 per year or
– The following expected annual cash flows:
$30,000
$60,000
$40,000
$70,000
$50,000
Required:
Calculate the payback period for each case
14-12
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Example
Even cash flows of $50,000 per year
Payback
period = Original investment / Annual cash flow
= $100,000 / $50,000
= 2 years
14-13
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Example
Uneven cash flows
Year
1
2
Unrecovered Investment
($) Beginning of year
Time Needed
Annual Cash for Payback
(years)
Flow ($)
100,000
70,000
The payback period will
include the entire first year
30,000
40,000
1.0
1.0
The payback period will
include the entire second year
14-14
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Example
Uneven cash flows
Year
1
2
3
Unrecovered Investment
($) Beginning of year
100,000
70,000
30,000
There is $30,000 still to
recover as the third year
begins
Time Needed
Annual Cash for Payback
(years)
Flow ($)
30,000
40,000
50,000
1.0
1.0
0.6
$30,000 + $50,000
Initial investment would be completely
recovered 60% of the way through
year 3
14-15
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Example
Uneven cash flows
Year
1
2
3
4
5
Unrecovered Investment
($) Beginning of year
100,000
70,000
30,000
0
0
Time Needed
Annual Cash for Payback
(years)
Flow ($)
30,000
40,000
50,000
60,000
70,000
1.0
1.0
0.6
0.0
0.0
2.6
years
14-16
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Accounting Rate of Return
•
Measures return on a project in terms of income
as opposed to using cash flow
Formula:
Accounting
Rate of =
Return
•
Average income / Initial investment
Average income is not the same as cash flows
Formula:
• Add net income for each year of the project and divide
by the number of years
14-17
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Example: Cornerstone 14-2
HOW TO Calculate the Accounting Rate of Return
Information:
• An investment requires an initial outlay of $100,000
• Life of the investment is five years
• Net Income stream:
$30,000
$30,000
$30,000
$50,000
$40,000
Required:
Calculate the accounting rate of return
14-18
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Example
Accounting
Rate of = Average Net Income / Initial Investment
Return
= $36,000 / $100,000
= 0.36 or 36%
Averaging the net incomes:
$30,000 + $30,000 + $40,000 + $30,000 + $50,000 = $180,000
$180,000 ÷ 5 = $36,000
14-19
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OBJECTIVE 3
Use net present value analysis
for capital investment decisions
involving independent projects
Net Present Value (NPV)
• Difference between present value of cash
inflows and outflows associated with a project
• Measures net cash flows of project
• Size of the positive NPV measures increase in
value of firm resulting from an investment
• A required rate of return must be defined
– Minimum acceptable rate of return
14-21
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Evaluating Net Present
Value (NPV)
• If NPV is positive:
– Rate of return on investment is greater than
the required rate of return
– Investment, the minimum rate of return, and
a return in excess of profit are all recovered
– Investment is acceptable
14-22
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Evaluating Net Present
Value (NPV)
• If NPV is zero:
– Rate of return on the investment is exactly
the required rate of return
– Investment and minimum rate of return are
recovered
– Decision maker will be ambivalent regarding
acceptance or rejection
14-23
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Evaluating Net Present
Value (NPV)
• If NPV is negative:
– Rate of return is less than required rate of
return
– Investment cost may or may not be
recovered, and minimum rate of return is
not recovered
– Initial investment should be rejected
14-24
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Example: Cornerstone 14-3
HOW TO Assess Cash Flows and Calculate Net Present Value
Information:
•
•
•
•
•
•
•
Expected annual earphone revenues, $300,000
Equipment to produce earphones will cost $320,000
After five years, the equipment can be sold for $40,000
Working capital is expected to increase by $40,000 because of increases
in inventories and receivables
Recovery of investment in working capital is expected at the end of the
project’s life
Annual cash operating expenses are estimated at $180,000
Required rate of return is 12%
Required:
Estimate the annual cash flows, and calculate the NPV
COPYRIGHT © 2012 Nelson Education Ltd.
14-25
Example
Step 1 Cash Flow Identification
Year
0
Item
Equipment
Working Capital
Total
Cash Flow
$(320,000)
(40,000)
$(360,000)
$360,000 is spent to get the equipment ready
The inflows over the next 5 years need to recoup this
cost and earn a profit for the firm
14-26
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Example
Step 1 Cash Flow Identification
Year
0
1-4
Item
Equipment
Working Capital
Total
Cash Flow
$(320,000)
(40,000)
$(360,000)
Revenues
Operating expenses
Total
$ 300,000
(180,000)
$ 120,000
In the first 4 years, the asset will provide
net inflows of $120,000 per year
14-27
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Example
Step 1 Cash Flow Identification
Year
0
1-4
5
Sale of
equipment
in year 5
Item
Equipment
Working Capital
Total
Cash Flow
$(320,000)
(40,000)
$(360,000)
Revenues
Operating expenses
Total
$ 300,000
(180,000)
$ 120,000
Revenues
Operating expenses
Salvage
Recovery of working capital
Total
$ 300,000
(180,000)
40,000
40,000
$ 200,000
COPYRIGHT © 2012 Nelson Education Ltd.
14-28
Example
Step 2A: Net Present Value Analysis
Year
0
Cash Flow
$(360,000)
Discount
Factor
Present
Value
1.00000
$(360,000)
Since the equipment is paid for now,
the amount paid is its present value
14-29
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Example
Step 2A: Net Present Value Analysis
Year
0
Cash Flow
$(360,000)
1
120,000
Discount
Factor
Present
Value
1.00000
$(360,000)
0.89286
107,143
1 ÷ (1 + 12%)1 or Exhibit 14B-1
14-30
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Example
Step 2A: Net Present Value Analysis
Discount
Factor
Present
Value
1.00000
$(360,000)
Year
0
Cash Flow
$(360,000)
1
120,000
0.89286
107,143
2
120,000
0.79719
95,663
1 ÷ (1 + 12%)2 or Exhibit 14B-1
14-31
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Example
Step 2A: Net Present Value Analysis
Discount
Factor
Present
Value
1.00000
$(360,000)
Year
0
Cash Flow
$(360,000)
1
120,000
0.89286
107,143
2
120,000
0.79719
95,663
3
120,000
0.71178
85,414
4
120,000
0.63552
76,262
5
200,000
0.56743
113,486
Net Present Value
$117,968
14-32
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Example
Step 2B: Net Present Value Analysis
Year
0
Cash Flow
$(360,000)
1-4
120,000
Discount
Factor
Present
Value
1.00000
$(360,000)
3.03735
364,482
Since years 1 through 4 have the same cash flow, we
can use the Exhibit 14B-2 or the PV annuity formula:
1/12%[1 – 1 ÷ (1 + 12%)4]
14-33
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Example
Step 2B: Net Present Value Analysis
Year
0
Cash Flow
$(360,000)
1-4
5
120,000
200,000
Discount
Factor
Present
Value
1.00000
$(360,000)
3.03735
0.56743
364,482
113,486
$117,968
Net Present Value
Using an annuity table generates the same NPV as
discounting the cash flows for each year separately
(difference due to rounding)
14-34
COPYRIGHT © 2012 Nelson Education Ltd.
OBJECTIVE 4
Use the internal rate of return
to assess the acceptability of
independent projects
Internal Rate of Return
(IRR)
• Interest rate that sets the project’s NPV to zero
– Formula:
I = ∑CFt / (1 + i)t
• Can use trial and error or PV tables
• If IRR > Required rate of return
– Project is deemed acceptable
• If IRR < Required rate of return
– Project is rejected
14-36
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Example: Cornerstone 14-4
HOW TO Calculate Internal Rate of Return with Uniform Cash
Flows
Information:
• Hospital has opportunity to invest $205,570.50 in a
new ultrasound system
• It will produce net cash inflows of $50,000 at the end
of each year for the next six years
Required:
Calculate the IRR for the ultrasound system
14-37
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Example
Internal Rate of Return
Discount factor = Investment / Annual Cash Flow
=
$202,570.50 / $50,000
=
4.11141
Using the PV of an Annuity table
Looking along the 6 period line, 4.11141 is found
in the 12% column.
IRR is 12%
COPYRIGHT © 2012 Nelson Education Ltd.
14-38
OBJECTIVE 5
Incorporate the tax shield
into capital expenditure
analysis
Capital Expenditures and
Income Tax
• Tax treatment of cash inflows and outflows
can have a drastic impact on capital
expenditure analysis
• Many companies incorporate a “tax shield”
using the following formula:
PV =
Cdt
1+0.5k
×
d+k
1+k
Where: C is cost of the asset
d is CA rate
t is rate
k is minimum acceptable rate of return.
COPYRIGHT © 2012 Nelson Education Ltd.
14-40
OBJECTIVE 6
Explain the role and
value of postaudits
Postaudit of Capital
Projects
• Follow-up analysis of project once it is
implemented
• Should be completed by independent party
• Compares:
– Actual benefits to estimated benefits
– Actual operating costs to estimated costs
• Evaluates overall investment outcome
• Proposed corrective action if needed
14-42
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Benefits of a Postaudit
• Ensures assets are used wisely
• Managers held accountable:
– More likely to make decisions in firm’s best interest
– Feedback is used in future decision making
14-43
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Drawbacks of a Postaudit
• Costly
• Limitations:
– Assumption driving original analysis may often be
invalidated by changes in the actual operating
environment
• Accountability must be qualified:
– By the impossibility of foreseeing every possible
eventuality
14-44
COPYRIGHT © 2012 Nelson Education Ltd.
OBJECTIVE 7
Explain why net present
value is better than internal
rate of return for capital
investment decisions
involving mutually
exclusive projects
Mutually Exclusive Projects
• NPV and IRR can produce different results
• NPV
– Assumes that each cash flow received is
reinvested at the required rate of return
– Measures cash flow profitability in absolute terms
• IRR
– Assumes that each cash flow is reinvested at the
computed IRR
– Measure cash flow profitability in relative terms
• NPV consistently selects the project which
maximizes the firm’s wealth
14-46
COPYRIGHT © 2012 Nelson Education Ltd.
Steps in Selecting Best
Project
1. Assess the flow pattern for each project
2. Compute the net present value (NPV) for each
project
3. Identify the project with the greatest NPV
14-47
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Example: Cornerstone 14-5
HOW TO Calculate Net Present Value and
Internal Rate of Return for Mutually Exclusive Projects
Information:
• Two pollution prevention designs:
– Design A
• Initial outlay of $180,000
• Project life of 5 years
• Net annual after-tax cash inflow of $60,000
– Design B
• Initial outlay of $210,000
• Project life of 5 years
• Net annual after-tax cash inflow of $70,000
COPYRIGHT © 2012 Nelson Education Ltd.
Example
Information continued: Cost of capital = 12%
Cash Flow Pattern
Year
Design A
Design B
0
$(180,000)
$(210,000)
1
60,000
70,000
2
60,000
70,000
3
60,000
70,000
4
60,000
70,000
5
60,000
70,000
Required:
Calculate NPV and IRR for each product
14-49
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Example
Design A: NPV Analysis
Year
0
1-5
Discount
Cash Flow Factor
$(180,000)
60,000
Present
Value
1.00000
$(180,000)
3.60478
216,287
Net present value
$ 36,287
14-50
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Example
Design A: Internal Rate of Return
Discount factor = Investment / Annual Cash Flow
=
$180,000/ $60,000
=
3.000
Using the PV of an Annuity table
Looking along the 5 period line, 3.000 is found
in the 20% column.
IRR is 20%
COPYRIGHT © 2012 Nelson Education Ltd.
14-51
Example
Design B: NPV Analysis
Year
0
1-5
Discount
Cash Flow Factor
$(210,000)
70,000
1.000
3.60478
Net present value
Present
Value
$(210,000)
252,335
$ 42,335
14-52
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Example
Design B: Internal Rate of Return
Discount factor = Investment / Annual Cash Flow
=
$210,000/ $70,000
=
3.000
Using the PV of an Annuity table
Looking along the 5 period line, 3.000 is found
in the 20% column.
IRR is 20%
COPYRIGHT © 2012 Nelson Education Ltd.
14-53