18 -1
CHAPTER
Capital
Investment
Decisions
18 -2
Objectives
1. Explain what a capital investment decision is,
After studying this
and distinguish between independent and
chapter, you should
mutually exclusive capital investment decisions.
be able to:
2. Compute the payback period and accounting rate
of return for a proposed investment, and explain
their roles in capital investment decisions.
3. Use net present value analysis for capital
investment decisions involving independent
projects.
18 -3
Objectives
4. Use the internal rate of return to assess the
acceptability of independent projects.
5. Discuss the role and value of postaudits.
6. Explain why NPV is better than IRR for capital
investment decisions involving mutually
exclusive projects.
7. Convert gross cash flows to after-tax cash
flows.
8. Describe capital investment in the advanced
manufacturing environment.
18 -4
Capital investment decisions are
concerned with the process of
planning, setting goals and
priorities, arranging financing,
and using certain criteria to
select long-term assets.
18 -5
Payback Method
Payback period =
Original investment
Annual cash flow
The cash flows is assume
to occur evenly.
18 -6
Payback Method
Year
1
2
3
4
5
Unrecovered Investment
(Beginning of year)
$100,000
70,000
30,000
------$30,000 was needed
in Year 3 to recover
the investment
Annual Cash Flow
$30,000
40,000
50,000
60,000
70,000
18 -7
Payback Method
Deficiency
 Ignores the time value of
money
 Ignores the performance of the
investment beyond the payback
period
18 -8
Payback Method
The payback period provides information to
managers that can be used as follows:
 To help control the risks associated with the
uncertainty of future cash flows.
 To help minimize the impact of an investment
on a firm’s liquidity problems.
 To help control the risk of obsolescence.
 To help control the effect of the investment on
performance measures.
18 -9
Accounting Rate Of Return (ARR)
ARR = Average income ÷ Original investment or
Average investment
Average annual net
cash flows, less
average
depreciation
Average investment
= (I + S)/2
I = the original investment
S = salvage value
Assume that the investment
is uniformly consumed
18 -10
Accounting Rate Of Return (ARR)
Example: Suppose that some new equipment requires
an initial outlay of $80,000 and promises
total cash flows of $120,000 over the next
five years (the life of the machine). What is
the ARR?
Answer: The average cash flow is $24,000
($120,000 ÷ 5) and the average
depreciation is $16,000 ($80,000 ÷ 5).
ARR = ($24,000 – $16,000) ÷ $80,000
= $8,000 ÷ $80,000
= 10%
18 -11
Accounting Rate Of Return (ARR)
Reasons for Using ARR
 A screening measure to ensure that new investment
will not adversely affect net income
 To ensure a favorable effect on net income so that
bonuses can be earned (increased)
18 -12
Accounting Rate Of Return (ARR)
The major deficiency of the accounting rate of
return is that it ignores the time value of money.
18 -13
The Net Present Value Method
NPV = P – I
where:
P = the present value of the project’s future cash
inflows
I = the present value of the project’s cost (usually
the initial outlay)
Net present value is the difference between the present
value of the cash inflows and outflows associated with a
project.
18 -14
The Net Present Value Method
Brannon Company has developed new
earphones for portable CD and tape
players that are expected to generate an
annual revenue of $300,000. Necessary
production equipment would cost
$320,000 and can be sold in five years
for $40,000.
18 -15
The Net Present Value Method
In addition, working capital is
expected to increase by $40,000 and is
expected to be recovered at the end of
five years. Annual operating expenses
are expected to be $180,000. The
required rate of return is 12 percent.
18 -16
STEP 1. CASH-FLOW IDENTIFICATION
YEAR
0
1-4
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
18 -17
STEP 2A.
YEAR
CASH FLOW
DISCOUNT FACTOR
0
$-360,000
Present
1
120,000
Value of $1
2
120,000
3
120,000
4
120,000
5
200,000
Net present value
STEP 2B.
YEAR
CASH FLOW
0
$-360,000
Present Value
1-4
120,000
of
an Annuity
Present
Value
5
200,000
of
of $1
$1
Net present value
NPV ANALYSIS
1.000
0.893
0.797
0.712
0.636
0.567
PRESENT VALUE
$-360,000
107,160
95,640
85,440
76,320
113,400
$117,960
NPV ANALYSIS
DISCOUNT FACTOR
1.000
3.307
0.567
PRESENT VALUE
$-360,000
364,400
113,400
$117,840
18 -18
The Net Present Value Method
Decision Criteria for NPV
If NPV = 0, this indicates:
1. The initial investment has been recovered
2. The required rate of return has been recovered
Thus, break even has been achieved and we are
indifferent about the project.
18 -19
The Net Present Value Method
Decision Criteria for NPV
If the NPV > 0 this indicates:
1. The initial investment has been recovered
2. The required rate of return has been recovered
3. A return in excess of 1. and 2. has been received
Thus, the earphones should be manufactured.
18 -20
The Net Present Value Method
Reinvestment Assumption
The NVP model assumes that all cash flows
generated by a project are immediately
reinvested to earn the required rate of return
throughout the life of the project.
18 -21
Internal Rate of Return
The internal rate of return (IRR) is the discount rate
that sets the project’s NPV at zero. Thus, P = I for the
IRR.
Example: A project requires a $10,000
investment and will return $12,000
after one year. What is the IRR?
$12,000/(1 + i) = $10,000
1 + i = 1.2
i = 0.20
18 -22
Internal Rate of Return
Decision Criteria:
If the IRR > Cost of Capital, the project
should be accepted.
If the IRR = Cost of Capital, acceptance or
rejection is equal.
If the IRR < Cost of Capital, the project
should be rejected.
NPV Compared With IRR
There are two major differences between net present
value and the internal rate of return:
 NPV assumes cash inflows are reinvested at the
required rate of return whereas the IRR method
assumes that the inflows are reinvested at the
internal rate of return.
 NPV measures the profitability of a project in
absolute dollars, whereas the IRR method
measures it as a percentage.
18 -23
NPV Compared With IRR
Bintley Corporation Example
Design A
Design B
Annual revenue
$179,460
Annual operating costs
119,460
Equipment (purchased before
Year 1)
180,000
Project life
5 years
$239,280
169,280
210,000
5 years
18 -24
NPV Compared With IRR
CASH-FLOW PATTERN
Year
Design A
Design B
0
$-180,000 $-210,000
1
60,000
70,000
2
60,000
70,000
3
60,000
70,000
4
60,000
70,000
5
60,000
70,000
DESIGN A: NPV ANALYSIS
Year
Cash Flow
0
$-180,000
1-5
60,000
Net present value
Discount Factor
1.000
3.605
Present Value
$-180,000
216,300
$ 36,300
18 -25
NPV Compared With IRR
IRR ANALYSIS
Discount factor =
=
Initial Investment
Annual cash flow
$180,000
60,000
= 3.000
From Exhibit 18B-2, df = 3,000
for five years; IRR = 20%
= 3,000
DESIGN B: NPV ANALYSIS
Year
Cash Flow
0
$-210,000
1-5
70,000
Net present value
Discount Factor
1.000
3.605
Present Value
$-210,000
252,350
$ 42,350
18 -26
NPV Compared With IRR
IRR ANALYSIS
Discount factor =
=
Initial Investment
Annual cash flow
$210,000
70,000
= 3.000
From Exhibit 18B-2, df = 3,000
for five years; IRR = 20%
= 3,000
18 -27
18 -28
Adjusting Forecast for Inflation
WITHOUT INFLATIONARY ADJUSTMENT
Cash Flow
Discount Factor
Present Value
Year
0
$-5,000,000
1-2
2,900,000
Net present value
1.000
1.528
$-5,000,000
4,431,200
$- 568,800
WITH INFLATIONARY ADJUSTMENT
Year
Cash Flow
Discount Factor
Present Value
0
$-5,000,000
1.000
$-5,000,000
1
3,335,000
0.833
2,778,055
2
3,835,250
0.694
2,661,664
Net present value
$ 439,719
After-Tax Operating Cash Flows
The Income Approach
After-tax cash flow = After-tax net income + Noncash expenses
Example:
Revenues
Less: Operating expenses*
Income before taxes
Less: Income taxes
Net income
*$100,000 is depreciation
After-tax cash flow = $264,000 + $100,000
= $364,000
$1,000,000
600,000
$ 400,000
136,000
$ 264,000
18 -29
After-Tax Operating Cash Flows
18 -30
Decomposition Approach
After-tax cash revenues
= (1 – Tax rate) x Cash revenues
After-tax cash expense
= (1 – Tax rate) x Cash expenses
Tax savings (noncash expenses) = (Tax rate) x Noncash
expenses
Total operating cash is equal to the after-tax cash
revenues, less the after-tax cash expenses, plus the tax
savings on noncash expenses.
After-Tax Operating Cash Flows
Decomposition Approach
Example: Revenues = $1,000,000, cash expenses = $500,000,
and depreciation = $100,000. Tax rate = 34%.
After-tax cash revenues (1 – .34)($1,000,000) =
$660,000
Less: After-tax cash expense (1 – .34)($500,000)= -330,000
Add: Tax savings (noncash exp.) .34($100,000) =
34,000
Total
$364,000
18 -31
Depreciation
Tax-Shielding Effect
Depreciation is a noncash expense and is not a
cash flow. Depreciation, however SHIELDS
revenues from being taxed and, thus, creates a
cash inflow equal to the tax savings.
Assume initially that tax laws DO NOT allow
depreciation to be deducted to arrive at taxable
income. If a company had before-tax
operating cash flows of $300,000 and
depreciation of $100,000, we have the
statement found on Slide 33.
18 -32
18 -33
Depreciation
Tax-Shielding Effect
Net operating cash flows
Less: Depreciation
Taxable income
Less: Income taxes (@ 34%)
Net income
$300,000
0
$300,000
102,000
$198,000
18 -34
Depreciation
Tax-Shielding Effect
Now assume that the tax laws allow a deduction for
depreciation:
Net operating cash flows
Less: Depreciation
Taxable income
Less: Income taxes (@ 34%)
Net income
$300,000
100,000
$200,000
-68,000
$132,000
Depreciation
Tax-Shielding Effect
Notice that the taxes saved are $34,000 ($102,000 –
$68,000). Thus, the firm has additional cash available
of $34,000.
This savings can be computed by multiplying the tax
rate by the amount of depreciation claimed:
.34 x $100,000 = $34,000
18 -35
18 -36
MACRS Depreciation Rates
The tax laws classify most assets into the following three classes
(class = Allowable years):
Class
3
5
7
Types of Assets
Most small tools
Cars, light trucks, computer equipment
Machinery, office equipment
Assets in any of the three classes can be depreciated using either
straight-line or MACRS (Modified Accelerated Cost Recovery
System) with a half-year convention.
18 -37
MACRS Depreciation Rates
 Half the depreciation for the first year can be
claimed regardless of when the asset is actually
placed in service.
 The other half year of depreciation is claimed in
the year following the end of the asset’s class
life.
 If the asset is disposed of before the end of its
class life, only half of the depreciation for that
year can be claimed.
18 -38
Example—S/L Depreciation
An automobile is purchased on March 1, 2003 at a
cost of $20,000. The firm elects the straight-line
method for tax purposes. Automobiles are five-year
assets (to refer to a chart, click on the car below; to
return to this slide, click on the hammer). The
annual depreciation is $4,000 ($20,000 ÷ 5).
However, due to the half-year convention, only
$2,000 can be deducted in 2003.
18 -39
Example—S/L Depreciation
Year
Depreciation Deduction
2003
2004
2005
2006
2007
2008
$2,000 (half-year amount)
4,000
4,000
4,000
4,000
2,000 (half-year amount)
Assume that the asset is disposed of in April 2005.
Only $2,000 of depreciation can be claimed, so the
book value would be $12,000 ($20,000 – $8,000).
18 -40
Example—MACRS Method
MACRS Depreciation Rates for
Five-Year Assets
Year
Percentage of Cost Allowed
1
2
3
4
5
6
20.00%
32.00
19.20
11.52
11.52
5.76
18 -41
Example—S/L Depreciation
Tax
Year Depreciation Rate
1
$2,000
0.40
2
4,000
0.40
3
4,000
0.40
4
4,000
0.40
5
4,000
0.40
6
2,000
0.40
Net present value
Tax
Discount Present
Savings
Factor
Value
$ 800.00
0.909 $ 727.20
1,600.00
0.826
1,321.60
1,600.00
0.751
1,201.60
1,600.00
0.683
1,092.80
1,600.00
0.621
993.60
1,600.00
0.564
451.20
$5,788.00
18 -42
Example—MACRS Method
Tax
Tax
Discount Present
Year Depreciation Rate Savings
Factor
Value
1
$4,000
0.40 $1,600.00
0.909 $1,454.40
2
6,400
0.40 2,560.00
0.826
2,114.56
3
3,840
0.40 1,536.00
0.751
1,153.54
4
2,304
0.40
921.60
0.683
629.45
5
2,304
0.40
921.60
0.621
572.31
6
1,152
0.40
460.80
0.564
259.89
Net present value
$6,184.15
How Estimates of Operating
Cash Flows Differ
18 -43
A company is evaluating a potential investment in a
flexible manufacturing system (FMS). The choice is to
continue producing with its traditional equipment,
expected to last 10 years, or to switch to the new system,
which is also expected to have a useful life of 10 years.
The company’s discount rate is 12 percent.
Present value ($4,000,000 x 5.65)
Investment
Net present value
$22,600,000
18,000,000
$ 4,600,000
How Estimates of Operating
Cash Flows Differ
Investment (current outlay):
Direct costs
Software, engineering
Total current outlay
Net after-tax cash flows
Less: After-tax cash flows
for status quo
Incremental benefit
FMS
STATUS QUO
$10,000,000
8,000,000
$18,000,000
$ 5,000,000
----$1,000,000
1,000,000
$ 4,000,000
n/a
n/a
18 -44
FMS
STATUS QUO
INCREMENTAL BENEFIT EXPLAINED
Direct benefits:
Direct labor
$1,500,000
Scrap reduction
500,000
Setups
200,000
$2,200,000
Intangible benefits (quality
savings):
Rework
$ 200,000
Warranties
400,000
Maintenance of competitive
position
1,000,000
1,600,000
Indirect benefits:
Production scheduling
$ 110,000
Payroll
90,000
200,000
Total
$4,000,000
18 -45
18 -46
Future Value: Time Value
of Money
Let:
F =
future value
i
the interest rate
=
P =
the present value or original outlay
n =
the number or periods
Future value can be expressed by the following formula:
F = P(1 + i)n
18 -47
Future Value: Time Value
of Money
Assume the investment
is $1,000. The interest
rate is 8%. What is the
future value if the
money is invested for
one year? Two?
Three?
18 -48
Future Value: Time Value
of Money
F = $1,000(1.08)
= $1,080.00 (after one year)
F = $1,000(1.08)2
= $1,166.40 (after two years)
F = $1,000(1.08)3
= $1,259.71 (after three years)
18 -49
Present Value
P = F/(1 + i)n
The discount factor, 1/(1 + i), is computed for various
combinations of I and n.
Example: Compute the present value of $300 to be
received three years from now. The interest rate is 12%.
Answer:
From Exhibit 18B-1, the discount factor is 0.712.
Thus, the present value (P) is:
P =
F(df)
= $300 x 0.712
= $213.60
18 -50
Present Value
Example: Calculate the present value of a $100 per year annuity,
to be received for the next three years. The interest rate is 12%.
Answer:
Year
Value
1
2
3
Cash
$100
100
100
Discount
Factor
0.893
0.797
0.712
2.402*
Present
$ 89.30
79.70
71.20
$240.20
* Notice that it is possible to multiply the sum of the individual discount
factors (.40) by $100 to obtain the same answer. See Exhibit 18 B-2 for these
sums which can be used as discount factors for uniform series.
18 -51
Chapter Eighteen
The End
18 -52