COST MANAGEMENT
Accounting & Control
Hansen▪Mowen▪Guan
Chapter 20
Capital Investment
COPYRIGHT © 2009 South-Western Publishing, a division of Cengage Learning.
Cengage Learning and South-Western are trademarks used herein under license.
1
Study Objectives
1. Describe the difference between independent and mutually
exclusive capital investment decisions.
2. Explain the roles of the payback period and accounting rate of
return in capital investment decisions.
3. Calculate the net present value (NPV) for independent projects.
4. Compute the internal rate of return (IRR) for independent projects.
5. Tell why NPV is better than IRR for choosing among mutually
exclusive projects.
6. Convert gross cash flows to after-tax cash flows.
7. Describe capital investment for advanced technology and
environmental impact settings.
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Capital Investment Decisions
• Capital investment decisions are
concerned with
– The planning process of planning
– Setting goals and priorities
– Arranging financing
– Using certain criteria to select long-term
assets
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Capital Investment Decisions
• Capital budgeting
– The process of making capital investment
decisions
• Types of capital budgeting projects
– Independent projects
• Projects that, if accepted or rejected, will not affect
the cash flows of another project.
– Mutually exclusive projects
• Projects that, if accepted, preclude the acceptance
of competing projects.
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Payback and Accounting Rate of
Return: Nondiscounting Methods
Payback Analysis
* At the beginning of Year 3, $60,000 is needed to recover the
investment.
Since a net cash inflow of $100,000 is expected, only 0.6
year ($60,000 ÷ $100,000) is needed to recover the
$60,000.
Thus, the payback period is 2.6 years (2 + 0.6).
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Payback and Accounting Rate of
Return: Nondiscounting Methods
Payback Analysis
• Provides information than can:
– Help control the risks associated with the uncertainty of future
cash flows.
– Help minimize the impact of an investment on a firm’s liquidity
problems.
– Help control the risk of obsolescence.
– Help control the effect of the investment on performance
measures.
• Deficiencies:
– Ignores the time value of money
– Ignores the performance of the investment beyond the payback
period
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Payback and Accounting Rate of
Return: Nondiscounting Methods
Accounting Rate Of Return (ARR)
ARR =
Average income
Original investment or
Average investment
Major deficiency: ignores
the time value of money
Average annual net cash
flows, less average
depreciation
Average investment
(I + S) ÷ 2
I = original investment
S = salvage value
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The Net Present Value Method
Net present value is the difference between the
present value of the cash inflows and outflows
associated with a project.
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)
The NPV model assumes that all cash flows
generated by a project are immediately reinvested.
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The Net Present Value Method
Polson Company has developed a new cell
phone that is expected to generate an annual
revenue of $750,000.
Necessary production equipment would cost
$800,000 and can be sold in five years for
$100,000.
Working capital is expected to increase by
$100,000 and is expected to be recovered at the
end of five years.
Annual operating expenses are expected to be
$450,000.
The required rate of return is 12 percent.
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The Net Present Value Method
10
The Net Present Value Method
c
difference due to rounding
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The Net Present Value Method
Decision Criteria for NPV
If NPV > 0:
1. The initial investment has been recovered
2. The required rate of return has been
recovered
For the cell phone project, NPV = $294,600
Polson should manufacture the cell phones.
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Internal Rate of Return
The internal rate of return (IRR) is the interest
rate that sets the project’s NPV at zero.
Thus, P = I for the IRR.
Example: A project requires a $240,000
investment and will return $99,900 at
the end of each of the next three
years. What is the IRR?
$240,000 = $99,900(df)
$240,000 ÷ $99,900 = 2.402
i = 12%
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Internal Rate of Return
Decision Criteria:
If the IRR > Cost of Capital, accept the project
If the IRR = Cost of Capital, accept or reject
If the IRR < Cost of Capital, reject the project
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NPV versus IRR:
Mutually Exclusive Projects
• Two major differences between net
present value and the internal rate of
return:
– Reinvestment of cash inflows
• NPV assumes reinvestment at the required rate of
return
• IRR assumes reinvestment at the internal rate of
return
– Measurement of profitability
• NPV measures profitability in absolute dollars
• IRR measures profitability as a percentage
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NPV versus IRR:
Mutually Exclusive Projects
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NPV versus IRR:
Mutually Exclusive Projects
a$1,440,000
+ [(1.20 x $686,342) - (1.08 x $686,342)]. This last term is what is needed to repay the capital and its cost
at the end of Year 2.
b$686,342
+ (1.20 x $686,342).
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NPV versus IRR:
Mutually Exclusive Projects
Milagro Travel Agency Example
Standard
T2
Annual revenues
Annual operating costs
System investment
Project life
$240,000
120,000
360,000
5 years
Custom
Travel
$300,000
160,000
420,000
5 years
The cost of capital is 12 percent
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NPV versus IRR:
Mutually Exclusive Projects
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NPV versus IRR:
Mutually Exclusive Projects
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NPV versus IRR:
Mutually Exclusive Projects
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Computing After-Tax Cash Flows
• Steps in computing cash flows
– Forecast revenues, expenses, and capital
outlays
– Adjust cash flows for inflation and tax effects
• The cost of capital is composed of two
elements
– The real rate
– The inflationary element
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Computing After-Tax Cash Flows
Disposition of Old Machine
Book Value
Sale Price
M1
M2
$ 600,000
1,500,000
$ 780,000
1,200,000
Acquisition of Flexible System
Purchase cost
Freight
Installation
Additional working capital
Total
$7,500,000
60,000
600,000
540,000
$8,700,000
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Computing After-Tax Cash Flows
aSale
bSale
price minus book value is $780,000 - $600,000.
price minus book value is $1,200,000 - $1,500,000.
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Computing After-Tax Cash Flows
The two machines are sold:
Sales price, M1
Sales price, M2
Tax savings
Net proceeds
The net investment is:
Total cost of flexible system
Less: Net proceeds
Net investment (cash outflow)
$ 780,000
1,200,000
48,000
$2,028,000
$8,700,000
2,028,000
$6,672,000
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Computing After-Tax Cash Flows
After-Tax Operating Cash Flows: Life of the Project
A company plans to make a new product that requires new
equipment costing $1,600,000. The new product is
expected to increase the firm’s annual revenue by
$1,200,000. Materials, labor, etc. will be $500,000 per year.
The income statement for the project is as follows:
Revenues
Less: Cash operating expenses
Depreciation (straight-line)
Income before income taxes
Less: Income taxes (40%)
Net income
$1,200,000
(500,000)
(400,000)
$ 300,000
(120,000)
$ 180,000
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Computing After-Tax Cash Flows
After-Tax Operating Cash Flows: Life of the Project
Revenues × (1 - tax rate)
– Cash expenses × (1 - tax rate)
+ Noncash expenses × tax rate*
= Cash Flow
$720,000
(300,000)
160,000
$580,000
* Non-cash expenses shield revenues from taxation, thus
generating cash flows (i.e., cash savings)
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Computing After-Tax Cash Flows
MACRS Depreciation
The tax laws classify most assets into 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.
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Computing After-Tax Cash Flows
MACRS Depreciation
– 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.
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Computing After-Tax Cash Flows
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Capital Investment:
Advanced Technology and Environmental
Considerations
How Estimates of Operating Cash Flows Differ
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 × 5.65)
Investment
Net present value
$22,600,000
18,000,000
$ 4,600,000
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Capital Investment:
Advanced Technology and Environmental
Considerations
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Capital Investment:
Advanced Technology and Environmental
Considerations
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Present Value Concepts
Future Value
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 formula:
F = P(1 + i)n
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Present Value Concepts
Future Value
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?
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)
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Present Value Concepts
Present Value
P = F/(1 + i)n
The discount factor df, 1/(1 + i), is computed
for various combinations of i and n.
P = F(df)
Compute the present value of $300 to be received three years
from now. The interest rate is 12%.
From Exhibit 20B-1, the discount factor is 0.712
The present value (P) is:
P = F(df)
= $300 × 0.712
= $213.60
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Present Value Concepts
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COST MANAGEMENT
Accounting & Control
Hansen▪Mowen▪Guan
End Chapter 20
COPYRIGHT © 2009 South-Western Publishing, a division of Cengage Learning.
Cengage Learning and South-Western are trademarks used herein under license.
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