Chapter 16 - Capital expenditure decisions. After completing this chapter, you should be able to: Use the net-present-value method and the internal-rate-of-return method to evaluate an investment proposal; compare the net-present-value and internal-rate-of-return methods, and state the assumptions underlying each method; use both the total-cost approach and the incremental-cost approach to evaluate an investment proposal;...
Chapter 16 Capital Expenditure Decisions Copyright © 2014 McGraw-Hill Education All rights reserved No reproduction or distribution without the prior written consent of McGraw-Hill Education Net-Present-Value Method 1 Prepare Prepareaatable tableshowing showingcash cashflows flowsfor foreach eachyear, year, 2 Calculate Calculatethe thepresent presentvalue valueof of each eachcash cashflow flowusing usingaa discount discountrate, rate, 3 Compute Computenet netpresent presentvalue, value, 4 If If the thenet netpresent presentvalue value(NPV) (NPV) is iszero zeroor orpositive, positive,accept acceptthe the investment investmentproposal proposal Otherwise, Otherwise,reject rejectit it 162 Internal-Rate-of-Return Method The Theinternal internal rate rateof of return returnis isthe thetrue trueeconomic economicreturn returnearned earned by bythe theasset assetover overits itslife life The Theinternal internal rate rateof of return returnis iscomputed computedby byfinding findingthe the discount discountrate ratethat thatwill will cause causethe thenet netpresent presentvalue valueof of aaproject project to tobe bezero zero 163 Internal-Rate-of-Return Method Black BlackCo Co.can canpurchase purchaseaanew newmachine machineat ataacost costof of $104,320 $104,320 that thatwill will save save$20,000 $20,000per peryear yearin incash cashoperating operatingcosts costs The Themachine machinehas hasaa10-year 10-yearlife life 164 Internal-Rate-of-Return Method 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 $104, 320 $20,000 = Present value factor = 5.216 165 Internal-Rate-of-Return Method The The present present value value factor factor (5.216) (5.216) is is located located on on the the Table Table IV IV in in the the Appendix Appendix Scan Scan the the 1010period period row row and and locate locate the the value value 5.216 5.216 Look Look at at the the top top of of the the column column and and you you find find aa rate rate of of 14%, 14%, which which is is the the internal internal rate rate of of return return $104,320 $20,000 = 5.216 166 Internal-Rate-of-Return Method Here’s the proof 167 Comparing the NPV and IRR Methods Net NetPresent PresentValue Value The Thecost costof of capital capital is isused used as asthe theactual actual discount discountrate rate Any Anyproject projectwith withaanegative negative net netpresent presentvalue valueis is rejected 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 168 Comparing the NPV and IRR Methods The Thenet netpresent presentvalue valuemethod methodhas has the thefollowing followingadvantages advantagesover over the theinternal internal rate rateof of return return method method Easier Easierto touse use Easier Easierto toadjust adjustfor forrisk risk 169 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 25,000 - 1610 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 1616 After-Tax Cash Flows High Country Department Stores Income Statement For the Year Ended Jun 30, 2013 Revenue $ 1,000,000 Expenses Income before taxes Income taxes Net Income (475,000) 525,000 (210,000) 315,000 The tax rate is 40%, so income taxes are The tax rate is 40%, so income taxes are $525,000 × 40% = $ 210,000 $525,000 × 40% = $ 210,000 Not Not all all expenses expenses require require cash cash outflows outflows The The most most common common example example is is depreciation depreciation 1617 Modified Accelerated Cost Recovery System (MACRS) Tax depreciation is usually computed using MACRS Here are the depreciation rate for 3, 5, and 7-year class life assets 1618 Investment in Working Capital Some investment proposals require additional outlays for working capital such as increases in cash, accounts receivable, and inventory 1619 Ranking Investment Projects We Wecan caninvest investin ineither either of of these theseprojects projects Use Useaa10% 10% discount discountrate rateto todetermine determinethe thenet netpresent presentvalue valueof of the the cash cashflows flows Project A Immediate cash outlay $ 100,000 Cash inflows: Year $ 50,000 Year 40,000 Year 30,000 Total inflows $ 120,000 Project B $ 100,000 $ 30,000 40,000 50,000 $ 120,000 The total cash flows are the same, but the pattern of the flows is different 1620 Ranking Investment Projects Let’s calculate the present value of the cash flows associated with Project A This This project project has has aa positive positive net net present present value value which which means means the the project’s project’s return return is is greater greater than than the the discount discount rate rate 1621 Ranking Investment Projects Here is the net present value of the cash flows associated with Project B Immediate cash outlay Cash inflows: Year Year Year Net present value Project B $(100,000) $ 30,000 40,000 50,000 PV Factor 1.000 PV $(100,000) 0.909 0.826 0.751 27,270 33,040 37,550 $ (2,140) Project Project B B has has aa negative negative net net present present value value which which means means the the project’s project’s return return is is less less than than the the discount discount rate rate 1622 Alternative Methods for Making Investment Decisions Payback Method Payback Initial investment = period Annual aftertax cash inflow A A company company can can purchase purchase aa machine machine for for $20,000 $20,000 that that will will provide provide annual annual cash cash inflows inflows of of $4,000 $4,000 for for 77 years years Payback $20,000 = = 5 years period $4,000 1623 Payback: Pro and Con 1 Fails Failsto toconsider considerthe thetime time value valueof of money money 2 Does Doesnot notconsider consideraa project’s project’scash cashflows flows beyond beyondthe thepayback payback period period Provides a tool for roughly screening investments For some firms, it may be essential that an investment recoup its initial cash outflows as quickly as possible 1624 Accounting-Rate-of-Return Method The following formula is used to calculate the accounting rate of return: Accounting rate of = return Average incremental revenues - Average incremental expenses, including depreciation & income taxes Initial investment 1625 Accounting-Rate-of-Return Method Meyers MeyersCompany Companywants wantsto toinstall install an anespresso espressobar bar in inits its restaurant restaurant The Theespresso espressobar: bar: Cost Cost$140,000 $140,000and andhas hasaa10-year 10-yearlife life Will Will generate generateincremental incremental revenues revenuesof of $100,000 $100,000and and incremental incremental expenses expensesof of $80,000 $80,000including includingdepreciation depreciation What Whatis isthe theaccounting accountingrate rateof of return returnon onthe theinvestment investmentproject? project? 1626 Accounting-Rate-of-Return Method Accounting = rate of return $100,000 - $80,000 $140,000 = 14.3% The The accounting accounting rate rate of of return return method method is is not not recommended recommended for for aa variety variety of of reasons, reasons, the the most most important important of of which which is is that that itit ignores ignores the the time time value value of of money money 1627 Estimating Cash Flows: The Role of Activity-Based Costing ABC ABC systems systemsgenerally generallyimprove improvethe theability abilityof of an ananalyst analystto to estimate estimatethe thecash cashflows flowsassociated associatedwith withaaproposed proposedproject project 1628 Justification of Investments in Advanced Manufacturing Systems Time Time horizons horizons are are too too short short Hurdle Hurdle rates rates are are too too high high Benefits Benefits difficult difficult to to quantify quantify Bias Bias towards towards incremental incremental projects projects Greater Greater cash cash flow flow uncertainty uncertainty 1629 Inflation Effects Nominal Nominal Dollars Dollars Real Real dollars dollars 1630 ...Net-Present -Value Method 1 Prepare Prepareaatable tableshowing showingcash cashflows flowsfor foreach eachyear, year, 2 Calculate Calculatethe thepresent presentvalue valueof of each eachcash cashflow... Themachine machinehas hasaa10-year 10-yearlife life 16? ?4 Internal-Rate-of-Return Method Future cash flows are the same every year in this example, so we can calculate the internal rate of return as follows:... expenses, including depreciation & income taxes Initial investment 16? ?25 Accounting-Rate-of-Return Method Meyers MeyersCompany Companywants wantsto toinstall install an anespresso espressobar bar in inits