Chapter 12 - Strategic investment decisions. The following will be discussed in this chapter: How are strategic investment decisions made? What cash flows are relevant for strategic investment decisions? How is net present value (NPV) analysis performed and interpreted?...
Cost Management Measuring, Monitoring, and Motivating Performance Chapter 12 Strategic Investment Decisions © John Wiley & Sons, Chapter 12: Strategic Investment DecisionsSlide # Chapter 12: Strategic Investment Decisions Learning objectives • • • • • • • • Q1: How are strategic investment decisions made? Q2: What cash flows are relevant for strategic investment decisions? Q3: How is net present value (NPV) analysis performed and interpreted? Q4: What business risks and limitations affect NPV analysis? Q5: What alternative methods (IRR, payback, and accrual accounting rate of return) are used for long-term decision making? Q6: What additional issues should be considered for strategic investment decisions? Q7: How income taxes affect strategic investment decision cash flows? Q8: How are the real and nominal methods used to address inflation in NPV analysis (Appendix 12A) © John Wiley & Sons, Chapter 12: Strategic Investment DecisionsSlide # Q1: Process for Making Strategic Investment Decisions • • • • The process used to compare and analyze long-term investment projects is called capital budgeting Strategic investment decisions typically involve a large up front investment Time value of money must be considered since the project life is greater than year Examples of strategic investment decisions? © John Wiley & Sons, Chapter 12: Strategic Investment DecisionsSlide # Q1: Process for Making Strategic Investment Decisions © John Wiley & Sons, Chapter 12: Strategic Investment DecisionsSlide # Q1: Process for Making Strategic Investment Decisions • The capital budgeting process includes the following stages: • • • • • • Identify decision alternatives Identify relevant cash flows Apply the appropriate quantitative techniques Perform sensitivity analysis Identify and analyze qualitative factors Consider quantitative and qualitative factors and make a decision © John Wiley & Sons, Chapter 12: Strategic Investment DecisionsSlide # Q1: Capital Budgeting Quantitative Techniques • • Methods that consider the time value of money: • Net present value (NPV) method • Internal rate of return (IRR) method Methods that not consider the time value of money: • Payback method • Accounting rate of return method © John Wiley & Sons, Chapter 12: Strategic Investment DecisionsSlide # Q2: Relevant Cash Flows in Capital Budgeting • • • Relevant cash flows occur in the future and are different across the alternatives Examples of relevant cash outflows include: • Initial investment outlay • Future operating costs • Project closing and cleanup costs Examples of relevant cash inflows include: • Future revenues • Decreased operating costs ã Salvage value of assets at projects end â John Wiley & Sons, Chapter 12: Strategic Investment DecisionsSlide # Q2: Relevant Cash Flows in Capital Budgeting © John Wiley & Sons, Chapter 12: Strategic Investment DecisionsSlide # Q3: Net Present Value (NPV) Analysis • The NPV of a project is the sum of the project’s discounted cash flows: n NPV = t t t=0 • • • • Expected cash flow , where ( 1+ r ) t = year of the project’s life in which cash flow occurs n = life of the project r = discount, or hurdle rate If a project’s NPV > 0, it is acceptable © John Wiley & Sons, Chapter 12: Strategic Investment DecisionsSlide # Q3: NPV Analysis and Project Ranking • • NPV analysis is often used to screen projects as to whether they are acceptable After screening, acceptable projects may be ranked according to their profitability index Profitability index • = Present value of benefits Present value of costs The profitability index allows for rankings of projects of various sizes © John Wiley & Sons, Chapter 12: Strategic Investment DecisionsSlide # 10 Q7: Capital Budgeting and Income Tax Considerations (NPV) Example Colby Products is considering the purchase of a new machine The cost is $180,000 and it is expected to last years and have no salvage value The machine is expected to generate cost savings of $50,000 per year Colby’s tax rate is 30% and its discount rate is 10% For simplification, suppose that Colby uses straight-line depreciation for both books and taxes Compute the IRR of this machine Cash inflows after taxes [$50,000 x (1 – 30%)] $35,000 Tax savings from depreciation [$30,000 x 30%] 9,000 Net after-tax annual cash inflows $44,000 NPV = $44,000 x PV factor of an annuity - $180,000 = $44,000 x 4.355 - $180,000 = $11,620 © John Wiley & Sons, Chapter 12: Strategic Investment DecisionsSlide # 26 Q7: Capital Budgeting and Income Tax Considerations (IRR) Example Colby Products is considering the purchase of a new machine The cost is $180,000 and it is expected to last years and have no salvage value The machine is expected to generate cost savings of $50,000 per year Colby’s tax rate is 30% and its discount rate is 10% For simplification, suppose that Colby uses straight-line depreciation for both books and taxes Compute the IRR of this machine Cash inflows after taxes [$50,000 x (1 – 30%)] $35,000 Tax savings from depreciation [$30,000 x 30%] 9,000 Net after-tax annual cash inflows $180,000 $44,000 $44,000 = PV of an annuity factor = 4.091 Locate the 4.091 factor in the present value of an annuity table, using n = years and note that it is found between the 12% & 13% columns, so the IRR is just over 12% © John Wiley & Sons, Chapter 12: Strategic Investment DecisionsSlide # 27 Q7: Capital Budgeting and Income Tax Considerations (Payback) Example Colby Products is considering the purchase of a new machine The cost is $180,000 and it is expected to last years and have no salvage value The machine is expected to generate cost savings of $50,000 per year Colby’s tax rate is 30% and its discount rate is 10% For simplification, suppose that Colby uses straight-line depreciation for both books and taxes Compute the payback period of this machine Cash inflows after taxes [$50,000 x (1 – 30%)] $35,000 Tax savings from depreciation [$30,000 x 30%] 9,000 Net after-tax annual cash inflows $180,000 $44,000 $44,000 = Payback period = 4.91 years © John Wiley & Sons, Chapter 12: Strategic Investment DecisionsSlide # 28 Q7: Capital Budgeting and Income Tax Considerations (Accrual Accounting ROR) Example Colby Products is considering the purchase of a new machine The cost is $180,000 and it is expected to last years and have no salvage value The machine is expected to generate cost savings of $50,000 per year Colby’s tax rate is 30% and its discount rate is 10% For simplification, suppose that Colby uses straight-line depreciation for both books and taxes Compute the accrual accounting rate of return of this machine Cash inflows after taxes [$50,000 x (1 – 30%)] $35,000 Tax savings from depreciation [$30,000 x 30%] 9,000 Net after-tax annual increase in operating income $44,000 $180,000 $44,000 = 24.44% accrual accounting ROR © John Wiley & Sons, Chapter 12: Strategic Investment DecisionsSlide # 29 Q8: Inflation and NPV Analysis • • • When the purchasing power of the dollar declines over time, it is known as inflation The real rate of interest does not consider changes in the purchasing power of a dollar The nominal rate of interest is the rate that investors demand when inflation is taken into consideration in their decisions © John Wiley & Sons, Chapter 12: Strategic Investment DecisionsSlide # 30 Q8: Inflation and NPV Analysis • • • • The risk-free rate is the rate of interest that is paid on long-term government bonds The risk premium is the additional rate of return investors demand to compensate them for taking risk The risk premium increases for riskier investments The real rate of interest is the nominal rate plus the risk premium demanded for that investment © John Wiley & Sons, Chapter 12: Strategic Investment DecisionsSlide # 31 Q8: Nominal and Real Methods of NPV Analysis • The real and nominal rates of interest are related as follows: Nominal rate of = interest • (1 + real rate) x (1 + inflation rate) -1 Nominal future cash flows are real cash flows inflated to future dollars: Nominal cash flow = Real cash flow x (1 + i)t, where i = rate of inflation, and t = the number of time periods in the future the cash flow occurs © John Wiley & Sons, Chapter 12: Strategic Investment DecisionsSlide # 32 Q8: Nominal and Real Methods of NPV Analysis • • In the real method of NPV analysis, future cash flows are state in real dollars (without considering changes in the purchasing power of the dollar) and a real rate of interest is used as the discount rate In the nominal method of NPV analysis, future cash flows and the terminal project value must be inflated to future dollars and a nominal rate of interest is used as the discount rate © John Wiley & Sons, Chapter 12: Strategic Investment DecisionsSlide # 33 Q8: Real Method of NPV Analysis • The depreciation tax shield is calculated in steps: • Calculate the annual depreciation deduction for tax purposes, Convert each year’s depreciation deduction from year zero dollars to real dollars by dividing by (1 + inflation rate)t, Multiply the real value of the depreciation deduction times the tax rate Calculate the NPV for the incremental cash flows, including the tax savings from depreciation, using the real rate of interest © John Wiley & Sons, Chapter 12: Strategic Investment DecisionsSlide # 34 Q8: Real Method of NPV Analysis Example Stiles, Inc is considering the purchase of a new machine The cost is $400,000 and it is expected to last years and have a salvage value of $80,000 Stiles’ tax rate is 30%, the risk-free rate is 3%, the expected inflation rate is 2%, and Stiles believes that a risk premium of 5% for this machine is appropriate The machine qualifies as 5-year MACRS property for tax purposes, which means that the depreciation deduction is taken over years at 20%, 32%, 19.2%, 11.52%, 11.52%, and 5.76% of asset cost, respectively Compute the depreciation tax shield in real dollars for this machine *this is the nominal depreciation over (1.02)t MACRS rate 20.00% 32.00% 19.20% 44 11.52% 11.52% 55 11.52% 11.52% 66 5.76% 5.76% Depreciation deduction (nominal) $80,000 $128,000 $76,800 $46,080 $46,080 $46,080 $46,080 $23,040 $23,040 Depreciation deduction (real)* Tax savings (real) $78,431 $123,030 $23,529 $36,909 $72,370 $21,711 $42,571 $42,571 $12,771 $12,771 $41,736 $41,736 $12,521 $12,521 $20,459 $20,459 $6,138 $6,138 © John Wiley & Sons, Chapter 12: Strategic Investment DecisionsSlide # 35 Q8: Real Method of NPV Analysis Example Compute the tax on the gain on the sale of the machine, in real dollars Asset cost Depreciation taken Tax basis of asset Proceeds from sale of asset Gain on sale Tax rate Taxes on gain $400,000 $400,000 $0 $80,000 $80,000 30% $24,000 Note that the tax will be paid in the same year as the disposal, so the $24,000 is already in real dollars On the prior slide, depreciation deductions taken in years – are based on an investment stated in year dollars, so they were not in real dollars and needed to be deflated © John Wiley & Sons, Chapter 12: Strategic Investment DecisionsSlide # 36 Q8: Nominal Method of NPV Analysis • • • Incremental cash inflows and the terminal cash flow must be adjusted (inflated) for inflation Calculate the gain on asset disposal as the historical cost compared to the nominal depreciation deduction The nominal and real methods yield the same NPV when the inflation rate is constant over the investment’s life © John Wiley & Sons, Chapter 12: Strategic Investment DecisionsSlide # 37 Q8: Nominal Method of NPV Analysis Example Stiles, Inc is considering the purchase of a new machine The cost is $400,000 and it is expected to last years and have a salvage value of $80,000 Stiles’ tax rate is 30%, the risk-free rate is 3%, the expected inflation rate is 2%, and Stiles believes that a risk premium of 5% for this machine is appropriate The machine qualifies as 5-year MACRS property for tax purposes, which means that the depreciation deduction is taken over years at 20%, 32%, 19.2%, 11.52%, 11.52%, and 5.76% of asset cost, respectively Compute the depreciation tax shield in nominal dollars for this machine MACRS rate 20.00% 32.00% 19.20% 11.52% 11.52% 5.76% Depreciation deduction $80,000 $128,000 $76,800 $46,080 $46,080 $23,040 Tax savings $24,000 $23,040 $13,824 $13,824 $6,912 $38,400 © John Wiley & Sons, Chapter 12: Strategic Investment DecisionsSlide # 38 Q8: Nominal Method of NPV Analysis Example Compute the tax on the gain on the sale of the machine, in nominal dollars Disposal value Inflation factor Inflated disposal value Tax basis of asset Gain on sale Tax rate Taxes on gain $80,000 1.12616 $90,093 $0 $90,093 30% $27,028 = (1.02)6 $400,000 cost less depreciation taken of $400,000 © John Wiley & Sons, Chapter 12: Strategic Investment DecisionsSlide # 39 Q8: Nominal Method of NPV Analysis Example Suppose the machine generates cost savings of $60,000 per year for years Compute the NPV of the machine using the nominal method Time period Total Cash inflows $60,000 $60,000 $60,000 $60,000 $60,000 $60,000 $360,000 Inflated cash inflows $61,200 $62,424 $63,672 $64,946 $66,245 $67,570 $386,057 Taxes on cash inflows ($18,360) ($18,727) ($19,102) ($19,484) ($19,873) ($20,271) ($115,817) Terminal cash flow, inflated $90,093 Taxes on gain $90,093 ($27,028) ($27,028) Depreciation tax savings $24,000 $38,400 $23,040 $13,824 $13,824 $6,912 $120,000 Net cash inflows PV factor (nominal) PV of annual net cash flow $66,840 $82,097 $67,611 $59,286 $60,195 $117,276 $453,305 0.90777 0.82405 0.74805 0.67905 0.61643 0.55957 $60,675 $67,652 $50,576 $40,258 $37,106 $65,624 Initial outlay NPV © John Wiley & Sons, Chapter 12: Strategic Investment DecisionsSlide # 40 $321,892 $400,000 ($78,108) ... Perform sensitivity analysis Identify and analyze qualitative factors Consider quantitative and qualitative factors and make a decision © John Wiley & Sons, Chapter 12: Strategic Investment DecisionsSlide... Sons, Chapter 12: Strategic Investment DecisionsSlide # 11 Q3: NPV Example Joseph Leasing is also looking at the purchase of a lot with a double-wide trailer on it The cost is $65,000 and the... 30%] 9,000 Net after-tax annual cash inflows $44,000 NPV = $44,000 x PV factor of an annuity - $180,000 = $44,000 x 4.355 - $180,000 = $11,620 © John Wiley & Sons, Chapter 12: Strategic Investment