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Chapter 16

Capital Expenditure Decisions

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning Objective 1

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Discounted-Cash-Flow Analysis
Plant expansion Equipment selection Equipment replacement

Cost reduction

Lease or buy

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Net-Present-Value Method
o

o
o

Prepare a table showing cash flows for each year, Calculate the present value of each cash flow using a discount rate, Compute net present value, If the net present value (NPV) is positive, accept the investment proposal. Otherwise, reject it.

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Net-Present-Value Method
Mattson Co. has been offered a five year contract to provide component parts for a large manufacturer.
Cost and revenue information Cost of special equipment $160,000 Working capital required 100,000 Relining equipment in 3 years 30,000 Salvage value of equipment in 5 years 5,000 Annual cash revenue and costs: Sales revenue from parts 750,000 Cost of parts sold 400,000 Salaries, shipping, etc. 270,000
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Net-Present-Value Method
At the end of five years the working capital will be released and may be used elsewhere by Mattson. Mattson uses a discount rate of 10%.

Should the contract be accepted?

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Net-Present-Value Method
Annual net cash inflows from operations
Sales revenue Cost of parts sold Gross margin Less out-of-pocket costs Annual net cash inflows $ 750,000 400,000 350,000 270,000 $ 80,000

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Net-Present-Value Method
Investment in equipment Working capital needed Annual net cash inflows Relining of equipment Salvage value of equip. Working capital released Net present value Years Now Now 1-5 3 5 5 Cash Flows $(160,000) (100,000) 80,000 (30,000) 5,000 100,000 10% Factor 1.000 1.000 3.791 0.751 0.621 0.621 Present Value $ (160,000) (100,000) 303,280 (22,530) 3,105 62,100 $ 85,955

Mattson should accept the contract because the present value of the cash inflows exceeds the present value of the cash outflows by $85,955. The project has a positive net present value.
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Internal-Rate-of-Return Method
The internal rate of return is the true economic return earned by the asset over its life. The internal rate of return is computed by finding the discount rate that will cause the net present value of a project to be zero.

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Internal-Rate-of-Return Method
Black Co. can purchase a new machine at a cost of $104,320 that will save $20,000 per year in cash operating costs. The machine has a 10-year life.

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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

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Internal-Rate-of-Return Method
The present value factor (5.216) is located on the Table IV in the Appendix. Scan the 10period row and locate the value 5.216. Look at the top of the column and you find a rate of 14% which is the internal rate of return.
$104, 320 $20,000

5.216

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Internal-Rate-of-Return Method
Heres the proof . . .
Investment required Annual cost savings Net present value Year Now 1-10 Amount $(104,320) 20,000 14% Factor 1.000 5.216 Present Value (104,320) 104,320 $ -

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Learning Objective 2

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Comparing the NPV and IRR Methods


Net Present Value The cost of capital is used as the actual discount rate. Internal Rate of Return The cost of capital is compared to the internal rate of return on a project. To be acceptable, a projects rate of return must be greater than the cost of capital.
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Any project with a negative net present value is rejected.

Comparing the NPV and IRR Methods


The net present value method has the following advantages over the internal rate of return method . . . Easier to use. Easier to adjust for risk.

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Assumptions Underlying Discounted-Cash-Flow Analysis


All cash flows are treated as though they occur at year end.

Assumes a perfect capital market.


Cash inflows are immediately reinvested at the required rate of return.

Cash flows are treated as if they are known with certainty.

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Choosing the Hurdle Rate


The discount rate generally is associated with the companys cost of capital. The cost of capital involves a blending of the costs of all sources of investment funds, both debt and equity.

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Learning Objective 3

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Comparing Two Investment Projects


To compare competing investment projects we can use the following net present value approaches:
Total-Cost Approach. Incremental-Cost Approach.

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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 16-21

Total-Cost Approach
MAINFRAME ($) Acquisition cost computer Acquisition cost software System update Salvage value Operating costs Time sharing revenue Total cash flow X Discount factor Present value Today (400,000) ( 40,000) Year 1 Year 2 Year 3 Year 4 Year 5 ( 40,000)

50,000 (335,000) (335,000) (335,000) (335,000) (335,000) (335,000) 20,000 20,000 20,000 20,000 20,000 20,000 440,000 (315,000) (315,000) (355,000) (315,000) (265,000) X 1.000 X .893 X .797 X .712 X .636 X .567 (440,000) (281,295) (251,055) (252,760) (200,340) (150,255)

SUM = ($1,575,705)
PERSONAL COMPUTER ($) Acquisition cost computer Acquisition cost software System update Salvage value Operating costs Time sharing revenue Total cash flow X Discount factor Present value Today (300,000) ( 75,000) Year 1 Year 2 Year 3 Year 4 Year 5

( 60,000)

50,000 (235,000) (235,000) (235,000) (235,000) (235,000) (235,000) -0-0-0-0-0-0_ 375,000 (235,000) (235,000) (295,000) (235,000) (205,000) X 1.000 X .893 X .797 X .712 X .636 X .567 (375,000) (209,855) (187,295) (210,040) (149,460) (116,235)

SUM = ($1,247,885)

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Total-Cost Approach

Net cost of purchasing Mainframe system

($1,575,705)

Net cost of purchasing Personal Computer system ($1,247,885)


Net Present Value of costs ($ 327,820)

Mountainview should purchase the personal computer system for a cost savings of $327,820.
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Incremental-Cost Approach
INCREMENTAL ($) Acquisition cost computer Acquisition cost software System update Salvage value Operating costs Time sharing revenue Total cash flow X Discount factor Present value

Today (100,000) 35,000

Year 1

Year 2

Year 3

Year 4

Year 5

20,000 20,000 (100,000) (100,000) (100,000) (100,000) (100,000) 20,000 20,000 20,000 20,000 20,000 20,000 ( 65,000) ( 80,000) ( 80,000) ( 80,000) ( 80,000) ( 60,000) X 1.000 X .893 X .797 X .712 X .636 X .567 ( 65,000) ( 71,440) ( 63,760) ( 42,720) ( 50,880) ( 34,020)

SUM = ($ 327,820)

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Total-Incremental Cost Comparison


Total Cost:
Net cost of purchasing Mainframe system ($1,575,705)

Net cost of purchasing Personal Computer system ($1,247,885)

Net Present Value of costs


Incremental Cost: Net Present Value of costs

($ 327,820)

($ 327,820)

Different methods, Same results.


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Managerial Accountants Role


Managerial accountants are often asked to predict cash flows related to operating cost savings, additional working capital requirements, and incremental costs and revenues. When cash flow projections are very uncertain, the accountant may . . .
1. increase the hurdle rate, 2. use sensitivity analysis.
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Postaudit of Investment Projects


A postaudit is a follow-up after the project has been approved to see whether or not expected results are actually realized.

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Learning Objective 4

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Income Taxes and Capital Budgeting


Cash flows from an investment proposal affect the companys profit and its income tax liability.
Income = Revenue - Expenses + Gains - Losses

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After-Tax Cash Flows


High Country Department Stores Income Statement For the Year Ended Jun 30, 2007 $ 1,000,000 (475,000)

Revenue Expenses

Income before taxes


Income taxes Net Income

525,000
(210,000) 315,000

The tax rate is 40%, so income taxes are $525,000 40% = $ 210,000
Not all expenses require cash outflows. The most common example is depreciation.
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Learning Objective 5

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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.
Year 1 2 3 4 5 6 7 8 3-year 33.33% 44.45% 14.81% 7.41% 5-year 20.00% 32.00% 19.20% 11.52% 11.52% 5.76% 7-year 14.29% 24.49% 17.49% 12.49% 8.93% 8.92% 8.93% 4.46%
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Learning Objective 6

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Investment in Working Capital


Some investment proposals require additional outlays for working capital such as increases in cash, accounts receivable, and inventory.
Current assets $ 100,000 Less: current liabilities (65,000) Working capital $ 35,000

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Extended Illustration
For a complete present value analysis for an investment decision facing High Country Department Stores, Inc., see the textbook. High Country Department Stores

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Learning Objective 7

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Ranking Investment Projects


We can invest in either of these projects. Use a 10% discount rate to determine the net present value of the cash flows.
Project A Immediate cash outlay $ 100,000 Cash inflows: Year 1 $ 50,000 Year 2 40,000 Year 3 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.
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Ranking Investment Projects


Lets calculate the present value of the cash flows associated with Project A.
Immediate cash outlay Cash inflows: Year 1 Year 2 Year 3 Net present value Project A $(100,000) $ 50,000 40,000 30,000 PV Factor 1.000 0.909 0.826 0.751 PV $(100,000) 45,450 33,040 22,530 $ 1,020

This project has a positive net present value which means the projects return is greater than the discount rate.
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Ranking Investment Projects


Here is the net present value of the cash flows associated with Project B.
Immediate cash outlay Cash inflows: Year 1 Year 2 Year 3 Net present value Project B $(100,000) $ 30,000 40,000 50,000 PV Factor 1.000 0.909 0.826 0.751 PV $(100,000) 27,270 33,040 37,550 $ (2,140)

Project B has a negative net present value which means the projects return is less than the discount rate.
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Learning Objective 8

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Alternative Methods for Making Investment Decisions


Payback Method
Payback Initial investment = period Annual after-tax cash inflow
A company can purchase a machine for $20,000 that will provide annual cash inflows of $4,000 for 7 years.

Payback = period

$20,000 $4,000

= 5 years
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Payback: Pro and Con


1. Fails to consider the time value of money. 2. Does not consider a projects cash flows beyond the payback period. 1. Provides a tool for roughly screening investments. 2. For some firms, it may be essential that an investment recoup its initial cash outflows as quickly as possible.
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Accounting-Rate-of-Return Method
Discounted-cash-flow method focuses on cash flows and the time value of money.

Accounting-rate-of-return method focuses on the incremental accounting income that results from a project.

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Accounting-Rate-of-Return Method
The following formula is used to calculate the accounting rate of return:
Average incremental revenues

Accounting rate of return

Average incremental expenses, including depreciation & income taxes

Initial investment

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Accounting-Rate-of-Return Method
Meyers Company wants to install an espresso bar in its restaurant.
The espresso bar:
Cost $140,000 and has a 10-year life. Will generate incremental revenues of $100,000 and incremental expenses of $80,000 including depreciation.

What is the accounting rate of return on the investment project?


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Accounting-Rate-of-Return Method
Accounting = rate of return $100,000 - $80,000 $140,000

= 14.3%

The accounting rate of return method is not recommended for a variety of reasons, the most important of which is that it ignores the time value of money.

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Learning Objective 9

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Estimating Cash Flows:


The Role of Activity-Based Costing
ABC systems generally improve the ability of an analyst to estimate the cash flows associated with a proposed project.

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Justification of Investments in Advanced Manufacturing Systems


Hurdle rates are too high Time horizons are too short Bias towards incremental projects

Benefits difficult to quantify

Greater cash flow uncertainty


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Learning Objective 10

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Inflation Effects
Nominal Dollars Real dollars

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End of Chapter 16

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