Strategic Investment Decisions: Measuring, Monitoring, and Motivating Performance

John Wiley & Sons, 2005
Chapter 12: Strategic Investment Decisions

Eldenburg & Wolcotts Cost Management, 1e Slide # 1
Cost Management
Measuring, Monitoring, and Motivating Performance

Prepared by
Gail Kaciuba
Midwestern State University
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 are the uncertainties and limitations of 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 do 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)
Q1: Process for Making Strategic
Investment Decisions
The process used to compare and analyze
long-term investment projects is called
capital budgeting.
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.
Q1: Capital Budgeting Quantitative Techniques
Methods that do not consider the time value
of money:
Payback method
Accounting rate of return method
Methods that consider the time value of
money:
Net present value (NPV) method
Internal rate of return (IRR) method
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
Salvage value of assets at projects end
Q3: Net Present Value (NPV) Analysis
The NPV of a project is the sum of the
projects discounted cash flows:

n
t
t
t=0
Expected cash flow
NPV =
1 r
, where
t = year of the projects life in which cash
flow occurs
n = life of the project
r = discount, or hurdle rate
If a projects NPV > 0, it is acceptable
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.
Q3: NPV Example
Joseph Leasing is considering an investment in a new apartment building.
The Lindie Lane building will cost $450,000 and the net annual cash
inflows are expected to be $45,000 for 7 years. At the end of the 7
th
year,
Joseph expects to be able to sell Lindie Lane building for $400,000.
Joseph demands a minimum required rate of return of 8% on all invest-
ments. Assume all cash inflows occur at the end of each year. Compute
the NPV of the Lindie Lane building. Is it an acceptable investment?
PV of cash inflows:
Annuity of cash inflows:
$45,000 x PV annuity factor of 5.206 $234,270
Sale of building:
$400,000 x PV of $1 factor of 0.583 233,200
467,470
PV of cash outflows:
Initial investment 450,000
NPV $17,470
Yes,
the NPV > 0,
so the
investment is
acceptable
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 expected net cash inflows are
$6,800 per year for 10 years. At the end of the 10
th
year, Joseph expects
to be able to sell the lot and trailer for $45,000. Compute the NPV of the
trailer investment. Is it an acceptable investment?
Yes, the
NPV > 0, so
the invest-
ment is
acceptable
PV of cash inflows:
Annuity of cash inflows:
$6,800 x PV annuity factor of 6.710 $45,628
Sale of lot and trailer:
$45,000 x PV of $1 factor of 0.463 20,835
66,463
PV of cash outflows:
Initial investment 65,000
NPV $1,463
Q3: NPV Example
Compare the two investments for Joseph using the profitability index, and
describe to him what the index means. Which investment (or both) should
he make?
The Lindie
Lane yields
a slightly
greater PV
for each
invested
dollar than
does the
trailer.
Profitability
index
Lindie Lane building:
PV of cash inflows 467,470
PV of cash outflows 450,000
Trailer:
PV of cash inflows 66,463
PV of cash outflows 65,000
= 1.0388
= 1.0225
If Joseph has sufficient capital, he should invest in both unless
he has alternatives that have even greater profitability indices.
Q4: Limitations of NPV Analysis
The uncertainty about future cash flows
increases the further the cash flow is in the
future, but NPV analysis uses only one
discount rate for all future periods.
Individuals providing information about the
future cash flows are likely to have a vested
interest in the projects acceptance.
Q5: Internal Rate of Return (IRR) Method
The IRR method computes the discount
rate required to set the NPV to zero.
For projects with equal annual cash inflows
where the only cash outlay is the initial
investment, the IRR can be determined by
computing the PV of an annuity factor and
solving for the interest rate.
PV of an annuity factor
=
Initial investment
Annual cash inflow
Then the discount rate is found by locating
the column for the PV factor, given n.
Q5: IRR Example
Graham Enterprises is considering the purchase of a new machine. The
cost is $100,000 and the machine is expected to generate cost savings of
$17,700 each year for 10 years. The machine is not expected to have any
salvage value at the end of its life. Assume the cost savings are realized
at the end of the year. Graham requires a 10% rate of return on all new
investments. Compute the IRR for the proposed machine. Should
Graham purchase the machine?
Since the machines IRR exceeds Grahams minimum rate of
return, the machine is an acceptable investment, but of course
should still be compared to other, potentially better, investments.
5.650 =
$100,000
$17,700
Locate the 5.65 factor in the present
value of an annuity table, using n =
10 years and note that it is found in
the 12% column, so the IRR = 12%.
Q5: Payback Method
The payback method computes the number
of years before the initial investment is
recovered.
If cash inflows are the same each year and
the project has only one initial outlay, the
payback period is computed as:
Payback period in years =
Initial investment
Annual cash inflow
For projects where annual cash inflows are
not equal, the payback period is computed
by merely counting the years required
before the initial investment is recovered.
Q5: Payback Method
The payback method is widely used
because of its simplicity.
However, the payback method is flawed
because:
It ignores the time value of money.
It ignores cash flows that occur after the
payback period.
If used at all, the payback method should be
used in conjunction with the NPV or IRR
methods to help assess project risk.
Q5: Payback Method Example
Graham Enterprises is considering the purchase of a new machine. The
cost is $100,000 and the machine is expected to generate cost savings of
$17,700 each year for 10 years. The machine is not expected to have any
salvage value at the end of its life. Compute the payback period for the
proposed machine.
Notice that the payback period is the same as the PV factor
computed in the IRR example.
5.650 years =
$100,000
$17,700
Q5: Payback Method Example
Cophil, Inc. is considering the purchase of a new machine. There are two
alternatives, and the cash flow information is given below. Compute the
payback period for each and comment on your findings.
The payback method shows Machine B to be
preferable to Machine A, but ignores the
large cash inflows of Machine A that occur
after the payback period.
The payback period for
Machine B is 2 years. The
payback period for Machine A
is 3.5 years ($60,000 covered
after 3 years, and $40,000 is
of year 4s cash inflow).
Machine A Machine B
0 ($100,000) ($100,000)
1 $10,000 $50,000
2 $20,000 $50,000
3 $30,000
4 $80,000
5 $80,000
6 $80,000
Cash Flow Time
period
Q5: Accrual Accounting Rate of Return Method
The accrual accounting rate of return
computes the projects rate of return using
operating income in place of cash flows.
This method is widely used because the
financial accounting information is readily
available, but is is flawed because it ignores
the time value of money.
Accrual
accounting rate
of return
Operating income
Annual cash inflow
=
Q5: Accrual Accounting Rate of Return
Method Example
Blanche Manufacturing is considering the purchase of a new machine.
The cost is $100,000 and it is expected to last 5 years and have no
salvage value. The machine is expected to generate cost savings of
$32,000 per year. Ignoring income tax effects, compute the accrual
accounting rate of return for this investment.
Annual cost savings $32,000
Annual depreciation expense ($100,000/5 years) 20,000
Effect on annual operating income $12,000
Accrual
accounting rate
of return
$12,000
$100,000
=
= 12%
Q6: Additional Considerations in Strategic
Investment Decisions
Qualitative issues that may arise in capital
budgeting include:
the effects of the decision on the companys
reputation,
the effects on the quality of the companys
products and services,
the effects on the companys community, and
the effects on employees.
After a capital budgeting decision is made,
a post-investment audit should be
performed to assess the decision process.
Q7: Income Tax Considerations
All cash flows should first be converted to
an after-tax amount.
The tax savings that result from the
depreciation deduction is called the
depreciation tax shield.
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 6 years and have no salvage value.
The machine is expected to generate cost savings of $50,000 per year.
Colbys 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
Tax Considerations (IRR) Example
taxes. Compute the IRR of this machine.
PV of an annuity factor = 4.091
=
$180,000
$44,000
Locate the 4.091 factor in the present value of an annuity table,
using n = 6 years and note that it is found between the 12% & 13%
columns, so the IRR is just over 12%.
Tax Considerations (Payback) Example
taxes. Compute the payback period of this machine.
=
Payback period = 4.91 years.
$180,000
$44,000
Q7: Capital Budgeting and Income Tax
Considerations (Accrual Accounting ROR) Example
taxes. Compute the accrual accounting rate of return of this machine.
Net after-tax annual increase in operating income $44,000
24.44% accrual accounting ROR
=
$44,000
$180,000
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.
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.
Q8: Nominal and Real Methods of NPV Analysis
The real and nominal rates of interest are
related as follows:
Nominal future cash flows are real cash
flows inflated to future dollars:
Nominal
rate of
interest
= (1 + real rate) x (1 + inflation rate) - 1
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
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.
Q8: Real Method of NPV Analysis
The depreciation tax shield is calculated in
3 steps:
1.Calculate the annual depreciation deduction
for tax purposes,
2.Convert each years depreciation deduction
from year zero dollars to real dollars by
dividing by (1 + inflation rate)
t
,
3.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.
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 6 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 6 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.
1 2 3 4 5 6
MACRS rate 20.00% 32.00% 19.20% 11.52% 11.52% 5.76%
Depreciation deduction
(nominal) $80,000 $128,000 $76,800 $46,080 $46,080 $23,040
(real)* $78,431 $123,030 $72,370 $42,571 $41,736 $20,459
Tax savings (real)
$23,529 $36,909 $21,711 $12,771 $12,521 $6,138
1 2 3 4 5 6
MACRS rate 20.00% 32.00% 19.20% 11.52% 11.52% 5.76%
(nominal) $80,000 $128,000 $76,800 $46,080 $46,080 $23,040
(real)* $78,431 $123,030 $72,370 $42,571 $41,736 $20,459
Tax savings (real)
$23,529 $36,909 $21,711 $12,771 $12,521 $6,138
*this is the nominal depreciation over (1.02)
t

Q8: Real Method of NPV Analysis Example
Compute the tax on the gain on the sale of the machine, in real dollars.
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 2 6 are based on an
investment stated in year 1 dollars, so they were not in real dollars
and needed to be deflated.
Asset cost $400,000
Depreciation taken $400,000
Tax basis of asset $0
Proceeds from sale of asset $80,000
Gain on sale $80,000
Tax rate 30%
Taxes on gain $24,000
Asset cost $400,000
Depreciation taken $400,000
Proceeds from sale of asset $80,000
Tax rate 30%
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 investments life.
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 6 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 6 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.
1 2 3 4 5 6
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 $38,400 $23,040 $13,824 $13,824 $6,912
1 2 3 4 5 6
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 $38,400 $23,040 $13,824 $13,824 $6,912
Compute the tax on the gain on the sale of the machine, in nominal
dollars.
= (1.02)
6

$400,000 cost less
depreciation taken
of $400,000
Disposal value $80,000
Inflation factor 1.12616
Inflated disposal value $90,093
Tax rate 30%
Disposal value $80,000
Inflation factor 1.12616
Inflated disposal value $90,093
Tax rate 30%
Suppose the machine generates cost savings of $60,000 per year for 6
years. Compute the NPV of the machine using the nominal method.
Time period 1 2 3 4 5 6 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 $90,093
Taxes on gain ($27,028) ($27,028)
Depreciation tax savings $24,000 $38,400 $23,040 $13,824 $13,824 $6,912 $120,000
Net cash inflows $66,840 $82,097 $67,611 $59,286 $60,195 $117,276 $453,305
PV factor (nominal) 0.90777 0.82405 0.74805 0.67905 0.61643 0.55957
PV of annual net cash
flow
$60,675 $67,652 $50,576 $40,258 $37,106 $65,624 $321,892
Initial outlay $400,000
NPV
($78,108)
Time period 1 2 3 4 5 6 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 $90,093
Taxes on gain ($27,028) ($27,028)
Depreciation tax savings $24,000 $38,400 $23,040 $13,824 $13,824 $6,912 $120,000
Net cash inflows $66,840 $82,097 $67,611 $59,286 $60,195 $117,276 $453,305
PV factor (nominal) 0.90777 0.82405 0.74805 0.67905 0.61643 0.55957
PV of annual net cash
flow
$60,675 $67,652 $50,576 $40,258 $37,106 $65,624 $321,892
Initial outlay $400,000
NPV
($78,108)

Strategic Investment Decisions: Measuring, Monitoring, and Motivating Performance

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Chapter 12: Strategic Investment Decisions

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