Chapter 16

Capital
Expenditure
Decisions

McGraw-Hill/Irwin

Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Learning Objective 1

16-2
16-2

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

Cost
Cost reduction
reduction

Equipment
Equipment replacement
replacement

Lease
Lease or
or buy
buy

16-3

Net-Present-Value Method
1.
1. Prepare
Prepare aa table
table showing
showing cash
cash flows
flows for
for each
each year,
year,
2.
2. Calculate
Calculate the
the present
present value
value of
of each
each cash
cash flow
flow
using
using aa discount
discount rate,
rate,
3.
3. Compute
Compute net
net present
present value,
value,
4.
4. IfIf the
the net
net present
present value
value (NPV)
(NPV) is
is zero
zero or
or positive,
positive,
accept
accept the
the investment
investment proposal.
proposal. Otherwise,
Otherwise, reject
reject it.
it.

16-4

Net-Present-Value Method
Mattson Co. has been offered a five year contract
to provide component parts for a large
manufacturer.

16-5

Net-Present-Value Method

At
At the
the end
end of
of five
five years,
years, the
the working
working capital
capital will
will

be
be released
released and
and may
may be
be used
used elsewhere
elsewhere by
by
Mattson.
Mattson.

Mattson
Mattson uses
uses aa discount
discount rate
rate of
of 10%.
10%.

Should
Should the
the contract
contract be
be accepted?
accepted?

16-6

Net-Present-Value Method
Annual net cash inflows from operations

16-7

Net-Present-Value Method

Mattson
Mattson should
should accept
accept the
the contract
contract because
because the
the
present
present value
value of
of the
the cash
cash inflows
inflows exceeds
exceeds the
the present
present
value
value of
of the
the cash
cash outflows
outflows by
by $85,955.
$85,955. The
The project
project
has
has aa positive
positive net
net present
present value.
value.
16-8

Internal-Rate-of-Return Method

The
The internal
internal rate
rate of
of return
return is
is the
the true
true economic
economic

return
return earned
earned by
by the
the asset
asset over
over its
its life.
life.

The
The internal
internal rate
rate of
of return
return is
is computed
computed by
by
finding
finding the
the discount
discount rate
rate that
that will
will cause
cause the
the net
net
present
present value
value of
of aa project
project to
to be
be zero.
zero.

16-9

Internal-Rate-of-Return Method

Black
Black Co.
Co. can
can purchase
purchase aa new
new machine
machine at
at aa cost
cost

of
of $104,320
$104,320 that
that will
will save
save $20,000
$20,000 per
per year
year in
in
cash
cash operating
operating costs.
costs.

The
The machine
machine has
has aa 10-year
10-year life.
life.

16-10

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

16-11

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

16-12

Internal-Rate-of-Return Method

Heres the proof . . .

16-13

Learning Objective 2

16-14

Comparing the NPV and IRR

Methods
Net
Net Present
Present Value
Value

The
The cost
cost of
of capital
capital is
is
used
used as
as the
the actual
actual
discount
discount rate.
rate.

Any
Any project
project with
with aa

negative
negative net
net present
present
value
value is
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

projects rate of return

must be greater than
the cost of capital.

16-15

Comparing the NPV and IRR

Methods
The
The net
net present
present value
value method
method
has
has the
the following
following advantages
advantages
over
over the
the internal
internal rate
rate of
of
return
return method
method .. .. ..

Easier
Easier to
to use.
use.

Easier
Easier to
to adjust
adjust for
for risk.
risk.

16-16

Assumptions Underlying
Discounted-Cash-Flow Analysis
All cash flows are
treated as though
they occur at year end.

Cash flows are

treated as if
they are known
with certainty.

Assumes a
perfect
capital
market.
Cash inflows are
immediately
reinvested at
the required
rate of return.

16-17

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.

16-18

Learning Objective 3

16-19

Comparing Two Investment

Projects

To compare competing investment projects, we

can use the following net present value
approaches:
Total-Cost Approach.
Incremental-Cost Approach.

16-20

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)
(335,000)
20,000
440,000
X 1.000
(440,000)

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

SUM OF PRESENT VALUES = ($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 OF PRESENT VALUES = ($1,247,885)

16-22

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.
16-23

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
( 65,000)
X 1.000
( 65,000)

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

SUM OF PRESENT VALUES = ($ 327,820)

16-24

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

($ 327,820)

Incremental Cost:
Net Present Value of costs

($ 327,820)

Different methods, Same results.

16-25

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.

16-26

Postaudit of Investment Projects

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

16-27

Learning Objective 4

16-28

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

16-29

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
The tax
tax rate
rate is
is 40%,
40%, so
so income
income taxes
taxes are
are
$525,000
$525,000 40%
40% == $$ 210,000
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.
16-30

Learning Objective 5

16-31

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.

16-32

Learning Objective 6

16-33

Investment in Working Capital

Some investment proposals require additional
outlays for working capital such as increases in
cash, accounts receivable, and inventory.

16-34

Learning Objective 7

16-35

Ranking Investment Projects

We
We can
can invest
invest in
in either
either of
of these
these projects.
projects. Use
Use
aa 10%
10% discount
discount rate
rate to
to determine
determine the
the net
net
present
present value
value of
of the
the cash
cash flows.
flows.
Project
Project A
A
Immediate
Immediate cash
cash outlay
outlay $$100,000
100,000
Cash
Cash inflows:
inflows:
Year
$$ 50,000
Year 11
50,000
Year
40,000
Year 22
40,000
Year
30,000
Year 33
30,000
Total
$$120,000
Total inflows
inflows
120,000

Project
Project B
B
$$100,000
100,000
$$ 30,000
30,000
40,000
40,000
50,000
50,000
$$120,000
120,000

The total cash flows are the same, but the pattern of
the flows is different.

16-36

Ranking Investment Projects

Lets 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 projects
projects return
return is
is greater
greater than
than the
the discount
discount rate.
rate.
16-37

Ranking Investment Projects

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

PV
$(100,000)
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 projects
projects return
return is
is less
less than
than the
the discount
discount rate.
rate.
16-38

Learning Objective 8

16-39

Alternative Methods for Making

Investment Decisions
Payback Method
Payback
Initial investment
=
period
Annual after-tax 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
=
period

$20,000
$4,000

= 5 years
16-40

Payback: Pro and Con

1.
1. Fails
Fails to
to consider
consider the
the
time
time value
value of
of money.
money.
2.
2. Does
Does not
not consider
consider aa
projects
projects cash
cash flows
flows
beyond
beyond the
the payback
payback
period.
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.
16-41

Accounting-Rate-of-Return
Method

Discounted-cash-flow
Discounted-cash-flow method
method focuses
focuses on
on cash
cash
flows
flows and
and the
the time
time value
value of
of money.
money.

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

16-42

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

16-43

Accounting-Rate-of-Return
Method

Meyers
Meyers Company
Company wants
wants to
to install
install an
an
espresso
espresso bar
bar in
in its
its restaurant.
restaurant.

The
The espresso
espresso bar:
bar:

Cost
Cost $140,000
$140,000 and
and has
has aa 10-year
10-year life.
life.

Will
Will generate
generate incremental
incremental revenues
revenues of
of

$100,000
$100,000 and
and incremental
incremental expenses
expenses of
of
$80,000
$80,000 including
including depreciation.
depreciation.
What
What is
is the
the accounting
accounting rate
rate of
of return
return on
on the
the
investment
investment project?
project?
16-44

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.

16-45

Learning Objective 9

16-46

Estimating Cash Flows:

The Role of Activity-Based Costing

ABC
ABC systems
systems generally
generally improve
improve the
the ability
ability of
of an
an
analyst
analyst to
to estimate
estimate the
the cash
cash flows
flows associated
associated
with
with aa proposed
proposed project.
project.

16-47

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
16-48

Learning Objective 10

16-49

Inflation Effects
Nominal
Nominal Dollars
Dollars
Real
Real dollars
dollars

16-50

End of Chapter 16

16-51