Chapter 16

Capital Expenditure
Decisions

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning
Objective
1

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Discounted-Cash-Flow Analysis
Plant expansion
Equipment selection

Cost reduction

Equipment replacement

Lease or buy

1-3

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.

1-4

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
1-5

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?

1-6

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

1-7

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.
1-8

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.

1-9

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.

1-10

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

1-11

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

1-12

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
$
-

1-13

Learning
Objective
2

McGraw-Hill/Irwin

Copyright 2011 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.
Any project with a
negative net
present value is
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.

1-15

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.

1-16

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.

1-17

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.

1-18

Learning
Objective
3

McGraw-Hill/Irwin

Copyright 2011 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.

1-20

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
1-21

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)

1-22

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.
1-23

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
(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)

1-24

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.

1-25

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.
1-26

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.

1-27

Learning
Objective
4

McGraw-Hill/Irwin

Copyright 2011 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

1-29

After-Tax Cash Flows

High Country Department Stores
Income Statement
For the Year Ended Jun 30, 2007

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

$525,000 40% = $ 210,000
Not all expenses require cash outflows. The most common example is depreciation.
1-30

Learning
Objective
5

McGraw-Hill/Irwin

Copyright 2011 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%
1-32

Learning
Objective
6

McGraw-Hill/Irwin

Copyright 2011 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

1-34

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

1-35

Learning
Objective
7

McGraw-Hill/Irwin

Copyright 2011 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.
1-37

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.
1-38

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

PV
$(100,000)

0.909
0.826
0.751

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.
1-39

Learning
Objective
8

McGraw-Hill/Irwin

Copyright 2011 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
1-41

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.
1-42

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.

1-43

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

1-44

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?
1-45

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.

1-46

Learning
Objective
9

McGraw-Hill/Irwin

Copyright 2011 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.

1-48

Justification of Investments in Advanced

Manufacturing Systems

Time
horizons
are too
short

Hurdle
rates are
too high

Benefits
difficult to
quantify

Bias
towards
incremental
projects

Greater
cash flow
uncertainty
1-49

Learning
Objective
10

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Inflation Effects
Nominal Dollars
Real dollars

1-51

End of Chapter 16

1-52