Chapter 16

Capital Expenditure
Decisions

McGraw-Hill/Irwin

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

Learning
Objective
1

McGraw-Hill/Irwin

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

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
oo
oo
oo
oo

Prepare
Prepare aa table
table showing
showing cash
cash flows
flows for
for each
each year,
year,
Calculate
Calculate the
the present
present value
value of
of each
each cash
cash flow
flow using
using aa
discount
discount rate,
rate,
Compute
Compute net
net present
present value,
value,
IfIf the
the net
net present
present value
value (NPV)
(NPV) is
is 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

McGraw-Hill/Irwin

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

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.

Internal Rate of Return

The cost of capital is
compared to the internal
rate of return on a project.

Any
Any project
project with
with aa
negative
negative net
net present
present
value
value is
is rejected.
rejected.

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

McGraw-Hill/Irwin

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

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 = ($1,575,705)
PERSONAL COMPUTER ($)
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)

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

16-27

Learning
Objective
4

McGraw-Hill/Irwin

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

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, 2007
Revenue
$ 1,000,000
Expenses

(475,000)

Income before taxes

Income taxes
Net Income

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 all expenses require cash outflows. The most common example is depreciation.
Not all expenses require cash outflows. The most common example is depreciation.

16-30

Learning
Objective
5

McGraw-Hill/Irwin

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

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

McGraw-Hill/Irwin

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

Investment in Working Capital

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

16-34

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

16-35

Learning
Objective
7

McGraw-Hill/Irwin

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

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
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.
16-37

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.
16-38

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
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.
16-39

Learning
Objective
8

McGraw-Hill/Irwin

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

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
16-41

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.
16-42

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.

16-43

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

16-44

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?
16-45

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.

16-46

Learning
Objective
9

McGraw-Hill/Irwin

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

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.

16-48

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
16-49

Learning
Objective
10

McGraw-Hill/Irwin

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

Inflation Effects
Nominal Dollars
Real dollars

16-51

End of Chapter 16

16-52