Chapter 16 - Capital expenditure decisions. After completing this chapter, you should be able to: Use the net-present-value method and the internal-rate-of-return method to evaluate an investment proposal; compare the net-present-value and internal-rate-of-return methods, and state the assumptions underlying each method; use both the total-cost approach and the incremental-cost approach to evaluate an investment proposal;...
Trang 1Capital Expenditure
Decisions
Chapter 16
Trang 2Net-Present-Value Method
1 Prepare a table showing cash flows for each year,
2 Calculate the present value of each cash flow using a
discount rate,
3 Compute net present value,
4 If the net present value (NPV) is zero or positive, accept the investment proposal Otherwise, reject it.
1 Prepare a table showing cash flows for each year,
2 Calculate the present value of each cash flow using a
discount rate,
3 Compute net present value,
4 If the net present value (NPV) is zero or positive, accept the investment proposal Otherwise, reject it.
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Trang 3Internal-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
by the asset over its life
discount rate that will cause the net present value of a project
to be zero
Trang 4Internal-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
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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Trang 5Internal-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 = Present value factor
$104, 320 $20,000 = 5.216
Trang 6Internal-Rate-of-Return Method
$104,320 $20,000 = 5.216 = 5.216
The present value factor (5.216) is located on
the Table IV in the Appendix Scan the
10-period 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.
The present value factor (5.216) is located on
the Table IV in the Appendix Scan the
10-period 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.
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Trang 7Internal-Rate-of-Return Method
Here’s the proof
Trang 8Comparing the NPV and IRR
Methods
Net Present ValueThe cost of capital is used
as the actual discount rate
Any project with a negative
net present value is
rejected
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 project’s rate of return must be greater than the cost of capital
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Trang 9Comparing 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.
The net present value method has
the following advantages over
the internal rate of return
method
Easier to use.
Easier to adjust for risk.
Trang 10Total-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:
(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 -
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Trang 11Total-Cost Approach
MAINFRAME ($) Today Year 1 Year 2 Year 3 Year 4 Year 5
Acquisition cost computer (400,000)
Acquisition cost software ( 40,000)
Operating costs (335,000) (335,000) (335,000) (335,000) (335,000) (335,000)
Time sharing revenue 20,000 20,000 20,000 20,000 20,000 20,000
Total cash flow 440,000 (315,000) (315,000) (355,000) (315,000) (265,000)
X Discount factor X 1.000 X .893 X .797 X .712 X .636 X .567
Present value (440,000) (281,295) (251,055) (252,760) (200,340) (150,255)
SUM OF PRESENT VALUES = ($1,575,705)
PERSONAL COMPUTER ($) Today Year 1 Year 2 Year 3 Year 4 Year 5
Acquisition cost computer (300,000)
Acquisition cost software ( 75,000)
Trang 12Total-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
$327,820.
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Trang 13Time sharing revenue 20,000 20,000 20,000 20,000 20,000 20,000
Total cash flow ( 65,000) ( 80,000) ( 80,000) ( 80,000) ( 80,000) ( 60,000)
X Discount factor X 1.000 X .893 X .797 X .712 X .636 X .567
Present value ( 65,000) ( 71,440) ( 63,760) ( 42,720) ( 50,880) ( 34,020)
SUM OF PRESENT VALUES = ($ 327,820)
Trang 14Total-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.
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Trang 15Managerial Accountant’s 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.
Trang 16Income Taxes and Capital Budgeting
Cash flows from an investment proposal affect the company’s
profit and its income tax liability
Income = Revenue - Expenses + Gains - Losses
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Trang 17After-Tax Cash Flows
Not all expenses require cash outflows The most common example is depreciation.
Trang 18Modified 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.
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Trang 19Investment in Working Capital
Some investment proposals require additional outlays for
working capital such as increases in cash, accounts
receivable, and inventory
Some investment proposals require additional outlays for
working capital such as increases in cash, accounts
receivable, and inventory
Trang 20Ranking 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
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 Project B Immediate cash outlay $ 100,000 $ 100,000
The total cash flows are the same, but the pattern of
the flows is different.
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Trang 21Ranking Investment Projects
Let’s calculate the present value of the cash flows associated
with Project A
This project has a positive net present value which means
the project’s return is greater than the discount rate.
This project has a positive net present value which means
the project’s return is greater than the discount rate.
Trang 22Ranking Investment Projects
Here is the net present value of the cash flows associated with
Project B has a negative net present value which means
the project’s return is less than the discount rate.
Project B has a negative net present value which means
the project’s return is less than the discount rate.
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Trang 23Alternative Methods for Making
Investment Decisions
Payback Method
Payback period = Initial investment Annual aftertax cash inflow
Payback period = $20,000 $4,000 = 5 years
A company can purchase a machine for $20,000 thatwill provide annual cash inflows of $4,000 for 7 years
A company can purchase a machine for $20,000 that
will provide annual cash inflows of $4,000 for 7 years
Trang 24Payback: Pro and Con
1 Fails to consider the time
value of money
2 Does not consider a
project’s cash flows
beyond the payback
period
1 Fails to consider the time
value of money
2 Does not consider a
project’s 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.
roughly screening investments.
may be essential that an investment recoup its initial
cash outflows as quickly as
possible.
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Trang 25income taxes
-Initial investment
Trang 26Accounting-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?
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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Trang 27Accounting-Rate-of-Return Method
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.
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.
Accounting
rate of return = $100,000 - $80,000 $140,000 = 14.3%
Trang 28Estimating 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
ABC systems generally improve the ability of an analyst to estimate the cash flows associated with a proposed project
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Trang 29Time horizons are too short
Bias towards incremental projects
Bias towards incremental projects
Greater cash flow uncertainty
Greater cash flow uncertainty
Benefits difficult to quantify
Benefits difficult to quantify
Trang 30Inflation Effects
Nominal DollarsReal dollars
Nominal DollarsReal dollars
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