ACCT2552 Week11

CapitalExpenditureDecisions

NicoleAng

TopicObjectives
1.Understandnature&purposeofCapExdecisions 2.BeabletodescribeatypicalCapExprocess 3.Beabletoapply&understandvarioustechniques 4.Understandthevalueofaudits 5.Understandtheconflictintroducedbyusingmeasuresfor projectevaluationthataredifferentfromthoseusedfor managerevaluation

Readings
LangfieldSmithetalChapter21
pp.9951034

LectureOutline
1.Whatiscapitalexpenditure? 2.Whyundertakecapitalexpenditure? 3.Investment/approvalprocess 3.1Investmentanalysistechniques 3.2Limitations 4.Managementoftheinvestment 5.Behaviouralimplications 6.Example

1.CapitalExpenditure(obj.1)
Whatisit? Expenditureonresourcesthatwillgeneratelongtermfuture cashflows Relatingthismaterialtoearliertopics: BPRandcostbehaviour Theoryofconstraints Quality Key:Activitiesthatgeneratevaluecannotbecarriedoutif organisationsdonothavetheresourcesnecessarytosupport them.
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2.Whyinvestinsuchresources?(obj.1)
Strategy
Furtherorganisationslongtermgoalforsuccess e.g.,enhancementofquality,expansion Marketposition

Profitability
Revenuegeneration Costreduction

Regulation Infrastructure Eachofthesemayhaveadifferentreturn

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3.Processofinvestment(obj.2)
1.Projectgeneration 2.Estimation&analysisofprojectedcashflows 3.Progresstoapproval 4.Analysisandselectionofprojects 5.Implementationofprojects 6.Postimplementationorpostcompletionauditofprojects

3.1.Investmentanalysistechniques (obj.3)
Considerincremental costsandbenefits Incrementalcashoutflows
initialcost operatingcostsoverprojectlife

Incrementalcashinflows
costsavings additionalrevenues

Incrementalcashflows simpleexample
WecurrentlyownmachineL
Ifwesellittodaywellget$1,000forit Costs$1,000ayeartomaintain Canproduce100unitsayear,allcanbesold Eachunituses$2ofmaterial,canbesoldfor$50

WeareconsideringreplacingLwithM
Theinitialcostis$10,000 Costs$500ayeartomaintain Canproduce200unitsayear,allcanbesold Eachunituses$1ofmaterial,canbesoldfor$50
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Incrementalcashflows
Whichcashflows arerelevant: InitialcostofM? CashfromsaleofL? Maintenance? Materials? Revenue?
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Ifwekeep MachineL?
Relevant?

Ifwebuy MachineM?

Sooverall, whatchanges ifwebuyM?

Estimatingincrementalcashflows
Morefactorstoconsider:
Inflation Workingcapital Opportunitycosts Disposalofequipment Relevantinflows/outflowsaftertax

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Moreontax recallLandMexample
RelevantCF
Increment

Taxeffect?

InitialcostofM CashfromsaleofL Maintenance Materials Revenue

$10,000 +$1,000 +$500/yr $0/yr +$5,000/yr

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Moreontax depreciationexpense
Depreciationmayreducetaxpaid
Decreaseinincometax=Depn expxtaxrate Reductionincashoutflow E.g.,Imagineprofitbeforedepreciationexpis$10,000. Depn expense$6,000. Tax30%. Cashimpactofdepreciationeffect?

Notedepreciationfortaxpurposesmaynotmatchdepreciation foraccountingpurposes...Butwewillassumeitdoes!
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Moreontax depreciationexpense
Profitifnodepn expense$10,000. Depn expense$6,000.Tax30%.Cashimpact? Longapproach:
Iftherehadbeenno depn exp,taxpaid=$ Withdepn exp,taxableprofit=$ Taxpaid=$ Theeffectofdepn expenseistodecreasetaxpaid=$

Muchfasterapproach:
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Moreontax gain/lossonsaletruckscenario1
Profit/lossondisposalalsohastaxeffects
Boughtatruckfor$50,000 Sincethen$35,000inaccumulateddepreciation Solditfor$10,000

Trucksbookvalueattimeofsale? Profit/Lossonsale? Aftertaxcashflowfromsale?(tax40%)

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Moreontax gain/lossonsale truckscenario2

Whatiswedsoldthetruckfor$20,000?
Boughtatruckfor$50,000 Sincethen$35,000inaccumulateddepreciation Solditfor$20,000

Trucksbookvalueattimeofsale? Profit/Lossonsale? Aftertaxcashflowfromsale?(tax40%)

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3.1Investmentanalysistechniques(obj.3) 3.1.1Payback 3.1.2Accountingrateofreturn 3.1.3DiscountedCashFlow

NPVandIRR

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3.1.1Paybackmethod
Timeforcashinflowsfromprojecttorecoveroriginal investment Paybackperiod
Evencashflow:

Initial outflow Annual after - tax cash inflow

E.g.,Projectcosting$10,000hasannualaftertaxinflowsof$2,000. Expectedpaybackof? years.

Unevencashflow:usecumulativecashflows

Acceptprojectifpaybackperiod<requiredtime
Advantagesandlimitations?
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Simpleexample:Payback,unevenCF
ProjectedcashflowsofProjectX: Initialinvestment:1,000.Paybackrequiredin2years. Year1:500Year2:400Year3:300Yr4:100 T=0 Lessinflowyr1 Lessinflowyr2 Inflowyr3 $1,000=Originaloutlay $_____ $=unrecoveredatendofyr1 $______ $______=unrecoveredatendofyr2 $ Yr3:___/____x12=___monthsforresidual Payback= yrs& months.Accept?
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3.1.2Accountingrateofreturnmethod
Focusonincrementalaccountingprofitthatresultsfromaproject Accountingrateofreturn

Advantages? Limitations?

Average annual after - tax profit from project Initial investment

Note:textalsousesaverageinvestmentindenominator.Stickwithinitial investmentunlesstoldotherwise.

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3.1.3Discountedcashflow(DCF)analysis
Explicitlyconsiderstimevalueofmoney $100todayisnotworth$100nextyear E.g.,investat10% now Howmuchis$100todayworthnextyear? $100x1.1=$110nextyear(assumingnoinflation!) Todaysvalueof$100receivednextyear? $(Atoday)x1.1=$100nextyear $A=100/1.1=$90.91 Todaysvalueof$100receivedin2years? $(Btoday)x1.1x1.1=$100intwoyears $B=100/(1.1)2 =$82.64

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3.1.3Discountedcashflow(DCF)analysis
Requiredrateofreturn
Ordiscountrate,hurdlerate,weightedavg costofcapital... Adjustedforriskofparticularproject Minimalacceptablerateofreturn

DCFmethodsinclude
Netpresentvalue(NPV),Internalrateofreturn(IRR)

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3.1.3Discountedcashflow(DCF)analysis
Importantassumptions
Yearendtimingofcashflows Certaintyofcashflows

Someadditionalassumptionswemakeinthiscourse(unless youaretoldotherwise):
Taxispaidinthesame yearthattheexpenseisincurred Companiesareprofitablei.e.,notmakinglosses Salesrevenue=cashinflow;operatingcostsotherthan depreciation/amortisation=cashoutflow. Depreciationisonastraightlinebasis.
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3.1.3aNetpresentvalue(NPV)method
CalculatesPVoffuturecashflowsofaproject
Usingrequiredrateofreturn,i

PV

CF (1 i) n

CalculatetotalNPV
PVofprojectcashflows initialinvestment

AcceptprojectifNPV>0

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Simpleexamplecontinued:NPV
RecallProjectX:Initialinvestment:1,000 Yr1:500Yr2:400Yr3:300Yr4:100 Assumerequiredreturnis10% Accept?

NPV (1,000)

500 400 300 100 $78.82 1.1 1.12 1.13 1.14

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Aside PresentValueTables
Wearetoldtherequiredreturnis10% 10%iscalledourdiscountrate

NPV (1,000)

500 400 300 100 $78.82 1.1 1.12 1.13 1.14

Weusethatratetoworkoutadiscountfactor foreachyear, e.g.,inyear1itis1/(1.1)=0.9091 Inyear2itis1/(1.1x1.1)=0.8264etc ItisfastertousePresentValuetables iftherearemanyyears

Useall4decimalplaces(intheexam).
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Aside Presentvaluetable:PVof$1
P re s e n t v a lu e o f $ 1 .0 0 P e rio d s 1 2 3 4 5 2% 0 .9 8 0 4 0 .9 6 1 2 0 .9 4 2 3 0 .9 2 3 8 0 .9 0 5 7 4% 0 .9 6 1 5 0 .9 2 4 6 0 .8 8 9 0 0 .8 5 4 8 0 .8 2 1 9 6% 0 .9 4 3 4 0 .8 9 0 0 0 .8 3 9 6 0 .7 9 2 1 0 .7 4 7 3 8% 0 .9 2 5 9 0 .8 5 7 3 0 .7 9 3 8 0 .7 3 5 0 0 .6 8 0 6 10% 0 .9 0 9 1 0 .8 2 6 4 0 .7 5 1 3 0 .6 8 3 0 0 .6 2 0 9

RecallProjectX:$500inflowyear1,10%requiredreturn. Soinyear1,insteadofcalculating500/1.1,youcouldcalculate...
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Aside Presentvaluetable:PVof$1
P re s e n t v a lu e o f $ 1 .0 0 P e rio d s 1 2 3 4 5 2% 0 .9 8 0 4 0 .9 6 1 2 0 .9 4 2 3 0 .9 2 3 8 0 .9 0 5 7 4% 0 .9 6 1 5 0 .9 2 4 6 0 .8 8 9 0 0 .8 5 4 8 0 .8 2 1 9 6% 0 .9 4 3 4 0 .8 9 0 0 0 .8 3 9 6 0 .7 9 2 1 0 .7 4 7 3 8% 0 .9 2 5 9 0 .8 5 7 3 0 .7 9 3 8 0 .7 3 5 0 0 .6 8 0 6 10% 0 .9 0 9 1 0 .8 2 6 4 0 .7 5 1 3 0 .6 8 3 0 0 .6 2 0 9

Year2:$400inflow,requiredreturn10%. Insteadof400/1.12,youcouldcalculate...
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Aside Presentvaluetable:PVofAnnuity
Ifconstant cashflowyoucanusethePVofAnnuitytable E.g.,$100eachyearfor4 years,rateis8% (100/1.08 ++100/1.084)or?

P r e s e n t v a lu e o f a n n u ity o f $ 1 .0 0 P e r io d s 1 2 3 4 2% 0 .9 8 0 4 1 .9 4 1 6 2 .8 8 3 9 3 .8 0 7 7 4% 0 .9 6 1 5 1 .8 8 6 1 2 .7 7 5 1 3 .6 2 9 9 6% 0 .9 4 3 4 1 .8 3 3 4 2 .6 7 3 0 3 .4 6 5 1 8% 0 .9 2 5 9 1 .7 8 3 3 2 .5 7 7 1 3 .3 1 2 1
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Example1:DEFLtd
Pleaseturntolectureexample1.
YYYcosts$800,000 Fullydepreciatedover4yrsfortax Actuallife=5yrs Willsellfor$50,000 2.$300,000additionalrevenuefor5yrs Taxrate30% Requiredrateofreturn=12% A.CalculateNPVofYYY B.ShouldYYYbepurchased?
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PVof$1.00
Present value of $1.00 Periods 1 2 3 4 5 6 7 2% 4% 6% 8% 10% 12% 14%

0.9804 0.9615 0.9434 0.9259 0.9091 0.8929 0.8772 0 0.9612 0.9246 0.8900 0.8573 0.8264 0.7972 0.7695 0 0.9423 0.8890 0.8396 0.7938 0.7513 0.7118 0.6750 0 0.9238 0.8548 0.7921 0.7350 0.6830 0.6355 0.5921 0 0.9057 0.8219 0.7473 0.6806 0.6209 0.5674 0.5194 0 0.8880 0.7903 0.7050 0.6302 0.5645 0.5066 0.4556 0
31 0.8706 0.7599 0.6651 0.5835 0.5132 0.4523 0.3996 0

PVofanannuityof$1.00
P r e s e n t v a lu e o f a n n u it y o f $ 1 . 0 0 P e r io d s 1 2 3 4 5 6 7 2% 0 .9 8 0 4 1 .9 4 1 6 2 .8 8 3 9 3 .8 0 7 7 4 .7 1 3 5 5 .6 0 1 4 6 .4 7 2 0 4% 0 .9 6 1 5 1 .8 8 6 1 2 .7 7 5 1 3 .6 2 9 9 4 .4 5 1 8 5 .2 4 2 1 6 .0 0 2 1 6% 0 .9 4 3 4 1 .8 3 3 4 2 .6 7 3 0 3 .4 6 5 1 4 .2 1 2 4 4 .9 1 7 3 5 .5 8 2 4 8% 0 .9 2 5 9 1 .7 8 3 3 2 .5 7 7 1 3 .3 1 2 1 3 .9 9 2 7 4 .6 2 2 9 5 .2 0 6 4 10% 0 .9 0 9 1 1 .7 3 5 5 2 .4 8 6 9 3 .1 6 9 9 3 .7 9 0 8 4 .3 5 5 3 4 .8 6 8 4 12% 0 .8 9 2 9 1 .6 9 0 1 2 .4 0 1 8 3 .0 3 7 3 3 .6 0 4 8 4 .1 1 1 4 4 .5 6 3 8 0 1 2 2 3 3 4

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Example1:DEFLtd
A.$159,105
=(800,000)+182,238+19,859+757,000 B.

Yr0Purchase: Yr14Depn effect: Yr5Sale: Yr15Revenue effect:

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3.1.3bInternalrateofreturn(IRR)method
DiscountrateatwhichNPVofcashflowsiszero

initial outlay

CFt (1 IRR) t t 1

Calculatemanuallyorusingsoftware Eg.ForprojectX,

0 (1,000)

500 400 300 100 (1 IRR) (1 IRR ) 2 (1 IRR ) 3 (1 IRR ) 4

IRR=14.5%

AcceptprojectifIRR <?or>? thanrequiredrateofreturn

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Capitalrationing:comparingNPVandIRR
NPV&IRR:samedecisionoutcomeforindependentprojects Butmayresultindifferentrankingoutcomesformultipleor mutuallyexclusiveprojectproposals IRRreinvestmentassumption
Assumptionthatcashflowscanbereinvestedatthesame rateastheprojectsrateofreturn NPV:usefirmdiscountrate(canadjustforrisk)

Differencesinprojectsize/lifespan
IRRusesrelativeterms NPV:measuresprofitabilityinabsoluteterms

NPVispreferred!
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Example:NPVv.IRR
WACC=10%,ProjectsA&Bmutuallyexclusive Outlay Time Proj A Proj B 0 (7,000) (12,000) 1 3,430 5,520 Net Cash Flows 2 3,430 5,520 3 3,430 5,520

ProjectAIRR=22%,NPV=$1,530 ProjectBIRR=18%,NPV=$1,728 Whichdoyouchoose?

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OveralladvantagesofNPV
AdvantagesofNPV
Easiertocalculatemanually Abletoadjustforrisk Willalwaysyieldonlyoneanswer Reinvestmentassumption:
ReinvestatWACCnotIRR

ButNPVbiasedtowardslargerprojects Profitabilityindex:PV/initialinvestment
E.g.Proj A=8530/7000=1.22, B =
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3.2Limitationsofconventionalanalysis
Heavyrelianceonestimation Useofunrealisticstatusquo Hurdleratestoohigh Timehorizonstooshort Difficultyingainingapprovalforlargeprojects Strategicandcompetitiveconcernsmaybeoverlooked Highpotentialforexclusionofbenefitsthataredifficultto quantifyorputinfinancialterms

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Financialandnonfinancialoutcomeegs
Financialoutcomes
Lowerdirectlabourcosts Lessscrapandrework Lowerstockcosts Increaseinsoftwarecosts

Outcomesmoredifficulttoputinfinancialterms
Reductioninmanufacturingcycletime Increaseinmanufacturingflexibility Increaseinbusinessriskduetohigherfixedcoststructure Improvedproductdeliveryandservice
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Dealingwithlimitations
Trytoquantifybenefits Considermarketconditionsandeconomictrends Includestrategicandcompetitiveconcerns Matchrequiredrateofreturntouncertainty Conductsensitivityanalysis Determinehowmuchestimatescanchangebeforean investmentlooksbad Conductmultiplescenarioanalysis

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Multiplescenarioanalysis
Riskanduncertaintycanbeincorporatedbyidentifying multiplescenariosandcalculatingexpectedNPVe.g., Status Quo: Keep one product No competition Introduce new product Competition No competition Competition 1 2 3 4
NPV1 x Probability

NPV2 x Probability NPV3 x Probability NPV4 x Probability

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Whatdoorganisationsdo?
2002studyofFortune1000(Ryan&Ryan,J.BusMgt)
99.5%requireformalanalysisforlargeprojects Preferences
1.NPV:49%alwaysuse,85%useoftenorincombn. 2.IRR:44%alwaysuse,77%useoftenorincombn. 3.Payback(in50sand60swasmostpreferred!)

SmallfirmsuseDCFless
Liquidityissues Unfamiliarwithtechniques Smallprojectsizesthatdontwarrantextensiveanalysis
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4.Managementoftheinvestment (obj.4)
Postimplementation&postcompletionaudits

Compareactualwithestimatedcashflow Serveasacontrolmechanism
Whichprojectsshouldbereviewed?

Providefeedbackontheaccuracyofinitialestimates
Hopefullybenefitfuturedecisions

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5.Behaviouralimplications(obj.5)
Performanceevaluation
Performancemeasures Investmentproposalgeneration Escalationofcommitment
E.g.Yourcompanywantsanavg portfolioreturnof10%. Youknowofaprojectthatisexpectedtogenerate12%. Yourbonusisbasedonyouravg portfolioreturnanditis currently15%. Whatshouldyoudo?...Whatwillyoudo?!
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Summary
Financialconsiderations Nonfinancialconsiderations Behaviouralconsiderations

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