FINANCIAL

ANALYSIS

Appendix C
McGraw-Hill/Irwin

Copyright 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning Objectives

LOC1: Evaluate capital investments

using the various types of cost, risk and
expected value, and depreciation.

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Concepts and Definitions

Fixed costs: any expense that remains

constant regardless of the level of output
Variable costs: expenses that fluctuate
directly with changes in the level of output
Sunk costs: past expenses or investments
that have no salvage value and therefore
should not be taken into account in
considering investment alternatives

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Concepts and Definitions (continued)

Opportunity cost: the benefit forgone, or

advantage lost, that results from choosing one
action over the best alternative course of
action
Avoidable costs: include any expense that is
not incurred if an investment is made but
must be incurred if the investment is not made
Expected value: the expected outcome
multiplied by the probability of its occurrence
Probability that actual
Expected
Expected
outcome will be the
outcome
value
expected outcome
Investment A : $25,000 0.80 $20,000
Investment B : $23,000 0.90 $20,700
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Concepts and Definitions (continued)

Economic life of a machine: the time period

over which it provides the best method for
performing its task
Obsolescence: occurs when a machine is worn
out
Depreciation: a method for allocating costs of
capital investment, including buildings,
machinery, and so on

May not reflect an assets true value because

obsolescence may at any time cause a large
difference between the true value and book value
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Depreciation Methods

Straight-line method: an assets value is

reduced in uniform annual amounts over its
estimated useful life
Sum-of-the-years-digits (SYD) method:
reduces the book value of an asset rapidly in
the early years and slower later in its life
Declining-balance method: an assets value
is decreased by reducing its value by a
constant percentage each year

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Depreciation Methods
(continued)

Double-declining-balance method:
uses a percentage twice the straight line
for the lift span but applies this rate to
the underappreciated original cost
Depreciation-by-use method: the life
of a machine is estimated in number of
operations and then actual usage is used
to calculate depreciation

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Activity-Based Costing

To know the cost, some method of

allocating overhead must be applied.
Traditional approach is to use labor
hours.

Can lead to questionable investment

decisions
Requires effort to track labor hours

Activity-based costing alleviates these

problems.
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Activity-Based Costing
(continued)
Causal factors are identified and used as a the
means of allocating overhead.

Cost drivers
Might include machine hours, beds occupied,
computer time, and so on

Activity-based costing is a two-stage

allocation processes.
1.
2.

Assigning overhead costs to cost activity pools

Costs are assigned from these pools based on the
number of pool-related activity required in their
completion

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Traditional and Activity-Based Costing

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Overhead Allocations by an Activity

Approach

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The Effects of Taxes

Tax rates occasionally change.

For investment proposals, tax
considerations often prove to be the
deciding factor.

Depreciation expenses directly affect

taxable income and, therefore, it affects
profits.

The ability to write-off depreciation in

early years provides an added source of
funds for investments.
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Choosing Among Investment Proposals

The capital investment decision has

become highly rationalized.
Made with a higher degree of confidence

Variables are relatively well known.

Variables can be quantified with fair
accuracy.

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Investment Decision
Categories
1.

2.

3.
4.
5.

6.

Purchase of new equipment and/or

facilities
Replacement of existing equipment or
facilities
Make-or-buy decisions
Lease-or-buy decisions
Temporary shutdowns or plantabandonment decisions
Addition or elimination of a product or
product line
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Determining the Cost of

Capital

The cost of capital is calculated from a

weighted average of debt and equity
security costs.
The average will vary depending on the
financing strategy employed.

Short-term debt
Long-term debt
Equity securities

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Interest Rate Effects

Compound value of a single amount

Compound value of an annuity
Present value of a future single payment
Present value of an annuity
Discounted cash flow

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Methods of Ranking
Investments

Net present value

Payback period
Internal rate of return
Ranking investments with uneven lives

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Example C.1: An Expansion Decision

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Example C.1: Yearly Income Before

Depreciation and Taxes

Acquisition cost is $500,000.

Installation cost is $20,000.
Lease expense is a sunk cost.
Annual production expenses are
$600,000.
Annual sales revenue is $10 X 100,000
units of output = $1,000,000.
Yearly income before depreciation and
taxes is $1,000,000 less $600,000 =
$400,000.
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Example C.1: Depreciation Charges and

Cash Flow

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Example C.1: Net Present

Value

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