COST MANAGEMENT

Accounting & Control

Hansen▪Mowen▪Guan

Chapter 20
Capital Investment

COPYRIGHT © 2009 South-Western Publishing, a division of Cengage Learning. 1

Cengage Learning and South-Western are trademarks used herein under license.
 Study Objectives
1. Describe the difference between independent and mutually
exclusive capital investment decisions.
2. Explain the roles of the payback period and accounting rate of
return in capital investment decisions.
3. Calculate the net present value (NPV) for independent projects.
4. Compute the internal rate of return (IRR) for independent projects.
5. Tell why NPV is better than IRR for choosing among mutually
exclusive projects.
6. Convert gross cash flows to after-tax cash flows.
7. Describe capital investment for advanced technology and
environmental impact settings.

2
 Capital Investment Decisions
• Capital investment decisions are
concerned with
– The planning process of planning
– Setting goals and priorities
– Arranging financing
– Using certain criteria to select long-term
assets

3
 Capital Investment Decisions
• Capital budgeting
– The process of making capital investment
decisions
• Types of capital budgeting projects
– Independent projects
• Projects that, if accepted or rejected, will not affect
the cash flows of another project.
– Mutually exclusive projects
• Projects that, if accepted, preclude the acceptance
of competing projects.

4
Payback and Accounting Rate of
Return: Nondiscounting Methods
Payback Analysis

* At the beginning of Year 3, $60,000 is needed to recover the

investment.
Since a net cash inflow of $100,000 is expected, only 0.6
year ($60,000 ÷ $100,000) is needed to recover the
$60,000.
Thus, the payback period is 2.6 years (2 + 0.6).

5
 Payback and Accounting Rate of
Return: Nondiscounting Methods
Payback Analysis
• Provides information than can:
– Help control the risks associated with the uncertainty of future
cash flows.
– Help minimize the impact of an investment on a firm’s liquidity
problems.
– Help control the risk of obsolescence.
– Help control the effect of the investment on performance
measures.
• Deficiencies:
– Ignores the time value of money
– Ignores the performance of the investment beyond the payback
period
6
 Payback and Accounting Rate of
Return: Nondiscounting Methods
Accounting Rate Of Return (ARR)

Average annual net cash

flows, less average
Average income depreciation
ARR =
Original investment or
Average investment

Average investment
Major deficiency: ignores (I + S) ÷ 2
the time value of money I = original investment
S = salvage value

7
The Net Present Value Method
Net present value is the difference between the
present value of the cash inflows and outflows
associated with a project.
NPV = P – I
where:
P = the present value of the project’s future
cash inflows
I = the present value of the project’s cost
(usually the initial outlay)

The NPV model assumes that all cash flows

generated by a project are immediately reinvested. 8
The Net Present Value Method
Polson Company has developed a new cell
phone that is expected to generate an annual
revenue of $750,000.
Necessary production equipment would cost
$800,000 and can be sold in five years for
$100,000.
Working capital is expected to increase by
$100,000 and is expected to be recovered at the
end of five years.
Annual operating expenses are expected to be
$450,000.
The required rate of return is 12 percent. 9
The Net Present Value Method

10
The Net Present Value Method

c 11
difference due to rounding
The Net Present Value Method
Decision Criteria for NPV

If NPV > 0:
1. The initial investment has been recovered
2. The required rate of return has been
recovered
For the cell phone project, NPV = $294,600
Polson should manufacture the cell phones.

12
 Internal Rate of Return
The internal rate of return (IRR) is the interest
rate that sets the project’s NPV at zero.

Thus, P = I for the IRR.

Example: A project requires a $240,000
investment and will return $99,900 at
the end of each of the next three
years. What is the IRR?

$240,000 = $99,900(df)
$240,000 ÷ $99,900 = 2.402
i = 12%
13
 Internal Rate of Return
Decision Criteria:
If the IRR > Cost of Capital, accept the project
If the IRR = Cost of Capital, accept or reject
If the IRR < Cost of Capital, reject the project

14
 NPV versus IRR:
Mutually Exclusive Projects
• Two major differences between net
present value and the internal rate of
return:
– Reinvestment of cash inflows
• NPV assumes reinvestment at the required rate of
return
• IRR assumes reinvestment at the internal rate of
return
– Measurement of profitability
• NPV measures profitability in absolute dollars
• IRR measures profitability as a percentage
15
 NPV versus IRR:
Mutually Exclusive Projects

16
 NPV versus IRR:
Mutually Exclusive Projects

a$1,440,000 + [(1.20 x $686,342) - (1.08 x $686,342)]. This last term is what is needed to repay the capital and its cost
at the end of Year 2. 17
b$686,342 + (1.20 x $686,342).
 NPV versus IRR:
Mutually Exclusive Projects
Milagro Travel Agency Example

Standard Custom
T2 Travel

Annual revenues $240,000 $300,000

Annual operating costs 120,000 160,000
System investment 360,000 420,000
Project life 5 years 5 years

The cost of capital is 12 percent

18
 NPV versus IRR:
Mutually Exclusive Projects

19
 NPV versus IRR:
Mutually Exclusive Projects

20
 NPV versus IRR:
Mutually Exclusive Projects

21
 Computing After-Tax Cash Flows
• Steps in computing cash flows
– Forecast revenues, expenses, and capital
outlays
– Adjust cash flows for inflation and tax effects
• The cost of capital is composed of two
elements
– The real rate
– The inflationary element

22
Computing After-Tax Cash Flows
Disposition of Old Machine
Book Value Sale Price
M1 $ 600,000 $ 780,000
M2 1,500,000 1,200,000

Acquisition of Flexible System

Purchase cost $7,500,000
Freight 60,000
Installation 600,000
Additional working capital 540,000
Total $8,700,000

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Computing After-Tax Cash Flows

aSale price minus book value is $780,000 - $600,000.

bSale price minus book value is $1,200,000 - $1,500,000.

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Computing After-Tax Cash Flows
The two machines are sold:
Sales price, M1 $ 780,000
Sales price, M2 1,200,000
Tax savings 48,000
Net proceeds $2,028,000

The net investment is:

Total cost of flexible system $8,700,000
Less: Net proceeds 2,028,000
Net investment (cash outflow) $6,672,000

25
Computing After-Tax Cash Flows
After-Tax Operating Cash Flows: Life of the Project
A company plans to make a new product that requires new
equipment costing $1,600,000. The new product is
expected to increase the firm’s annual revenue by
$1,200,000. Materials, labor, etc. will be $500,000 per year.

The income statement for the project is as follows:

Revenues $1,200,000
Less: Cash operating expenses (500,000)
Depreciation (straight-line) (400,000)
Income before income taxes $ 300,000
Less: Income taxes (40%) (120,000)
Net income $ 180,000
26
Computing After-Tax Cash Flows
After-Tax Operating Cash Flows: Life of the Project

Revenues × (1 - tax rate) $720,000

– Cash expenses × (1 - tax rate) (300,000)
+ Noncash expenses × tax rate* 160,000
= Cash Flow $580,000

* Non-cash expenses shield revenues from taxation, thus

generating cash flows (i.e., cash savings)

27
Computing After-Tax Cash Flows
MACRS Depreciation

The tax laws classify most assets into three classes

(class = allowable years):
Class Types of Assets
3 Most small tools
5 Cars, light trucks, computer equipment
7 Machinery, office equipment
Assets in any of the three classes can be depreciated using
either straight-line or MACRS (Modified Accelerated Cost
Recovery System) with a half-year convention.

28
 Computing After-Tax Cash Flows
MACRS Depreciation
– Half the depreciation for the first year can be claimed regardless
of when the asset is actually placed in service.
– The other half year of depreciation is claimed in the year
following the end of the asset’s class life.
– If the asset is disposed of before the end of its class life, only half
of the depreciation for that year can be claimed.

29
Computing After-Tax Cash Flows

30
 Capital Investment:
Advanced Technology and Environmental
Considerations
How Estimates of Operating Cash Flows Differ
A company is evaluating a potential investment in a flexible
manufacturing system (FMS). The choice is to continue
producing with its traditional equipment, expected to last 10
years, or to switch to the new system, which is also expected
to have a useful life of 10 years. The company’s discount rate
is 12 percent.

Present value ($4,000,000 × 5.65) $22,600,000

Investment 18,000,000
Net present value $ 4,600,000

31
 Capital Investment:
Advanced Technology and Environmental
Considerations

32
 Capital Investment:
Advanced Technology and Environmental
Considerations

33
 Present Value Concepts
Future Value
Let:
F = future value
i = the interest rate
P = the present value or original outlay
n = the number or periods

Future value can be expressed by the formula:

F = P(1 + i)n

34
 Present Value Concepts
Future Value
Assume the investment is $1,000. The interest
rate is 8%. What is the future value if the money
is invested for one year? Two? Three?

F = $1,000(1.08) = $1,080.00 (after one year)

F = $1,000(1.08)2 = $1,166.40 (after two years)
F = $1,000(1.08)3 = $1,259.71 (after three years)

35
 Present Value Concepts
Present Value
P = F/(1 + i)n The discount factor df, 1/(1 + i), is computed
for various combinations of i and n.
P = F(df)

Compute the present value of $300 to be received three years

from now. The interest rate is 12%.

From Exhibit 20B-1, the discount factor is 0.712

The present value (P) is:
P = F(df)
= $300 × 0.712
= $213.60
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Present Value Concepts

37
COST MANAGEMENT
Accounting & Control
Hansen▪Mowen▪Guan

End Chapter 20

COPYRIGHT © 2009 South-Western Publishing, a division of Cengage Learning. 38

Cengage Learning and South-Western are trademarks used herein under license.