Transcript Chapter Eleven - Capital Investment Decisions

11
Capital
Investment
Decisions
PowerPresentation® prepared by
David J. McConomy, Queen’s University
Copyright © 2004 by Nelson, a division of Thomson Canada Limited.
11-1
Learning Objectives

Explain what a capital investment decision
is and distinguish between independent and
mutually exclusive capital investment
projects.

Compute the payback period and
accounting rate of return for a proposed
investment and explain their roles in capital
investment decisions.
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11-2
Learning Objectives
(continued)

Use net present value (NPV) analysis for
capital investment decisions involving
independent projects.

Use the internal rate of return (IRR) to
assess the acceptability of independent
projects.
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11-3
Learning Objectives
(continued)

Explain why NPV is better than IRR for
capital investment decisions involving
mutually exclusive projects.

Explain the role and value of postaudits.

Convert gross cash flows to after-tax cash
flows.

Describe capital investment in an advanced
manufacturing environment.
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11-4
Capital Budgeting

Capital budgeting is the process of making
capital investment decisions.
Two types of capital budgeting projects:
1. Independent projects:
Projects that, if accepted or rejected, will not affect the
cash flows of another project.
2. Mutually exclusive projects:
Projects that, if accepted, preclude the accepting all
other competing projects.
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11-5
Payback Method: Uneven Cash
Flows
Payback Period is the time required to recover a
project’s original investment.
Example: Investment = $100,000
Year
Unrecovered
Investment
(beg. Of Year)
1: $100,000
2:
70,000
3:
30,000
4:
-5:
--
Annual Cash
Flow
$30,000
$40,000
$50,000
$60,000
$70,000
Payback = 2.6 years.
$30,000 (yr. 1) + $40,000 (yr. 2) + $30,000 (60% of yr. 3).
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11-6
Payback Method
Possible reasons for use

To help control the risks associated with
the uncertainty of future cash flows

To help minimize the impact of an
investment on the company’s liquidity

To help control the risk of obsolescence

To help control the effect of the
investment on performance measures
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11-7
Payback Method
Major deficiencies

Ignores the
performance of the
investment beyond
the payback period

Ignores the time
value of money
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11-8
Accounting Rate Of Return
(ARR)
ARR = Average Income/Investment
Average income equals average annual net
cash flows, less average amortization.
Example:
Suppose that some new equipment requires an
initial outlay of $80,000 and promises total cash
flows of $120,000 over the next five years (the life
of the machine). What is the ARR?
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11-9
Accounting Rate Of Return
(ARR) (continued)
Answer:
The average cash flow is $24,000
($120,000/5)
and the average amortization is $16,000
($80,000/5).
ARR
=
=
=
($24,000 - $16,000)/$80,000
$8,000/$80,000
10%
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11-10
Accounting Rate Of Return
(ARR)
Possible reasons for use

A screening measure to
ensure that new
investment will not
adversely affect
financial ratios

To ensure a favourable
effect on net income so
that bonuses can be
earned (increased)
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11-11
Accounting Rate Of Return
(ARR)
The major
deficiency of the
accounting rate of
return is that it
ignores the time
value of money.
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11-12
Net Present Value (NPV)
Definition:
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)
NPV IS A MEASURE OF THE PROFITABILITY OF AN
INVESTMENT, EXPRESSED IN CURRENT DOLLARS.
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11-13
Net Present Value (NPV):
Example
Majestic Company has an opportunity to invest $360,000 for new
equipment. The new equipment will generate an additional net
income of $120,000 per year. Calculate the net present value of
the project assuming a 12% discount rate.
Year
Cash Flow
Discount
Factor
Present
Value
0
$(360,000)
1.000
$(360,000)
1
120,000
0.893
107,160
2
120,000
0.797
95,640
3
120,000
0.712
85,440
4
5
120,000
200,000
0.636
0.567
76,320
113,400
$117,960
=====
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11-14
Decision Criteria for NPV
If the NPV > 0 this indicates:
1. The initial investment has been
recovered
2. The required rate of return has
been recovered
3. A return in excess of 1. and 2.
has been received
Thus, the project should be accepted.
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11-15
Decision Criteria for NPV
(continued)
If NPV = 0, this indicates:
1. The initial investment has been
recovered
2. The required rate of return has been
recovered
Thus, break even has been achieved and we
are indifferent about the project.
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11-16
Decision Criteria for NPV
(continued)
If NPV < 0, this indicates:
1. The initial investment may or may not
be recovered
2. The required rate of return has not
been recovered
Thus, the project should be rejected.
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11-17
Reinvestment Assumption
The NVP model
assumes that all cash
flows generated by a
project are
immediately reinvested
to earn the required
rate of return
throughout the life of
the project.
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11-18
Internal Rate Of Return (IRR)
The internal rate of return (IRR) is the discount
rate that sets the project’s NPV at zero. Thus, P = I
for the IRR.
Example: A project requires a $10,000
investment and will return $12,000
after one year. What is the IRR?
$12,000/(1 + i) = $10,000
1 + I = 1.2
I = 0.20
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11-19
Internal Rate Of Return (IRR)
Decision criteria:

If the IRR > Cost of Capital, the project
should be accepted.

If the IRR = Cost of Capital, the project
breaks even, and acceptance or
rejection is equal.

If the IRR < Cost of Capital, the project
should be rejected.
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11-20
Internal Rate Of Return (IRR)
Reinvestment Assumption
The cash inflows
received from the
project are
immediately reinvested
to earn a return equal
to the IRR for the
remaining life of the
project.
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11-21
NPV versus IRR
There are two major differences between the two
approaches:
• NPV assumes cash inflows are reinvested
at the required rate of return whereas the
IRR method assumes that the inflows are
reinvested at the internal rate of return.
• NPV measures the profitability of a project
in absolute dollars, whereas the IRR method
measures the profitability in relative terms.
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11-22
NPV versus IRR (continued)
Conflicting Signals (required rate of return) = 20%
Year
0
1
2
3
4
5
Design A
$(180,000)
60,000
60,000
60,000
60,000
60,000
Design B
$(210,000)
70,000
70,000
70,000
70,000
70,000
IRR
20%
20%
NPV
$ 36,300
$ 42,350
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11-23
NPV versus IRR (continued)
Which project should be selected?
IRR signals either Design, whereas NPV signals Design B.
The terminal value of Design A is $36,300.
The terminal value of Design B is $42,350.
Design B provides the most wealth and should be
selected (AS SIGNALED BY NPV).
IRR may be misleading.
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11-24
Discount Rate:
The Cost Of Capital
The appropriate discount rate to
use for NPV computations is the
cost of capital. The COST OF
CAPITAL is the weighted
average of the returns expected
by the different parties
contributing funds. The weights
are determined by the
proportion of funds provided by
each source.
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11-25
Discount Rate:
The Cost Of Capital
Example: A company is planning on financing a project by borrowing
$10,000 and by raising $20,000 by issuing capital stock. The net cost of
borrowing is 6% per year. The stock carries an expected return of 9%.
The sources of capital for this project and their cost are in the same
proportion and amounts that the company usually experiences.
Calculate the cost of capital.
Source
Amount
Cost
Weight
Cost x Weight
Debt
$10,000
6%
1/3
2%
Stock
20,000
9%
2/3
6%
Weighted-Average Cost of Capital
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8%
===
11-26
Inflationary Adjustment
An Illustrative Example
Assume that the rate of inflation is 15% per year.
Analysis without Inflationary Adjustment (assumes a 20% discount rate)
Year
Cash Flow
Discount Factor
Present Value
0
(5,000,000 )
1.000
(5,000,000)
1-2
2,900,000
1.528
4,431,200
NPV
(568,800)
========
Analysis with Inflationary Adjustment
Year
Cash Flow
Discount Factor
1.000
Present Value
0
(5,000,000 )
1
3,335,000
* 0.833
2,778,055
2
3,835,250
**0.694
2,661,664
NPV
*
1.15 x $2,900,000
**
1.15 x 1.15 x $2,900,000
(5,000,000)
439,719
========
Notice that adjustment for inflation can affect the decision.
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11-27
After-Tax Operating Cash Flows
The Income Approach
After-tax cash flow = After-tax net income + Noncash expenses
Example:
Revenues
Less: Operating expenses*
Income before taxes
Less: Income taxes
Net income
$1,000,000
600,000
$ 400,000
136,000
$ 264,000
========
* Includes $100,000 amortization expense
After-tax cash flow
=
=
$264,000 + $100,000
$364,000
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11-28
After-Tax Flows
Decomposition Approach
After-tax cash revenues
After-tax cash expenses
Tax savings (noncash expenses)
= (1 - Tax rate) x Cash revenues
= (1 - Tax rate) x Cash expenses
= (Tax rate) x Noncash expenses
Total operating cash =
after-tax cash revenues
- after-tax cash expenses
+ tax savings on noncash expenses
Example:
Revenues = $1,000,000,
cash expenses = $500,000, and
amortization = $100,000.
Tax rate = 34%.
After-tax cash revenues
(1 - .34) x ($1,000,000)
Less: After-tax cash expense
(1 - .34) x ($500,000)
Add: Tax savings (noncash exp.)
.34 x ($100,000)
Total
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=
=
=
$660,000
(330,000)
34,000
$364,000
=======
11-29
Amortization
Tax-Shielding Effect
Amortization is a noncash expense and is not a cash flow. Amortization, however
SHIELDS revenues from being taxed and, thus, creates a cash inflow equal to the
tax savings.
Assume initially that tax laws DO NOT allow amortization to be deducted to arrive
at taxable income. If a company had before-tax operating cash flows of $300,000
and amortization of $100,000, we have the following statement:
Net operating cash flows
Less: amortization
Taxable income
Less: Income taxes (@ 34%)
Net income
$ 300,000
0
$ 300,000
(102,000)
$ 198,000
========
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11-30
Amortization
Tax-Shielding Effect
Now assume that the tax laws allow a deduction for amortization:
Net operating cash flows
Less: Amortization
$300,000
100,000
Taxable income
Less: Income taxes (@ 34%)
Net income
$200,000
(68,000)
$132,000
=======
Notice that the taxes saved are $34,000 ($102,000 - $68,000). Thus, the firm has
additional cash available of $34,000.
This savings can be computed by multiplying the tax rate by the amount of
amortization claimed:
.34 x $100,000 = $34,000
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11-31
Tax Laws: Capital Cost Allowance
In Canada, amortization is not allowed as a deduction in
determining taxable income, but
 Capital cost allowance is allowed as a deduction instead. CCA is
similar to amortization but is governed by a special set of rules
dictated by the income tax act and regulations.
 Each capital asset is assigned to a capital asset class along with
other similar assets
 A pre-determined CCA rate applies to the balance of the capital cost
in a particular class
 There are currently more than 40 separate classes, each with a
specific maximum rate
 CCA applies a declining-balance system, and the size of the tax
shield will be different for each year
 CCA applies to an asset pool in a given class. If there are other
assets in the class, a project may continue to affect the firm’s cash
flows even after the project’s assets are retired.

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11-32
Capital Cost Allowance A Sample of Asset Tax Classes
Class
Examples of Assets Included
Class 1
Buildings and other structures
Class 7
Boats, ships
15%
Class 8
Equipment and machinery
20%
Class 9
Aircraft
25%
Class 10
Computer equipment, trucks
30%
Class 12
Small tools, computer software
Class 33
Timber resource property
15%
Class 37
Amusement park buildings and equipment
15%
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Maximum Rate
4%
100%
11-33
Capital Cost Allowance
Present Value of CCA Tax Shield
= (R x C x T) / (R + i)
Where
R = CCA (R)ate
C = Original (C)apital cost of the project
$300,000
T = (T)ax rate
i = Required rate of return [(i)nterest factor]
PV of CCA Tax Shield
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Example
30%
40%
10%
= (30% x 300,000 x 40%) / (30% + 10%)
= $90,000
11-34
APPENDIX A
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11-35
Future Value: Time Value of
Money
Let:
F
i
P
n
=
=
=
=
future value
the interest rate
the present value or original outlay
the number or periods
Future value can be expressed by the following formula:
F = P(1 + i)n
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11-36
Future Value: Example
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?
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11-37
Future Value (continued)
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)
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11-38
Present Value
P = F/(1 + i)n
The discount factor, 1/(1 + i), is computed for various
combinations of I and n. See Exhibit 11B-1.
Example:
Compute the present value of $300 to be received three years
from now. The interest rate is 12%.
Answer:
P
=
=
From Exhibit 11B-1, the discount factor is 0.712. Thus, the
present value (P) is:
=
F (df)
$300 x 0.712
$213.60
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11-39
Present Value (continued)
Example: Calculate the present value of a $100 per year annuity, to be received for
the next three years. The interest rate is 12%.
Answer:
Year
1
2
3
Cash
$100
100
100
Discount
Factor
0.893
0.797
0.712
2.402 *
Present
Value
$ 89.30
79.70
71.20
$240.20
======
* Notice that it is possible to multiply the sum of the individual discount factors
(.40) by $100 to obtain the same answer. See Exhibit 11 B-2 for these sums which
can be used as discount factors for uniform series.
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11-40