SUPPLEMENT
Financial Analysis
J
LEARNING GOALS
After reading this supplement,
you should be able to:
1. Explain the time value of money
concept.
2. Demonstrate the use of the net
present value, internal rate of
return, and payback methods of
financial analysis.
3. Discuss the importance of
combining managerial judgment
with quantitative techniques
when making investment
decisions.
Many decisions in operations management involve large
capital investments. Automation, vertical integration, capac-
ity expansion, layout revisions, and installing a new ERP sys-
tem are but some examples. In fact, most of a firm’s assets
are tied up in the operations function. Therefore, the opera-
tions manager should seek high-yield capital projects and
then assess their costs, benefits, and risks.
Such projects require strong cross-functional coordina-
tion, particularly with finance and accounting. The projects
must fit in with the organization’s financial plans and capabili-
ties. If a firm plans to open a new production facility in 2010,
it must begin lining up financing in 2006. The projects must
also be subjected to one or more types of financial analysis to
assess their attractiveness relative to other investment
opportunities. This supplement presents a brief overview of
basic financial analyses and the types of computer support
available for making such decisions. See your finance text-
book for a more comprehensive treatment of the subject.
J.1
J.2 SUPPLEMENT J > FINANCIAL ANALYSIS
time value of money
The concept that a dollar in hand can be
invested to earn a return, so that more
than one dollar will be available in the
future.
compounding interest
The process by which interest on an
investment accumulates, and then earns
interest itself for the remainder of the
investment period.
future value of an investment
The value of an investment at the end of
the period over which interest is
compounded.
present value of an investment
The amount that must be invested now
to accumulate to a certain amount in the
future at a specific interest rate.
discounting
The process of finding the present value
of an investment, when the future value
and the interest rate are known.
discount rate
The interest rate used in discounting the
future value to its present value.
<
> TIME VALUE OF MONEY <
An important concept underlying many financial analysis techniques is that a dollar in hand
today is worth more than a dollar to be received in the future. A dollar in hand can be
invested to earn a return, so that more than one dollar will be available in the future. This
concept is known as the time value of money.
FUTURE VALUE OF AN INVESTMENT
If $5,000 is invested at 10 percent interest for one year, at the end of the year the $5,000 will
have earned $500 in interest and the total amount available will be $5,500. If the interest
earned is allowed to accumulate, it also earns interest and the original investment will grow
to $12,970 in 10 years. The process by which interest on an investment accumulates, and
then earns interest itself for the remainder of the investment period, is known as compound-
ing interest. The value of an investment at the end of the period over which interest is com-
pounded is called the future value of an investment.
To calculate the future value of an investment, you first express the interest rate and the
time period in the same units of time as the interval at which compounding occurs. Let us
assume that interest is compounded annually, express all time periods in years, and use
annual interest rates. To find the value of an investment one year in the future, multiply the
amount invested by the sum of 1 plus the interest rate (expressed as a decimal). The value of
a $5,000 investment at 12 percent per year one year from now is
$5,000(1.12) = $5,600
If the entire amount remains invested, at the end of two years you would have
$5,600(1.12) = $5,000(1.12)2 = $6,272
In general,
F = P(1 + r)n
where
F = future value of the investment at the end of n periods
P = amount invested at the beginning, called the principal
r = periodic interest rate
n = number of time periods for which the interest compounds
PRESENT VALUE OF A FUTURE AMOUNT
Let us look at the converse problem. Suppose that you want to make an investment now that
will be worth $10,000 in one year. If the interest rate is 12 percent and P represents the
amount invested now, the relation becomes
F = $10,000 = P(1 + 0.12)
Solving for P gives
F 10,000
P= = = $8,929
(1 + r )n (1 + 0.12)1
The amount that must be invested now to accumulate to a certain amount in the future
at a specific interest rate is called the present value of an investment. The process of finding
the present value of an investment, when the future value and the interest rate are known, is
called discounting the future value to its present value. If the number of time periods n for
which discounting is desired is greater than 1, the present value is determined by dividing
the future value by the nth power of the sum of 1 plus the interest rate. The general formula
for determining the present value is
F
P=
(1 + r )n
The interest rate is also called the discount rate.
 > TECHNIQUES OF ANALYSIS < J.3

PRESENT VALUE FACTORS

Although you can calculate P from its formula in a few steps with most pocket calculators,
you also can use a table. To do so, write the present value formula another way:
F ⎡ 1 ⎤
P= =F ⎢ n⎥
(1 + r )n
⎣ (1 + r ) ⎦
Let [1/(1 + r)n] be the present value factor, which is called pf and which you can find in Table J.1.
This table gives you the present value of a future amount of $1 for various time periods and
interest rates. To use the table, locate the column for the appropriate interest rate and the row
for the appropriate period. The number in the body of the table where this row and column TUTOR J.1
intersect is the pf value. Multiply it by F to get P. For example, suppose that an investment will
generate $15,000 in 10 years. If the interest rate is 12 percent, Table J.1 shows that pf = 0.3220.
Multiplying it by $15,000 gives the present value, or
P = F(pf) = $15,000(0.3220)
= $4,830

ANNUITIES
An annuity is a series of payments of a fixed amount for a specified number of years. All such annuity
payments are treated as happening at the end of a year. Suppose that you want to invest an A series of payments on a fixed amount
amount at an interest rate of 10 percent so that you may draw out $5,000 per year for each of for a specified number of years.
the next four years. You could determine the present value of this $5,000 four-year annuity by
treating the four payments as single future payments. The present value of an investment
needed now, in order for you to receive these payments for the next four years, is the sum of
the present values of each of the four payments. That is,
$5,000 $5,000 $5,000 $5,000
P= + + +
1 + 0.10 (1 + 0.10)2 (1 + 0.10)3 (1 + 0.10)4
= $4,545 + $4,132 + $3,757 + $3,415
= $15,849
A much easier way to calculate this amount is to use Table J.2. Look for the factor in the
table at the intersection of the 10 percent column and the fourth-period row. It is 3.1699. For an-
nuities, this present value factor is called af, to distinguish it from the present value factor for a
single payment. To determine the present value of an annuity, multiply its amount by af, to get TUTOR J.2
P = A(af) = $5,000(3.1699)
= $15,849
where
P = present value of an investment
A = amount of the annuity received each year
af = present value factor for an annuity

> TECHNIQUES OF ANALYSIS <

You can now apply these concepts to the financial analysis of proposed investments. Three
basic financial analysis techniques are
1. the net present value method
2. the internal rate of return method
3. the payback method
These methods work with cash flows. Cash flow is the cash that will flow into and out of the cash flow
organization because of the project, including revenues, costs, and changes in assets and lia- The cash that will flow into and out of the
bilities. Be sure to remember two points when determining cash flows for any project: organization because of the project,
1. Consider only the amounts of cash flows that will change if the project is undertaken. including revenues, costs, and changes
These amounts are called incremental cash flows and are the difference between the in assets and liabilities.
cash flows with the project and without it.
 TABLE J.1 Present Value Factors for a Single Payment

J.4
Interest Rate (r)

Number of
Periods (n) 0.01 0.02 0.03 0.04 0.05 0.06 0.08 0.10 0.12 0.14 0.16 0.18 0.20 0.22 0.24 0.26 0.28 0.30

1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9259 0.9091 0.8929 0.8772 0.8621 0.8475 0.8333 0.8197 0.8065 0.7937 0.7812 0.7692
2 0.9803 0.9612 0.9426 0.9246 0.9070 0.8900 0.8573 0.8264 0.7972 0.7695 0.7432 0.7182 0.6944 0.6719 0.6504 0.6299 0.6104 0.5917
3 0.9706 0.9423 0.9151 0.8890 0.8638 0.8396 0.7938 0.7513 0.7118 0.6750 0.6407 0.6086 0.5787 0.5507 0.5245 0.4999 0.4768 0.4552
4 0.9610 0.9238 0.8885 0.8548 0.8227 0.7921 0.7350 0.6830 0.6355 0.5921 0.5523 0.5158 0.4823 0.4514 0.4230 0.3968 0.3725 0.3501
5 0.9515 0.9057 0.8626 0.8219 0.7835 0.7473 0.6806 0.6209 0.5674 0.5194 0.4761 0.4371 0.4019 0.3700 0.3411 0.3149 0.2910 0.2693
6 0.9420 0.8880 0.8375 0.7903 0.7462 0.7050 0.6302 0.5645 0.5066 0.4556 0.4104 0.3704 0.3349 0.3033 0.2751 0.2499 0.2274 0.2072
7 0.9327 0.8706 0.8131 0.7599 0.7107 0.6651 0.5835 0.5132 0.4523 0.3996 0.3538 0.3139 0.2791 0.2486 0.2218 0.1983 0.1776 0.1594
8 0.9235 0.8535 0.7894 0.7307 0.6768 0.6274 0.5403 0.4665 0.4039 0.3506 0.3050 0.2660 0.2326 0.2038 0.1789 0.1574 0.1388 0.1226
9 0.9143 0.8368 0.7664 0.7026 0.6446 0.5919 0.5002 0.4241 0.3606 0.3075 0.2630 0.2255 0.1938 0.1670 0.1443 0.1249 0.1084 0.0943
10 0.9053 0.8203 0.7441 0.6756 0.6139 0.5584 0.4632 0.3855 0.3220 0.2697 0.2267 0.1911 0.1615 0.1369 0.1164 0.0922 0.0847 0.0725
11 0.8963 0.8043 0.7224 0.6496 0.5847 0.5268 0.4289 0.3505 0.2875 0.2366 0.1954 0.1619 0.1346 0.1122 0.0938 0.0787 0.0662 0.0558
12 0.8874 0.7885 0.7014 0.6246 0.5568 0.4970 0.3971 0.3186 0.2567 0.2076 0.1685 0.1372 0.1122 0.0920 0.0757 0.0625 0.0517 0.0429
13 0.8787 0.7730 0.6810 0.6006 0.5303 0.4688 0.3677 0.2897 0.2292 0.1821 0.1452 0.1163 0.0935 0.0754 0.0610 0.0496 0.0404 0.0330
14 0.8700 0.7579 0.6611 0.5775 0.5051 0.4423 0.3405 0.2633 0.2046 0.1597 0.1252 0.0985 0.0779 0.0618 0.0492 0.0393 0.0316 0.0254
15 0.8613 0.7430 0.6419 0.5553 0.4810 0.4173 0.3152 0.2394 0.1827 0.1401 0.1079 0.0835 0.0649 0.0507 0.0397 0.0312 0.0247 0.0195
16 0.8528 0.7284 0.6232 0.5339 0.4581 0.3936 0.2919 0.2176 0.1631 0.1229 0.0930 0.0708 0.0541 0.0415 0.0320 0.0248 0.0193 0.0150
17 0.8444 0.7142 0.6050 0.5134 0.4363 0.3714 0.2703 0.1978 0.1456 0.1078 0.0802 0.0600 0.0451 0.0340 0.0258 0.0197 0.0150 0.0116
18 0.8360 0.7002 0.5874 0.4936 0.4155 0.3503 0.2502 0.1799 0.1300 0.0946 0.0691 0.0508 0.0376 0.0279 0.0208 0.0156 0.0118 0.0089
19 0.8277 0.6864 0.5703 0.4746 0.3957 0.3305 0.2317 0.1635 0.1161 0.0829 0.0596 0.0431 0.0313 0.0229 0.0168 0.0124 0.0092 0.0068
20 0.8195 0.6730 0.5537 0.4564 0.3769 0.3118 0.2145 0.1486 0.1037 0.0728 0.0514 0.0365 0.0261 0.0187 0.0135 0.0098 0.0072 0.0053
21 0.8114 0.6598 0.5375 0.4388 0.3589 0.2942 0.1987 0.1351 0.0926 0.0638 0.0443 0.0309 0.0217 0.0154 0.0109 0.0078 0.0056 0.0040
22 0.8034 0.6468 0.5219 0.4220 0.3418 0.2775 0.1839 0.1228 0.0826 0.0560 0.0382 0.0262 0.0181 0.0126 0.0088 0.0062 0.0044 0.0031
23 0.7954 0.6342 0.5067 0.4057 0.3256 0.2618 0.1703 0.1117 0.0738 0.0491 0.0329 0.0222 0.0151 0.0103 0.0071 0.0049 0.0034 0.0024
24 0.7876 0.6217 0.4919 0.3901 0.3101 0.2470 0.1577 0.1015 0.0659 0.0431 0.0284 0.0188 0.0126 0.0085 0.0057 0.0039 0.0027 0.0018
25 0.7798 0.6095 0.4776 0.3751 0.2953 0.2330 0.1460 0.0923 0.0588 0.0378 0.0245 0.0160 0.0105 0.0069 0.0046 0.0031 0.0021 0.0014
26 0.7720 0.5976 0.4637 0.3607 0.2812 0.2198 0.1352 0.0839 0.0525 0.0331 0.0211 0.0135 0.0087 0.0057 0.0037 0.0025 0.0016 0.0011
27 0.7644 0.5859 0.4502 0.3468 0.2678 0.2074 0.1252 0.0763 0.0469 0.0291 0.0182 0.0115 0.0073 0.0047 0.0030 0.0019 0.0013 0.0008
28 0.7568 0.5744 0.4371 0.3335 0.2551 0.1956 0.1159 0.0693 0.0419 0.0255 0.0157 0.0097 0.0061 0.0038 0.0024 0.0015 0.0010 0.0006
29 0.7493 0.5631 0.4243 0.3207 0.2429 0.1846 0.1073 0.0630 0.0374 0.0224 0.0135 0.0082 0.0051 0.0031 0.0020 0.0012 0.0008 0.0005
30 0.7419 0.5521 0.4120 0.3083 0.2314 0.1741 0.0994 0.0573 0.0334 0.0196 0.0116 0.0070 0.0042 0.0026 0.0016 0.0010 0.0006 0.0004
35 0.7059 0.5000 0.3554 0.2534 0.1813 0.1301 0.0676 0.0356 0.0189 0.0102 0.0055 0.0030 0.0017 0.0009 0.0005 0.0003 0.0002 0.0001
40 0.6717 0.4529 0.3066 0.2083 0.1420 0.0972 0.0460 0.0221 0.0107 0.0053 0.0026 0.0013 0.0007 0.0004 0.0002 0.0001 0.0001 0.0000
F
P= = F ( pf )
( 1+ r )n

where P = present value of a single investment

F = future value of a single payment
n = number of periods for which P is to be invested
r = periodic interest rate
pf = present value factor for $1 = 1/(1 + r)n
 TABLE J.2 Present Value Factors of an Annuity

Interest Rate (r)

Number of
Periods (n) 0.01 0.02 0.03 0.04 0.05 0.06 0.08 0.10 0.12 0.14 0.16 0.18 0.20 0.22 0.24 0.26 0.28 0.30

1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9259 0.9091 0.8929 0.8772 0.8621 0.8475 0.8333 0.8197 0.8065 0.7937 0.7812 0.7692
2 1.9704 1.9416 1.9135 1.8861 1.8594 1.8334 1.7833 1.7355 1.6901 1.6467 1.6052 1.5656 1.5278 1.4915 1.4568 1.4235 1.3916 1.3609
3 2.9410 2.8839 2.8286 2.7751 2.7232 2.6730 2.5771 2.4869 2.4018 2.3216 2.2459 2.1743 2.1065 2.0422 1.9813 1.9234 1.8684 1.8161
4 3.9020 3.8077 3.7171 3.6299 3.5460 3.4651 3.3121 3.1699 3.0373 2.9137 2.7982 2.6901 2.5887 2.4936 2.4043 2.3202 2.2410 2.1662
5 4.8534 4.7135 4.5797 4.4518 4.3295 4.2124 3.9927 3.7908 3.6048 3.4331 3.2743 3.1272 2.9906 2.8636 2.7454 2.6351 2.5320 2.4356
6 5.7955 5.6014 5.4172 5.2421 5.0757 4.9173 4.6229 4.3553 4.1114 3.8887 3.6847 3.4976 3.3255 3.1669 3.0205 2.8850 2.7594 2.6427
7 6.7282 6.4720 6.2303 6.0021 5.7864 5.5824 5.2064 4.8684 4.5638 4.2883 4.0386 3.8115 3.6046 3.4155 3.2423 3.0833 2.9370 2.8021
8 7.6517 7.3255 7.0197 6.7327 6.4632 6.2098 5.7466 5.3349 4.9676 4.6389 4.3436 4.0776 3.8372 3.6193 3.4212 3.2407 3.0758 2.9247
9 8.5660 8.1622 7.7861 7.4353 7.1078 6.8017 6.2469 5.7590 5.3282 4.9464 4.6065 4.3030 4.0310 3.7863 3.5655 3.3657 3.1842 3.0190
10 9.4713 8.9826 8.5302 8.1109 7.7217 7.3601 6.7101 6.1446 5.6502 5.2161 4.8332 4.4941 4.1925 3.9232 3.6819 3.4648 3.2689 3.0915
11 10.3676 9.7868 9.2526 8.7605 8.3064 7.8869 7.1390 6.4951 5.9377 5.4527 5.0286 4.6560 4.3271 4.0354 3.7757 3.5435 3.3351 3.1473
12 11.2551 10.5753 9.9540 9.3851 8.8633 8.3838 7.5361 6.8137 6.1944 5.6603 5.1971 4.7932 4.4392 4.1274 3.8514 3.6059 3.3868 3.1903
13 12.1337 11.3484 10.6350 9.9856 9.3936 8.8527 7.9038 7.1034 6.4235 5.8424 5.3423 4.9095 4.5327 4.2028 3.9124 3.6555 3.4272 3.2233
14 13.0034 12.1062 11.2961 10.5631 9.8986 9.2950 8.2442 7.3667 6.6282 6.0021 5.4675 5.0081 4.6106 4.2646 3.9616 3.6949 3.4587 3.2487
15 13.8651 12.8493 11.9379 11.1184 10.3797 9.7122 8.5595 7.6061 6.8109 6.1422 5.5755 5.0916 4.6755 4.3152 4.0013 3.7261 3.4834 3.2682
16 14.7179 13.5777 12.5611 11.65423 10.8378 10.1059 8.8514 7.8237 6.9740 6.2651 5.6685 5.1624 4.7296 4.3567 4.0333 3.7509 3.5026 3.2832
17 15.5623 14.2919 13.1661 12.1657 11.2741 10.4773 9.1216 8.0216 7.1196 6.3729 5.7487 5.2223 4.7746 4.3908 4.0591 3.7705 3.5177 3.2948
18 16.3983 14.9920 13.7535 12.6593 11.6896 10.8276 9.3719 8.2014 7.2497 6.4674 5.8178 5.2732 4.8122 4.4187 4.0799 3.7861 3.5294 3.3037
19 17.2260 15.6785 14.3238 13.1339 12.0853 11.1581 9.6036 8.3649 7.3658 6.5504 5.8775 5.3162 4.8435 4.4415 4.0967 3.7985 3.5386 3.3105
20 18.0456 16.3514 14.8775 13.5903 12.4622 11.4699 9.8181 8.5136 7.4694 6.6231 5.9288 5.3527 4.8696 4.4603 4.1103 3.8083 3.5458 3.3158
21 18.8570 17.0112 15.4150 14.0292 12.8212 11.7641 10.0168 8.6487 7.5620 6.6870 5.9731 5.3837 4.8913 4.4756 4.1212 3.8161 3.5514 3.3198
22 19.6604 17.6580 15.9369 14.4511 13.1630 12.0416 10.2007 8.7715 7.6446 6.7429 6.0113 5.4099 4.9094 4.4882 4.1300 3.8223 3.5558 3.3230
23 20.4558 18.2922 16.4436 14.8568 13.4886 12.3034 10.3711 8.8832 7.7184 6.7921 6.0442 5.4321 4.9245 4.4985 4.1371 3.8273 3.5592 3.3254
24 21.2434 18.9139 16.9355 15.2470 13.7986 12.5504 10.5288 8.9847 7.7843 6.8351 6.0726 5.4509 4.9371 4.5070 4.1428 3.8312 3.5619 3.3272
25 22.0232 19.5235 17.4131 15.6221 14.0939 12.7834 10.6748 9.0770 7.8431 6.8729 6.0971 5.4669 4.9476 4.5139 4.1474 3.8342 3.5640 3.3286
26 22.7952 20.1210 17.8768 15.9828 14.3752 13.0032 10.8100 9.1609 7.8957 6.9061 6.1182 5.4804 4.9563 4.5196 4.1511 3.8367 3.5656 3.3297
27 23.5596 20.7069 18.3270 16.3296 14.6430 13.2105 10.9352 9.2372 7.9426 6.9352 6.1364 5.4919 4.9636 4.5243 4.1542 3.8387 3.5669 3.3305
28 24.3164 21.2813 18.7641 19.6631 14.8981 13.4062 11.0511 9.3066 7.9844 6.9607 6.1520 5.5016 4.9697 4.5281 4.1566 3.8402 3.5679 3.3312
29 25.0658 21.8444 19.1885 16.9837 15.1411 13.5907 11.1584 9.3696 8.0218 6.9830 6.1656 5.5098 4.9747 4.5312 4.1585 3.8414 3.5687 3.3317
30 25.8077 22.3965 19.6004 17.2920 15.3725 13.7648 11.2578 9.4269 8.0552 7.0027 6.1772 5.5168 4.9789 4.5338 4.1601 3.8424 3.5693 3.3321
35 29.4086 24.9986 21.4872 18.6646 16.3742 14.4982 11.6546 9.6442 8.1755 7.0700 6.2153 5.5386 4.9915 4.5411 4.1644 3.8450 3.5708 3.3330
40 32.8347 27.3555 23.1148 19.7929 17.1591 15.0463 11.9246 9.7791 8.2438 7.1050 6.2335 5.5482 4.9966 4.5439 4.1659 3.8458 3.5712 3.3332
n
A A A j
P= + + + =A ∑1/ (1+ r ) = A( af )
( 1+ r ) ( 1+ r )2 ( 1+ r )n
j =1

where P = present value of a single investment

A = amount of annuity to be received at the end of each period
n = number of periods for which the annuity is received
r = periodic interest rate n
af = annuity factor for an annuity of $1= 1/ ( 1+ r ) j ∑
j =1

J.5
J.6 SUPPLEMENT J > FINANCIAL ANALYSIS
straight-line method
The simplest method of calculating
annual depreciation; found by subtracting
the estimated salvage value from the
amount of investment required at the
beginning of the project, and then
dividing by the asset’s expected
economic life.
salvage value
The cash flow from the sale or disposal
of plant and equipment at the end of a
project’s life.
TUTOR J.3
Modified Accelerated Cost
Recovery System (MACRS)
The only acceptable depreciation method
for tax purposes that shortens the lives of
investments, giving firms larger early tax
deductions.
<
2. Convert cash flows to after-tax amounts before applying the net present value, payback,
or internal rate of return method to them. This step introduces taxes and depreciation
into the calculations.
DEPRECIATION AND TAXES
Depreciation is an allowance for the consumption of capital. In this type of analysis, depreci-
ation is relevant for only one reason: It acts as a tax shield. Depreciation is not a legitimate
cash flow because it is not cash that is actually paid out each year. However, depreciation
does affect how an accountant calculates net income, against which the income-tax rate is
applied. Therefore, depreciation enters into the calculation, as a tax shield, only when tax lia-
bility is figured. Taxes must be paid on pretax cash inflows minus the depreciation that is
associated with the proposed investment. United States tax laws allow either straight-line or
accelerated depreciation.
Straight-Line Depreciation The straight-line method of calculating annual deprecia-
tion is the simplest and usually is adequate for internal planning purposes. First, subtract the
estimated salvage value from the amount of investment required at the beginning of the proj-
ect and then divide by the number of years in the asset’s expected economic life. Salvage
value is the cash flow from the sale or disposal of plant and equipment at the end of a proj-
ect’s life.1 The general expression for annual depreciation is
I −S
D=
n
where
D = annual depreciation
I = amount of the investment
S = salvage value
n = number of years of project life
Accelerated Depreciation If the tax shields come earlier, they are worth more. Tax laws
allow just that, with what is called accelerated depreciation. Since 1986, the only acceptable
accelerated depreciation method is the Modified Accelerated Cost Recovery System
(MACRS). MACRS shortens the lives of investments, giving firms larger tax deductions. It cre-
ates six classes of investments, each of which has a recovery period or class life. Depreciation
for each year is calculated by multiplying the asset’s cost by the fixed percentage in Table J.3.2
The following are examples of the first four classes.
3-year class: specially designed tools and equipment used in research
5-year class: autos, copiers, and computers
7-year class: most industrial equipment and office furniture
10-year class: some longer-life equipment
Table J.3 does not show the 27.5- and 31.5-year classes, which are reserved for real
estate. MACRS depreciation calculations ignore salvage value and the actual expected eco-
nomic life. If there is salvage value after the asset has been fully depreciated, it is treated as
taxable income.
Taxes The income-tax rate varies from one state or country to another. Calculation of the
tax total should include all relevant federal, state, and local income taxes. When doing a
financial analysis, you may want to use an average income-tax rate based on the firm’s tax
rate over the past several years, or you may want to base the tax rate on the highest tax
1Disposal of property often results in an accounting gain or loss that can increase or decrease income tax
and affect cash flows. These tax effects should be considered in determining the actual cash inflow or
outflow from disposal of property.
2The table can be confusing because it allows a depreciation deduction for one more year than would
seem appropriate for a given class. The reason is that MACRS assumes that assets are in service for only
6 months of the first year and 6 months of the last year. An asset in the second class still has a 5-year life,
but it spans 6 calendar years.
 > TECHNIQUES OF ANALYSIS < J.7

TABLE J.3 MACRS Depreciation Allowances

Class of Investment

Year 3-Year 5-Year 7-Year 10-Year

1 33.33 20.00 14.29 10.00

2 44.45 32.00 24.49 18.00
3 14.81 19.20 17.49 14.40
4 7.41 11.52 12.49 11.52
5 11.52 8.93 9.22
6 5.76 8.93 7.37
7 8.93 6.55
8 4.45 6.55
9 6.55
10 6.55
11 3.29
100.0% 100.0% 100.0% 100.0%

bracket that applies to the taxpaying unit. The one thing you should never do is ignore taxes
in making a financial analysis.

ANALYSIS OF CASH FLOWS

You now are ready to determine the after-tax cash flow for each year of the project’s life. Use
the following four steps to calculate the flow year by year.

1. Subtract the new expenses attributed to the project from new revenues. If revenues are
unaffected, begin with the project’s cost savings.
2. Next subtract the depreciation (D), to get pretax income.
3. Subtract taxes, which constitute the pretax income multiplied by the tax rate. The differ-
ence is called the net operating income (NOI).
4. Compute the total after-tax cash flow as NOI + D, adding back the depreciation that was
deducted temporarily to compute the tax.

Calculating After-Tax Cash Flows EXAMPLE J.1

A local restaurant is considering adding a salad bar. The investment required to remodel the dining area and add
the salad bar will be $16,000. Other information about the project is as follows.

1. The price and variable cost per salad are $3.50 and $2.00, respectively.
2. Annual demand should be about 11,000 salads.
3. Fixed costs, other than depreciation, will be $8,000, which cover the energy to operate the refrigerated unit
and wages for another part-time employee to stock the salad bar during peak business hours.
4. The assets go into the MACRS 5-year class for depreciation purposes, with no salvage value.
5. The tax rate is 40 percent.
6. Management wants to earn a return of at least 14 percent on the project.

Determine the after-tax cash flows for the life of this project.
J.8 SUPPLEMENT J > FINANCIAL ANALYSIS <

SOLUTION
The cash flow projections are shown in the following table. Depreciation is based on Table J.3. For example,
depreciation in 2009 is $3,200 (or $16,000 × 0.20). The cash flow in 2014 comes from depreciation’s tax shield
in the first half of the year.

Year

Item 2008 2009 2010 2011 2012 2013 2014

Initial Information
Annual demand (salads) 11,000 11,000 11,000 11,000 11,000
Investment $16,000
Interest (discount) rate 0.14

Cash Flows
Revenue $38,500 $38,500 $38,500 $38,500 $38,500
Expenses: Variable costs 22,000 22,000 22,000 22,000 22,000
Expenses: Fixed costs 8,000 8,000 8,000 8,000 8,000
Depreciation (D ) 3,200 5,120 3,072 1,843 1,843 922
Pretax income $ 5,300 $ 3,380 $ 5,428 $ 6,657 $ 6,657 ⫺$922
Taxes (40%) 2,120 1,352 2,171 2,663 2,663 ⫺369
Net operating Income (NOI) $ 3,180 $ 2,208 $ 3,257 $ 3,994 $ 3,994 ⫺$553
Total cash flow (NOI + D ) $ 6,380 $ 7,148 $ 6,329 $ 5,837 $ 5,837 $ 369

NET PRESENT VALUE METHOD

net present value (NPV)
method
The method that evaluates an investment
by calculating the present values of all
after-tax total cash flows and then
subtracting the initial investment amount
for their total.
hurdle rate
The interest rate that is the lowest desired
return on an investment; the hurdle over
which the investment must pass.
internal rate of return (IRR)
The discount rate that makes the NPV of
a project zero.
payback method
A method for evaluating projects that
determines how much time will elapse
before the total of after-tax flows will
equal, or pay back, the initial investment.
The net present value (NPV) method is used to evaluate an investment by calculating the
present values of all after-tax total cash flows and then subtracting the original investment
amount (which is already a present value) from their total. The difference is the project’s net
present value. If it is positive for the discount rate used, the investment earns a rate of return
higher than the discount rate. If the net present value is negative, the investment earns a rate
of return lower than the discount rate. Most firms set the discount rate equal to the overall
weighted average cost of capital, which becomes the lowest desired return on investment. If a
negative net present value results, the project is not approved. The discount rate that repre-
sents the lowest desired return on investment is thought of as a hurdle over which the invest-
ment must pass and is often referred to as the hurdle rate.
INTERNAL RATE OF RETURN METHOD
A related technique involves calculating the internal rate of return (IRR), which is the dis-
count rate that makes the NPV of a project zero. It is “internal” because it depends only on
the cash flows of the investment, not on rates offered elsewhere. With this method, a project
is acceptable only if the IRR exceeds the hurdle rate. The IRR is a single number that summa-
rizes the merits of the investment. It can be used to rank multiple projects from best to worst,
so it is particularly useful when the budget limits new investments in any year.
You can find the IRR by trial and error. Start with a low discount rate and calculate the
NPV. If it exceeds 0, increase the discount rate and try again. The NPV will eventually go to 0
and later to a negative value. When the NPV is near 0, you have found the IRR.
PAYBACK METHOD
The other commonly used method of evaluating projects is the payback method, which
determines how much time will elapse before the total of after-tax cash flows will equal, or
pay back, the initial investment.
 > TECHNIQUES OF ANALYSIS < J.9

Even though it is scorned by many academics, the payback method continues to be

widely used, particularly at lower management levels. It can be quickly and easily applied
and gives decision makers some idea of how long recovery of invested funds will take.
Uncertainty surrounds every investment project. The costs and revenues on which analyses
are based are best estimates, not actual values. An investment project with a quick payback
is not considered as risky as one with a long payback. The payback method also has draw-
backs. A major criticism is that it encourages managers to focus on the short run. A project
that takes a long time to develop but generates excellent cash flows later in its life usually is
rejected under the payback method. The payback method also has been criticized for its fail-
ure to consider the time value of money. For these reasons, we recommend that payback
analysis be combined with a more sophisticated method such as NPV or IRR in analyzing the
financial implications of a project.

Calculating NPV, IRR, and Payback Period EXAMPLE J.2

What are the NPV, IRR, and payback period for the salad bar project in Example J.1?

SOLUTION
Management wants to earn a return of at least 14 percent on its investment, so we use that rate to find the pf val- TUTOR J.4
ues in Table J.1. The present value of each year’s total cash flow and the NPV of the project are as follows.
2009: $6,380(0.8772) = $5,597
2010: $7,148(0.7695) = $5,500
2011: $6,329(0.6750) = $4,272
2012: $5,837(0.5921) = $3,456
2013: $5,837(0.5194) = $3,032
2014: $ 369(0.4556) = $ 168

NPV of project
= ($5,597 + $5,500 + $4,272 + $3,456 + $3,032 + $168) – $16,000
= $6,024

Because the NPV is positive, the recommendation would be to approve the project.
To find the IRR, let us begin with the 14 percent discount rate, which produced a positive NPV. Incrementing
at 4 percent with each step, we reach a negative NPV with a 30 percent discount rate. If we back up to 28 per-
cent to “fine tune” our estimate, the NPV is $322. Therefore, the IRR is about 29 percent. The computer can pro-
vide a more precise answer with much less computation.

Discount Rate NPV

14% $6,025
18% $4,092
22% $2,425
26% $ 977
30% ⫺$ 199

To determine the payback period, we add the after-tax cash flows at the bottom of the table in Example J.1
for each year until we get as close as possible to $16,000 without exceeding it. For 2009 and 2010, cash flows
are $6,380 + $7,148 = $13,528. The payback method is based on the assumption that cash flows are evenly
distributed throughout the year, so in 2011 only $2,472 must be received before the payback point is reached. As
$2,472/$6,329 is 0.39, the payback period is 2.39 years.
J.10 SUPPLEMENT J > FINANCIAL ANALYSIS <

COMPUTER SUPPORT
The proliferation of microcomputers and the corresponding use of computer spreadsheets
make it easy to evaluate projected cash flows with NPV, IRR, and payback period methods.
The following computer output shows spreadsheet analysis for the salad bar in Example J.1.
The analyst inputs the investment expenditure, depreciation method, discount rate, and
pretax cash flows. If only cost savings are involved, the revenue row would be replaced by
them and there would be no separate rows for variable costs and fixed costs. The computer
then calculates the depreciation, taxes, after-tax cash flows, NPV, IRR, and payback period.
OM Explorer makes it easy to evaluate projected cash flows with NPV, IRR, and payback
period methods. Figure J.1 shows the output using the Financial Analysis Solver for the salad
bar in Example J.1.
With such spreadsheets, the analyst no longer performs present value calculations by
using formulas or tables but instead focuses on data collection and the evaluation of many
different scenarios relating to a project. They are referred to as “what-if” analyses and allow
an analyst to look at what would happen to financial performance if certain events or com-
binations of events were to occur.

MANAGING BY THE NUMBERS

The precision and analytical detachment that come from using the NPV, IRR, or payback
method can be deceiving. In fact, U.S. business has been accused of managing by the num-
bers, with a preference for short-term results from low-risk projects. Part of the problem lies
with managers who are on the fast track to the top of their organizations. They occupy a rung
on the ladder for a short time and then move up, and so they perceive it to be in their career
interests to favor investments that give quick results. They establish short paybacks and high
hurdle rates. They ignore or forgo long-term benefits from technological advances, innova-
tive product plans, and strategic capacity additions. Over the long run, this narrow vision
jeopardizes the firm’s competitive advantage—and even its survival.
Managing by the numbers has a second cause. Projects with the greatest strategic
impact are likely to be riskier and have qualitative benefits that cannot be easily quantified.
Consider an investment in some of the newer types of flexible automation. Benefits can
include better quality, quicker delivery times, higher sales, and lower inventory. The equip-
ment might be reprogrammed to handle new products not yet conceived of by the firm.
Enough might be learned with the new technology that subsequent investments will pay off

FIGURE J.1 OM Explorer Output for Salad Bar

 > SELECTED REFERENCES < J.11

at an even higher rate of return. The mistake is to ignore these benefits simply because they
cannot be easily quantified. Including risks and qualitative factors as part of the analysis is
far better than ignoring them. Using a preference matrix also may help an analyst recognize
qualitative factors more explicitly.
The message is clear. Financial analysis is a valuable tool for evaluating investment pro-
jects. However, it can never replace the insight that comes from hands-on experience.
Managers must use their judgment, taking into account not only NPV, IRR, or payback data
but also how the project fits operations and corporate strategy.

> SELECTED REFERENCES <

Brealey, Richard A., Stewart C. Meyers, and Alan J. Marcus.
Fundamentals of Corporate Finance. New York: McGraw-
Hill, 1995.
Brigham, Eugene F., and Louis C. Gapenski. Financial Manage-
ment: Theory and Practice, 7th ed. Orlando: Dryden, 1994.
Hayes, Robert H., and William J. Abernathy. “Managing Our
Way to Economic Decline.” Harvard Business Review (July–
August 1980), pp. 67–77.
Hodder, James E., and Henry E. Riggs. “Pitfalls in Evaluating
Risky Projects.” Harvard Business Review (January–February
1985), pp. 128–135.
Kieso, Donald E., and Jerry J. Weygandt. Intermediate Account-
ing, 4th ed. New York: John Wiley & Sons, 1983.
Luehrman, Timothy A. “What’s It Worth? A General Manager’s
Guide to Valuation.” Harvard Business Review (May–June
1997), pp. 132–142.
Ross, Stephen A., Randolph W. Westerfield, and Bradford D.
Jordon. Fundamentals of Corporate Finance, 2d ed. Home-
wood, Ill.: Irwin Professional Publication, 1993.