Professional Documents
Culture Documents
Capital Investment
Capital Investment
CHAPTER
Capital
Investment
Decisions
18 -2
Objectives
4. Use the internal rate of return to assess the
acceptability of independent projects.
5. Discuss the role and value of postaudits.
6. Explain why NPV is better than IRR for capital
investment decisions involving mutually
exclusive projects.
7. Convert gross cash flows to after-tax cash
flows.
8. Describe capital investment in the advanced
manufacturing environment.
18 -4
Payback Method
Payback period =
Original investment
Annual cash flow
Payback Method
Unrecovered Investment
Year (Beginning of year) Annual Cash Flow
1 $100,000 $30,000
2 70,000 40,000
3 30,000 50,000
4 ---- 60,000
5 ----
$30,000 was needed
70,000
in Year 3 to recover
the investment
18 -7
Payback Method
Deficiency
Ignores the time value of
money
Ignores the performance of the
investment beyond the
payback period
18 -8
Payback Method
The payback period provides information to
managers that can be used as follows:
To help control the risks associated with the
uncertainty of future cash flows.
To help minimize the impact of an investment
on a firm’s liquidity problems.
To help control the risk of obsolescence.
To help control the effect of the investment on
performance measures.
18 -9
5 Revenues $300,000
Operating expenses -180,000
Salvage 40,000
Recovery of working capital 40,000
Total $200,000
18 -17
$12,000/(1 + i) = $10,000
1 + i = 1.2
i = 0.20
18 -22
Decision Criteria:
If the IRR > Cost of Capital, the project
should be accepted.
If the IRR = Cost of Capital, acceptance or
rejection is equal.
If the IRR < Cost of Capital, the project
should be rejected.
18 -23
NPV Compared With IRR
There are two major differences between net present
value and the internal rate of return:
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 it as a percentage.
18 -24
NPV Compared With IRR
Bintley Corporation Example
Design A Design B
Annual revenue $179,460 $239,280
Annual operating costs 119,460 169,280
Equipment (purchased before
Year 1) 180,000 210,000
Project life 5 years 5 years
18 -25
NPV Compared With IRR
CASH-FLOW PATTERN
Year Design A Design B
0 $-180,000 $-210,000
1 60,000 70,000
2 60,000 70,000
3 60,000 70,000
4 60,000 70,000
5 60,000 70,000
DESIGN A: NPV ANALYSIS
Year Cash Flow Discount Factor Present Value
0 $-180,000 1.000 $-180,000
1-5 60,000 3.605 216,300
Net present value $ 36,300
18 -26
NPV Compared With IRR
IRR ANALYSIS
Initial Investment
Discount factor =
Annual cash flow
$180,000
= = 3.000
60,000
From Exhibit 18B-2, df = 3,000 for five years; IRR = 20%
= 3,000
DESIGN B: NPV ANALYSIS
Year Cash Flow Discount Factor Present Value
0 $-210,000 1.000 $-210,000
1-5 70,000 3.605 252,350
Net present value $ 42,350
18 -27
NPV Compared With IRR
IRR ANALYSIS
Initial Investment
Discount factor =
Annual cash flow
$210,000
= = 3.000
70,000
From Exhibit 18B-2, df = 3,000 for five years; IRR = 20%
= 3,000
18 -28
Depreciation
Tax-Shielding Effect
Depreciation
Tax-Shielding Effect
Depreciation
Tax-Shielding Effect
Now assume that the tax laws allow a deduction for
depreciation:
Net operating cash flows $300,000
Less: Depreciation 100,000 Taxable income
$200,000
Less: Income taxes (@ 34%) -68,000
Net income $132,000
18 -35
Depreciation
Tax-Shielding Effect
Example—S/L Depreciation
An automobile is purchased on March 1, 2003 at a
cost of $20,000. The firm elects the straight-line
method for tax purposes. Automobiles are five-year
assets (to refer to a chart, click on the car below; to
return to this slide, click on the hammer). The
annual depreciation is $4,000 ($20,000 ÷ 5).
However, due to the half-year convention, only
$2,000 can be deducted in 2003.
18 -39
Example—S/L Depreciation
Year Depreciation Deduction
2003 $2,000 (half-year amount)
2004 4,000
2005 4,000
2006 4,000
2007 4,000
2008 2,000 (half-year amount)
Assume that the asset is disposed of in April 2005.
Only $2,000 of depreciation can be claimed, so the
book value would be $12,000 ($20,000 – $8,000).
18 -40
Example—MACRS Method
MACRS Depreciation Rates for
Five-Year Assets
Year Percentage of Cost Allowed
1 20.00%
2 32.00
3 19.20
4 11.52
5 11.52
6 5.76
18 -41
Example—S/L Depreciation
Tax Tax Discount Present
Year Depreciation Rate Savings Factor Value
1 $2,000 0.40 $ 800.00 0.909 $ 727.20
2 4,000 0.40 1,600.00 0.826 1,321.60
3 4,000 0.40 1,600.00 0.751 1,201.60
4 4,000 0.40 1,600.00 0.683 1,092.80
5 4,000 0.40 1,600.00 0.621 993.60
6 2,000 0.40 1,600.00 0.564 451.20
Net present value $5,788.00
18 -42
Example—MACRS Method
Tax Tax Discount Present
Year Depreciation Rate Savings Factor Value
1 $4,000 0.40 $1,600.00 0.909 $1,454.40
2 6,400 0.40 2,560.00 0.826 2,114.56
3 3,840 0.40 1,536.00 0.751 1,153.54
4 2,304 0.40 921.60 0.683 629.45
5 2,304 0.40 921.60 0.621 572.31
6 1,152 0.40 460.80 0.564 259.89
Net present value $6,184.15
18 -43
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 x 5.65) $22,600,000
Investment 18,000,000
Net present value $ 4,600,000
18 -44
How Estimates of Operating
Cash Flows Differ
Present Value
P = F/(1 + i)n
The discount factor, 1/(1 + i), is computed for various
combinations of I and n.
Example: Compute the present value of $300 to be
received three years from now. The interest rate is 12%.
Answer: From Exhibit 18B-1, the discount factor is 0.712.
Thus, the present value (P) is:
P = F(df)
= $300 x 0.712
= $213.60
18 -50
Present Value
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:
Discount Present Year Cash Factor
Value
1 $100 0.893 $ 89.30
2 100 0.797 79.70
3 100 0.712 71.20
2.402* $240.20
Chapter Eighteen
The End
18 -52