Chapter 16

Capital Expenditure
Decisions

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Discounted-Cash-Flow Analysis
Plant
Plant expansion
expansion

Equipment
Equipment selection
selection Equipment
Equipment replacement
replacement

Cost
Cost reduction
reduction Lease
Lease or
or buy
buy

16-2
 Net-Present-Value Method

oo Prepare
Prepare aa table
table showing
showing cash
cash flows
flows for
for each
each year,
year,
oo Calculate
Calculate the the present
present value
value of
of each
each cash
cash flowflow using
using aa
discount
discount rate,
rate,
oo Compute
Compute net net present
present value,
value,
oo IfIf the
the net
net present
present value
value (NPV)
(NPV) isis positive,
positive, accept
accept the
the
investment
investment proposal.
proposal. Otherwise,
Otherwise, reject
reject it.
it.

16-3
 Net-Present-Value Method
Mattson Co. has been offered a five year contract to
provide component parts for a large manufacturer.

16-4
 Net-Present-Value Method
•• At
At the
the end
end of
of five
five years
years the
the working
working capital
capital
will
will be
be released
released and
and may
may bebe used
used elsewhere
elsewhere
by
by Mattson.
Mattson.
•• Mattson
Mattson uses
uses aa discount
discount rate
rate of
of 10%.
10%.

Should
Should the
the contract
contract be
be accepted?
accepted?

16-5
 Net-Present-Value Method
Annual net cash inflows from operations

16-6
 Net-Present-Value Method

Mattson
Mattson should
should accept
accept the
the contract
contract because
because the
the
present
present value
value ofof the
the cash
cash inflows
inflows exceeds
exceeds the
the present
present
value
value of
of the
the cash
cash outflows
outflows byby $85,955.
$85,955. The
The project
project
has
has aa positive
positive net
net present
present value.
value.
16-7
 Internal-Rate-of-Return Method
•• The
The internal
internal rate
rate of
of return
return is
is the
the true
true
economic
economic return
return earned
earned byby the
the asset
asset over
over
its
its life.
life.
•• The
The internal
internal rate
rate of
of return
return is
is computed
computed by by
finding
finding thethe discount
discount rate
rate that
that will
will cause
cause the
the
net
net present
present value
value of
of aa project
project to
to be
be zero.
zero.

16-8
 Internal-Rate-of-Return Method
•• Black
Black Co.
Co. can
can purchase
purchase aa new
new machine
machine at
at aa
cost
cost of
of $104,320
$104,320 that
that will
will save
save $20,000
$20,000 per
per
year
year in
in cash
cash operating
operating costs.
costs.
•• The
The machine
machine hashas aa 10-year
10-year life.
life.

16-9
Internal-Rate-of-Return Method
Future cash flows are the same every year in
this example, so we can calculate the
internal rate of return as follows:

Investment required
= Present value factor
Net annual cash flows

$104, 320
= 5.216
$20,000

16-10
Internal-Rate-of-Return Method

The
The present
present value
value factor
factor (5.216)
(5.216) is
is located
located on
on
the
the Table
Table IVIV in
in the
the Appendix.
Appendix. Scan
Scan thethe 10-
10-
period
period row
row and
and locate
locate the
the value
value 5.216.
5.216. Look
Look
at
at the
the top
top of
of the
the column
column and and you
you find
find aa rate
rate of
of
14%
14% which
which is is the
the internal
internal rate
rate of
of return.
return.

$104, 320
= 5.216
$20,000

16-11
Internal-Rate-of-Return Method

Here’s the proof . . .

16-12
 Comparing the NPV and IRR
Methods
Net
Net Present
Present Value
Value Internal Rate of Return
 The
The cost
cost of
of capital
capital is
is  The cost of capital is
used
used as
as the
the actual
actual compared to the internal
discount
discount rate.
rate. rate of return on a project.

 Any
Any project
project with
with aa  To be acceptable, a
negative
negative net
net present
present project’s rate of return
value
value is
is rejected.
rejected. must be greater than the
cost of capital.

16-13
Comparing the NPV and IRR
Methods
The
The net
net present
present value
value
method
method hashas the
the following
following
advantages
advantages overover the the
internal
internal rate
rate of
of return
return
method
method .. .. ..
1.
1. Easier
Easier to
to use.
use.
2.
2. Easier
Easier to
to adjust
adjust for
for risk.
risk.

16-14
 Assumptions Underlying
Discounted-Cash-Flow Analysis
Assumes a
All cash flows are
perfect
treated as though
capital
they occur at year end.
market.

Cash inflows are

Cash flows are
immediately
treated as if
reinvested at
they are known
the required
with certainty.
rate of return.

16-15