18 CAPITAL INVESTMENT

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1 18 CAPITAL INVESTMENT (Contributed by Deryl Northcott) Introduction Capital Investment Defined Who is Involved in Making CI Decisions? Why Are Capital Investment Decisions Important? Types of Capital Investments The Capital Investment Process What Information is Relevant to a CI Decision? Financial Analysis of Capital Investment Projects Accounting Concepts - Payback Period - Accounting Rate of Return Economics and Finance Concepts - The Net Present Value Method - A Variation on NPV - Profitability Index - Internal Rate of Return - Discounted Payback Period - The Winner - NPV Issues in Using NPV Correctly - The Timing of Cashflows - Taxation - Depreciation - Taxation Investment Incentives - Taxation Effects - Summary - Inflation - Capital Rationing Using NPV - Summary Using NPV - An Extended Example People Are Important Too! Summary Introduction It is an unfortunate requirement that to make money, an organisation usually has to spend money - the trick is always in spending it wisely. Making decisions about what is and isn t worth spending money on is never easy, especially where the

2 368 Financial Management and Decision Making expenditure is large and the returns risky, as is generally the case with capital investment. Capital Investment Defined Capital investment (CI) can be seen as a sub-set of capital budgeting. Capital budgeting refers to both the selection of long-term investments, and planning for their financing. The Fisher Separation Theorem states that, in theory at least, the investment decision is separate from the financial decision. There are special circumstances when the investment and financial decisions are inter-related. However, deciding which projects should be undertaken is sufficiently problematic to warrant consideration on its own, and so forms the focus of this chapter. Capital investment (CI) can be defined as follows: Capital investment entails the making, communication and acceptance of decisions about investment in long-term, risky capital assets. These decisions take place within the organisational context and impact upon the strategic and operating position of the organisation, and also upon those people who constitute the organisation. Therefore, we would expect CI decisions to take into account the strategic and behavioural implications of the proposed investment, as well as some rigorous examination of its financial effects. Who is Involved in Making CI Decisions? There is no one answer to this question. Evidence from practice suggests that a variety of people may participate in CI decisions (Bower, 1970; Mukherjee & Henderson, 1987), even though much of the prescriptive literature suggest that these decisions are the domain of the accountant. It is common in practice to see any or all of the following personnel contributing: - accountants / financial managers - operational managers - line staff (who work with the capital assets) - production personnel - engineers - specialist capital investment officers / committees - general managers and boards of directors (who are often responsible for the final decision to commit to large items of expenditure). It is therefore rare for CI decisions to be made behind the closed doors of the accountant s office. Although accountants have a role in providing financial analyses and advice, specialist technical expertise is often required to assess potential investments.

3 Chapter 18: Capital Investment 369 Why Are Capital Investment Decisions Important? Capital investment decisions are significant at two levels: for the future operability of the organisation making the investment, and for the economy of a nation as a whole. Capital investment directs significant resources towards particular areas of economic activity. So collectively, CI decisions made by individual organisations impact upon the future economic position of a nation. At an organisational level, the commitment of resources to long-term capital assets has implications for many aspects of operations. Capital investment may concern the purchase or modification of plant and machinery, so the cost, range, quality, innovation and leadership of products are all affected by CI decisions. Types of Capital Investments Capital investment projects can take many forms. Generally, they involve: 1. Replacement of existing assets, 2. Expansion of existing operations, 3. Strategic expenditure to develop new types of production technologies or product lines, perhaps re-positioning the organisation in the market place, or responding to some change in the operating environment, or 4. Non-financially motivated expenditures, e.g. safety, environmental or legislatively required expenditures. Depending on what the purpose of a CI is, the criteria for approving the project may differ. For example, a risky, innovative project which launches the organisation into a new area of operations will generally be expected to show a good financial return. In comparison, a plant alteration required to meet health or safety regulations may not be expected to achieve any financial return - it is a necessity, and the focus will be on minimising the cost of achieving the legal requirements. The Capital Investment Process It is important to recognise that there are several phases involved in making CI decisions. The nature and relationship of these phases is shown in Exhibit Exhibit 18.1 A Capital Investment Model

4 370 Financial Management and Decision Making Strategic Planning Formal CI Systems Indentification of potential investments Project definition and screening Analysis and acceptance Implementation Monitoring and post-audit Feedback Organisational personnel Source: Northcott, 1992 First, potential CI projects must be identified. This requires both innovation in generating investment ideas, and judgement in being able to recognise a good idea when it appears! Once the initial idea has been identified, the project needs to be defined and detailed. Here, it is important to consider all the implications of the project, for example: How much will it cost? What are its financial and strategic advantages? How will it affect the organisation s operations? At this stage, it is usually possible to screen out those CI ideas which are clearly infeasible, or which may not be as good as was first thought. Once CI ideas have been formulated and screened, the promising projects continue on to the analysis and acceptance stage. Here, rigorous financial analyses are used to assess the financial implications of a CI project (later in this chapter we will look at the kinds of financial analysis which can be used). Normally, if a project meets the requirements of financial analysis, it will be accepted, and then implemented. Once the project is up and running, it may be monitored so that a post audit can be conducted, looking at how successful the investment has been. Exhibit 18.1 shows that this decision process has links to the strategic planning function in an organisation, and to the personnel who make CI decisions, implement the projects and work with the capital assets. Finally, it is important to recognise that this decision making process takes place within the organisational environment, and so is subject to the objectives, traditions and culture of the organisation. All of this looks simple. However, practice rarely reflects tidy, structured models. The phases of this process may, in practice, be interactive and iterative and may occur out of order or not at all! However, this model presents a useful starting point for considering the facets of CI decision making. Each of the phases is important, and a successful programme of CI decision making should include elements of them

5 Chapter 18: Capital Investment 371 all. What Information is Relevant to a CI Decision? The short answer to this question is: anything that changes as a result of a CI decision will be relevant to assessing the viability of that investment. That is, the CI decision maker must identify relationships between the decision made, and the costs and benefits which accrue from it either immediately or in the future. Some typical examples of relevant information include: - the purchase and installation cost of the capital asset, - changes in revenues or costs, - required increases in working capital items (e.g. inventory). Getting this information is often more difficult than it would first appear. For example, the purchase price of a fixed asset is often the only explicit component of the initial outlay cost. Other less obvious costs might include installation, legal costs, re-training of employees, redundancy payments associated with the discontinuation of present employees and production set-up costs. Capital investment decision makers must be careful that they have considered all the effects of implementing a CI project. A number of irrelevant factors are often incorrectly included in the analysis of proposed CIs. Examples include: - sunk costs (costs already incurred which cannot now be changed, no matter what decision is made), - future costs and revenues which would have accrued regardless of the current CI decision, - allocations of fixed costs (where the total cost to the organisation will not change, even though the way it is allocated for reporting purposes may), and - financing costs (already taken into account in the required rate of return imposed on a CI proposal). Again, asking the simple question: "Will these costs or revenues change as a result of the decision made?" is usually enough to reveal their relevance (or irrelevance) to the decision. Remember though - it can be difficult to predict what might happen if the CI is not undertaken, so working out the changes caused by a project may not be easy! Once the information relevant to a CI decision is identified, financial viability is an important factor in deciding whether or not to accept proposed investments in many organisations. However, there are many more organisations for which profit results and wealth generation are not of primary importance, but are merely means to an end. Such organisations include central and local Government bodies and not-forprofit organisations such as clubs, social services and charities. For these organisations, the financial viability of a CI may not be a relevant criterion in establishing its desirability. Investment decisions may be based on criteria which are difficult to quantify, thus making CI decision making an especially challenging

6 372 Financial Management and Decision Making task in these organisations. Although making money is not the objective of many organisations, in some instances financial analyses can be a helpful input to their CI decisions. For example, financial considerations may be relevant where more than one alternative way of achieving a goal is identified and a choice must be made about which option to pursue. Where financial analysis has utility, CI decision makers in all types of organisations need to be aware of the range of decision support techniques available for considering financial aspects of investments. In the next part of this chapter, this range of financial analysis techniques is presented after looking at the different theoretical perspectives of the alternative approaches. Financial Analysis of Capital Investment Projects There are two main views of financial performance measurement which form the theoretical underpinnings of CI analysis techniques: accounting concepts and economics or finance concepts. Notions of stewardship and accountability, together with accounting concepts and conventions, have given financial accounting a particular view of the world. From an accounting perspective, long-term financial success is measured by profitability, while short-term success places greater emphasis on liquidity. These concerns of liquidity and profitability have formed the basis of two CI analysis techniques: payback period and accounting rate of return. These accounting-based methods are popular in practice, especially among CI decision makers in small and medium sized firms, and are often referred to as traditional methods. Economics and finance theory have introduced notions of financial success concerned with the maximisation of shareholder wealth and the consideration of risk. As CI decision making is concerned with effective resource allocation, it follows that successful CI projects are those which add to the value of the firm, thus increasing shareholder wealth. Following from this, a CI is acceptable if its expected cash returns exceed its expected cash costs, so liquidity (the timing of these cashflows) and profitability (determined for the financial reporting of these cashflows) become less important. The combination of assumed wealth maximisation objectives and risk considerations has led to the development of CI analysis techniques quite different from the traditional accounting-based methods. These techniques are the net present value, profitability index, internal rate of return and discounted payback period approaches. How each of the alternative analysis techniques is used, and the strengths and weaknesses of each approach will now be discussed.

7 Chapter 18: Capital Investment 373 Accounting Concepts Payback Period Payback period (PP) is concerned with liquidity. It is a short-term oriented method which asks, "How soon will the CI project pay itself back?" The faster a CI project can recoup its initial cost, the better. Payback period focuses on the cashflows from a CI project, and the speed at which they are received, rather than on any measure of profitability or overall return. Decision makers using the PP criterion must decide on an acceptable PP time horizon as a yardstick for assessing CI proposals. The greater the liquidity needs of the investor, the shorter may be the acceptable PP time period. The selection of a PP cut-off point is therefore arbitrary. Example Calculating Payback Period A firm is considering investing in a new computer system. The cost of purchasing and installing the system is $6,000. The expected cost savings associated with the computer system will improve as staff become more familiar with using it. The pattern of expected cash benefits is: Year Cashflow ($) ,000 1,200 1,500 2,000 2,000 2,000 Cumulative Cashflow ($) 500 1,300 2,300 3,500 5,000 7,000 9,000 11,000 From the cumulative cashflows, we can see that the computer system s payback period is between five and six years. If we assume that cashflows accrue evenly throughout the year, then the payback period is 5.5 years. Should the firm purchase the computer system? The answer depends on the PP criterion they use. If the firm has established a cut-off point of four years, then they would not purchase the computer system. If, however, their cut-off was six years, then the computer system is acceptable. The PP analysis method has two major deficiencies. First, it ignores any cashflows which occur after the project s payback period. The benefits accruing from the computer system in the previous example in years seven and eight could have been

8 374 Financial Management and Decision Making enormous, yet the PP calculation would have taken no account of them. This deficiency reflects the short-term orientation of the PP technique. Therefore, the use of PP as a decision making tool penalises those projects with inherently long lives and promotes projects which produce rapid returns, even though those returns may be modest and short-lived. The second major deficiency of the PP technique is that it ignores the time value of money. A modified version of the PP analysis method, called Discounted Payback Period (DPP) has been proposed as a means of overcoming this problem, and will be discussed later in this chapter. Despite its deficiencies, payback period is often used in practice. PP analysis may be useful as a first screening device where an organisation is concerned with liquidity. However, PP should not be used as the sole basis for CI decisions, if the intention is to maximise shareholder wealth. Accounting Rate of Return The second of the accounting-based CI analysis methods is the accounting rate of return (AROR). This method compares a CI project s profitability to the capital employed in the investment. One of the difficulties of this method is that there are several ways of representing profit and capital employed. Alternative profit measures can include or omit financing expenses, depreciation and tax. Capital employed can be either initial capital (i.e. the historic cost of the organisation s assets) or average capital employed. However, the most common definition of AROR uses the earnings before interest and tax (EBIT) profit figure (which includes the effects of depreciation), and the average capital employed. The average capital employed concept requires that we know how much is invested in an asset at the beginning and end of its useful life. This investment comprises both the value of the asset itself, and the value of any working capital which is held in association with this asset (often this working capital component is constant over the asset s life). The concept of capital employed is illustrated in Exhibit Exhibit 18.2 The Capital Employed over the Life of an Investment

9 Chapter 18: Capital Investment 375 $ invested Where: wc + pp wc = working capital employed sv = salvage value pp = purchase price n = the life of the investment wc + sv wc year n Time Using this approach, the formula for AROR is given below: AROR = average annual accounting profit average capital employed i.e ( Σ annual EBITS) n years (initial outlay + residual value) 2 Where initial outlay = pp + wc and residual value = sv + wc Example Calculation of AROR An asset costs $12,000 to purchase, and has an expected life of five years with a salvage value of $2,000. Additional inventories costing $1,000 are required at the time the asset is commissioned, but can be liquidated for $1,000 at the end of the asset s life. It is estimated that the asset will increase annual revenues by $5,000, although it will create a straight-line annual depreciation expense of $2,000. What is the asset s AROR? The annual pre-tax profit generated by this asset is ($5,000 - $2,000) = $3,000 for

10 376 Financial Management and Decision Making each of its five years of life. So: Average capital employed: = (Initial capital + terminal capital) ) 2 = [$13,000 + ($2,000 + $1,000)] ) 2 = ($13,000 + $3.000) ) 2 = $8,000 AROR: = $3,000 ) $8,000 = or 37.5% Like the payback period method, AROR is not without substantial flaws. This method uses accounting profit, rather than cashflows, as a measure of return on an investment. Inconsistencies in the derivation of profit figures (perhaps due to changing accounting policies) can produce widely differing AROR results. Also, accounting profits suffer from distortions such as depreciation expenses and gains and losses on the sale of fixed assets. Although these items feature in the determination of profit, they do not result in the actual payment or receipt of cash by the organisation. And, since they are not actual cashflows, they have no impact on the wealth of the investors. The second major flaw of the AROR method is shared with the PP method - it does not take account of the time value of money. The return on a CI is deemed to be its average accounting profits, even though these profits occur in different time periods and may change from year to year. However, AROR is frequently used in practice as a CI decision support technique. It may be that some CI decision makers prefer to analyse investments using a profitbased measure. Often such an approach is consistent with the profit performance measures to which managers are themselves subjected. Whatever the reason for its use, the AROR approach is inappropriate for those organisations seeking to maximise shareholder wealth. So, it can be seen that the two main traditional analysis methods are not ideal. Although both are used in practice, they have serious shortcomings, and can lead to incorrect CI decisions. These techniques have largely fallen from favour in the normative CI literature, and have been replaced with the sophisticated techniques which find their roots in economic theory. Economics and Finance Concepts The Net Present Value Method The net present value (NPV) analysis method discounts all future cashflows from a CI back to their present value, and compares them with the present value cost of entering into the investment. Hence, the net present value is the difference between the present values of the investment s inflows and outflows. The decision criterion used in conjunction with the NPV method is the same for all

11 Chapter 18: Capital Investment 377 investments and all organisations: if the NPV is positive (i.e. greater than zero), then the investment should be accepted. Conversely, if the NPV is negative the investment should be rejected. A positive NPV indicates that an addition to the wealth of the investors is expected. Theoretically, a decision maker would be indifferent about a CI with a NPV of exactly zero. However, intuitively, a zero increase in wealth is usually insufficient reward for the effort of pursuing the investment, and so a zero NPV project would rarely be attractive. In order to use the NPV analysis method, there are several inputs which must be determined. Broadly the required information includes: - the CI s required initial outlay, - the relevant future cash flows associated with the CI, - the anticipated life of the CI, and - the appropriate discount rate to be used. As noted earlier, determining the initial outlay and future cashflows associated with a CI is rarely straight-forward. Similarly, uncertain effects such as wear and tear, obsolescence and changes in the activities of the organisation can render asset life estimates incorrect. Perhaps the most problematic input is the determination of an appropriate risk-adjusted discount rate - the choice of discount rate is crucial to the outcome of the NPV analysis. Example Calculating Net Present Value (NPV) Vehicle Purchase Proposal Porter Co. is considering purchasing a delivery vehicle at a cost of $16,000. An employee will be trained to obtain a Heavy Transport Licence at a cost of $100. Vehicle running costs are estimated at $3,000 p.a., but Porter Co.will save $7,000 p.a. in contract delivery charges. The vehicle will have a useful life of six years, to be sold for $3,000 at the end of year six. Porter Co. requires a 12% rate of return on this type of investment (tax and depreciation are ignored until later in this chapter). Detailing the relevant cashflows using a time-line : Cashflows ($00s) Time 0 (now) Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Purchase price HTL training Running costs Savings on delivery costs

12 378 Financial Management and Decision Making Sale of vehicle +30 Total annual cashflows All initial outlay costs are said to occur in time 0 - i.e. now. Note that running costs and savings on delivery contract charges are annuities continuing for the life of the investment. Note also the implicit assumption that cashflows occur at the end of each year. For example, the first year s running costs are assumed to occur in one year s time, and will be discounted by one year to obtain their present value. This assumption facilitates simple illustrations, and in practice, where it is difficult to ascertain the exact timing of cashflows, such simplifying assumptions may be used. Finding the vehicle s NPV: NPV = -$16,100 + (PV of an annuity of $4,000 for 6 12%) + (PV of a sum of $3,000 received in 6 years time, at 12%) = -$16,100 + ($4,000 x ) + ($3,000 x ) = -$16,100 + $16,446 + $1,520 = + $1,866 So, the vehicle purchase opportunity has a positive NPV, and should be accepted. A Variation on NPV - Profitability Index The Profitability Index (PI) measure uses exactly the same discounted cashflow information as the NPV method. However, instead of finding the difference between initial outlay and the present value of future cashflows, the PI approach finds the ratio of these two values. A generalised formula for PI is: PI = Σ PVs of future cash flows Initial Outlay For example, if we calculated the PI of the delivery vehicle proposal in the previous example, it would be: $17,966 PI = $16,100 = A PI of greater than 1 indicates an acceptable project, while a project with a PI less than 1 should be rejected. The PI approach will always produce the same accept or reject decision as the NPV approach, as it is simply a re-ordering of the same information. However, PI has advantages over NPV where a firm is subject to capital rationing, as will be noted later. Internal Rate of Return Internal rate of return (IRR) is another major CI analysis method derived from the theoretical perspective of economics. The IRR approach focuses on finding the discount rate at which the NPV of a project would be zero. That is, the IRR is the

13 Chapter 18: Capital Investment 379 rate of return earned by the project itself, and equates the present value of future cashflows to the initial outlay. Simple examples illustrate this approach. Example IRR Calculations 1. Simple returns: You invest $1,000, and at the end of the year you receive an interest cheque for $120. The IRR of this investment is easily found: IRR = = $120 $1,000 12% 2. Compound returns: You invest $1000 in Municorp. shares. After holding these shares for four years, you sell them and receive $1, The IRR of this investment can be found by solving the following equation: FV ($1, ) = PV ($1,000) ( 1+ IRR) $1, $1,000 = ( 1+ IRR) = ( 1+ IRR) At this point there are two choices: you can consult a table of compound interest factors to find the four year rate which has a factor of (16%), or you can solve the equation algebraically: = (1+ IRR) (1+ IRR) = 1.16 IRR = 16% In practice, finding the IRR of a project involves complex calculations. Now that computers are widely available, IRRs can be automatically computed for a series of cashflows. However, it aids our understanding of how IRR works to consider a trial and error approach to finding the IRR of a CI project. Let us reconsider the delivery vehicle purchase example. We can restate the problem in terms of the IRR. To find the IRR, we set the NPV at zero and solve for the discount rate, that is: 0 = -$16,100 + (PV of an annuity of $4,000 for 6 IRR%) + (PV of a sum of $3,000 received in 6 years time, at IRR%) Without the help of a computer, there is no quick way to solve this equation. The simplest manual approach is to repeatedly guess at the IRR until answers are obtained which are close to the required zero. Once we have obtained a discount rate which produces a slightly positive NPV, and a discount rate which produces a

14 380 Financial Management and Decision Making slightly negative NPV, then we can use linear interpolation between the two points to find an estimate of the IRR which will give an NPV of zero. Example Finding a Project s IRR by Interpolation (Based on example of vehicle purchase proposal) The IRR of the vehicle purchase opportunity is the discount rate at which the NPV equals zero, i.e.: 0 = -$16,100 + (PV of an annuity of $4,000 for 6 IRR%) + (PV of a sum of $3,000 received in 6 years time, at IRR%) The NPV of this project has already been calculated at 12% as +$1,866. Since this result is positive, raising the discount rate will reduce the NPV. Re-calculating the NPV using a 16% discount rate: NPV = -$16,100 + (PV of an annuity of $4,000 for 6 16%) + (PV of a sum of $3,000 received in 6 years time, at 16%) = -$16,100 + ($4,000 x ) + ($3,000 x ) = -$16,100 + $14,739 + $1,204 = -$157 With one positive NPV result and one negative NPV result, linear interpolation is used to estimate the IRR. This can be represented graphically: NPV The IRR (NPV = 0) +$1866 -$157 12% 16% Discount rate Interpolation is based on the trigonometric relationship that: (i) the distances between the two observed NPVs and the zero NPV point

15 Chapter 18: Capital Investment 381 (i.e. $1866 and $157), and (ii) the distances between the two trial discount rates and the IRR have the same ratio. Interpolating between the 12% and 16% results we find that: 1866 IRR = 12% + (16% - 12%) (-157) = 12% + ( %) = 15.69% The IRR of 15.69% is much closer to 16% than to 12%, and this was obvious from the NPV results. The 12% calculation produced an answer that deviated by $1866 from the desired zero point, while the 16% answer was only $157 off target. It should be noted that linear interpolation provides only an estimate of IRR. Linear interpolation assumes that the relationship between the two data points is that of a straight line. This is rarely true. So, the closer are the two discount rates used, the more accurate will be the answer, as a straight line will better approximate the relationship over a shorter distance. It can be seen that the IRR method, while using the same cashflow information as the NPV method, presents a percentage return on the investment, rather than measuring the investment s net contribution to wealth. Research evidence suggests that many practitioners favour the percentage expression of IRR (Pike, 1982). However, it is thought that this preference is due to the mistaken belief that using IRR removes the need to determine a discount rate. Of course, when considering the acceptability of a CI project, its IRR must be compared to some pre-determined required rate of return. So, even using IRR, the need to work out an appropriate discount rate is not escaped! There are also some weaknesses associated with IRR, arising both from its mathematical formulation, and from the model s inherent assumptions. The IRR equation requires that a polynomial root (or solution) can be found which makes the NPV equal to zero. However, there are cases where a series of cashflows has no root, or multiple roots, as demonstrated in the following examples: Example Cashflows with No IRR Solution Time 0 Yr 1 Yr 2 Cashflow +$1000 -$3000 $2500 Because of the opposite signs of the cashflows in Yr 1 and Yr 2, there is no discount rate which will produce a zero NPV for this series of cashflows.

16 382 Financial Management and Decision Making Example Cashflows with Multiple IRR Solutions Time 0 Yr 1 Yr 2 Cashflow -$4000 +$ $25000 This set of cashflows has IRR solutions at 25% and 400%, and would produce a positive NPV at any discount rate between these two values. In such cases, the use of IRR as a decision-support tool is problematic. Which IRR is the correct one? A necessary (but not sufficient) condition for multiple IRR solutions is that there is more than one change in the sign of the cashflows. Typically, we see an initial cash outflow followed by a series of inflows over the life of the CI. However, where there are further changes in the sign of the cashflows, the multiple solution problem can occur. The possibility of multiple IRRs makes this method less attractive as a CI analysis tool. The second main problem with the IRR approach is that it can produce rankings of CI projects which conflict with those obtained using NPV. This becomes a problem where a firm must select between mutually exclusive CI projects, as illustrated in the following example. Example Conflicting Project Rankings Using IRR and NPV Ratima Co. owns a factory. The company is considering investing in modifications to that factory, and must choose between two options with the following cashflows: (i) spend $40,000 now and receive $58,000 in 3 years time, or (ii) spend $40,000 now and receive $46,000 in 1 year s time. This factory modification is a one-off expenditure for Ratima Co. and no further investment opportunities are expected for at least four years. Ratima Co. has a required rate of return of 10%. Calculating the NPV and IRR of these two options we get: Project IRR (i) + $3, % (ii) + $1, % Therefore, using the NPV rule we would accept option (i) as it has the greater NPV. However, using the IRR rule (where both options exceed the RRR), we would be inclined to select option (ii) as it has the greater IRR. The different rankings result from the differing assumptions of the NPV and IRR approaches, in this case best referred to as opportunity cost assumptions. If Project (i) is foregone, the investor forfeits a return (for three years) of 13.19%. If

17 Chapter 18: Capital Investment 383 Project (ii) is forgone, the investor forfeits a return (for one year) of 15%. While the IRR of project (ii) appears more appealing, the NPV shows that on an investment of $40,000, a 15% return for one year is worth less than a 13.19% return for three years. It is not appropriate to use the IRR approach for ranking mutually exclusive projects. Clearly project (i) should be accepted, as it will make the larger contribution to the wealth of the investor. Reliance on the IRR rankings would lead to an incorrect decision in this instance. The re-investment assumption of the IRR model causes problems where cashflows accrue over the life of an investment. The IRR model assumes that all cashflows produced by a CI can be re-invested at the IRR. This is often unrealistic. If a project has an IRR of 20%, but market rates for investment are only 14%, then we cannot expect to re-invest cashflows arising from the CI at the 20% rate. So, the IRR method has overstated the return which will realistically be generated by the CI. Using NPV no such assumption is required, as it is possible to vary discount rates to reflect changing investment possibilities over the life of the project. Here again, NPV is preferred over the IRR method. Discounted Payback Period When the payback period (PP) method was considered earlier, it was noted that a variation called the discounted payback period (DPP) improved this approach. The DPP approach has all the perceived advantages of PP - it is easy to understand and compute, and it allows the investor to focus on liquidity where this is appropriate. But, unlike PP, DPP takes into account the time value of money. Therefore, the DPP approach is a useful step towards the theoretically superior method of NPV, particularly for smaller business managers who find the PP approach attractive. The DPP method discounts each year s net cash flow by the appropriate discount rate and determines the number of years it takes for these discounted cashflows to recoup the CI s initial outlay. Because DPP recognises the time value of money, it produces a longer payback period than does the non-discounted PP approach, and takes into account more of the CI s cashflows. Another advantage of DPP over the traditional PP method is that it has a clear accept or reject criterion. Using DPP, a project is acceptable if it pays back within its lifetime. An example illustrates the difference between the PP and DPP approaches. Example Payback Period v. Discounted Payback Period An investment, with an initial outlay of $20,000, produces net cash inflows of $7,000 p.a. for six years. Year Net Cashflow Present Value Cumulative Present Value ($) ($)

18 384 Financial Management and Decision Making 0-20,000-20,000-20, ,000 +6,087-13, ,000 +5,293-8, ,000 +4,603-4, ,000 +4, ,000 +3,480 +3, ,000 +3,026 +6,491 Would this investment be accepted? Using the PP method: The PP is just under three years ($20,000 $7,000). Acceptance depends on the chosen cut-off time: if cut-off is two years, would reject, if three years would accept. Using the DPP method: The discounted payback period is just over four years. The investment would be accepted, as it pays back within its six year lifetime. Discounted payback period still does share one limitation with PP - cashflows which occur after the payback period are ignored. However, since the DPP is always longer than the PP, the DPP method ignores fewer of these cashflows. DPP also conveys a sense of liquidity measurement which is not achieved using the NPV method. Since PP is often the only CI analysis undertaken in smaller businesses, switching to DPP is a step in the right direction for many CI decision makers. The Winner- NPV Financial analysis techniques do not provide all the answers in CI decision making. Organisations may have objectives which cannot be reflected in quantitative financial analyses. However, where it is relevant to consider the financial performance of a CI, there are several reasons why NPV provides the best means for doing so. Payback period is a useful first screening device, and AROR has some strength in facilitating comparison of CI outcomes with profit performance measures. But, only the discounted cashflow methods focus, as the name suggests, on cash (the source of wealth) and the time value of money (the value of that cash). NPV has none of the computational problems of IRR, and a combination of NPV and PI can tell us both the value of the CI, and the significance of that return relative to the size of the investment (which is useful when limited funds are available for investment). The NPV also allows for additivity of CI values, whereas IRRs cannot be added to achieve a sense of the total return to the organisation. So, IRR can work, (but sometimes doesn t and is complex), DPP is a step in the right direction, and NPV is best! Since NPV is preferred, there are some issues that must be addressed to ensure that it is used correctly.

19 Chapter 18: Capital Investment 385 Issues in Using NPV Correctly The Timing of Cashflows A key aspect of using NPV is the recognition of the different timing of cashflows from a CI project. In practice, cashflows may occur at any time throughout the year, but for simplicity we assume that all cashflows occur at the end of the year. For example, if considering a CI investment on 1 January 1993, and the first running cost is to be incurred in July 1993, we would assume that this running cost cashflow occurs on 31 December 1993, and discount it by one year to find its present value. Such assumptions will, of course, slightly distort NPV results. For major projects where the amount of the cash flow is significant it is, of course, important to discount the cash flows by the exact number of days required. However, it should be recognised that NPV can only ever be a decision support tool. It can never provide an exact answer, as many of the cashflows are themselves uncertain and must be estimated. The effect of simplifying assumptions about cashflows usually has limited impact on the analysis. Taxation Up until now the effects of taxation have been ignored, for simplicity. However, in reality, tax has a significant impact on the cashflows of CIs. Where cashflows from a CI change the amount of tax payable, then this is itself a real cashflow effect. There are a number of ways in which these tax effects occur: - when revenues (or reduced costs) from a CI increase profit, - when costs (or reduced revenues) of a CI decrease profit, - when a gain or loss is made on the sale of a fixed asset, - when a CI is depreciated or written down, and - when special taxation relief is provided as an investment incentive. Tax Effects on Costs and Revenues The first of these taxation effects is perhaps the most obvious. It is unrealistic to consider only pre-tax cash revenues from a CI, as revenues which change reported profits also change tax liabilities, and produce taxation cashflows. It is important also to consider the timing of these tax cashflows. Most businesses pay tax one year after the end of each financial year. So for example, a cost or revenue which occurs in three years time will normally produce a taxation effect in four years time, assuming (for simplicity) that all cashflows occur at the end of the year. Example Tax Effect on CI Costs and Revenues Hall Co. is considering purchasing a new packaging machine. The machine will cost $52,000, plus installation costs will be $4,000. A $2,000 increase in inventory will be required, which can be liquidated for $2,000 at the end of the machine s 5 year life. The machine is expected to cost $26,000 per year to run, but will reduce packaging costs by an estimated $60,000 per year. It will have a zero salvage value in five years time. Hall Co.is subject to a 35% tax rate. Calculating tax cashflows:

20 386 Financial Management and Decision Making Only the increased costs and revenues appear in the income statement, affecting profit and therefore tax. Both the asset price and installation cost are capitalised to the asset account, and the increased inventory is a current asset rather than an expense. The relevant cashflows are: Cashflows Time 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 ($000s) Purchase price -52 Installation -4 Inventory Running Costs Cost Savings Increased tax* TOTALS * the tax effect is calculated as: (increase in profit) x (tax rate) = ($60,000 - $26,000) x 0.35 = $11,900 and as profit has increased, so will the tax liability, producing a cash outflow, assumed to occur one year after the costs and revenues themselves. Gains or Losses on Asset Sales If a CI project involves the sale of a currently held asset, further taxation effects can occur. If the selling price differs from the asset s net book value then a gain or loss on sale occurs. Although not actual cashflows in themselves, gains will increase profit thus increasing tax, and losses will decrease profit and reduce tax payable. Again, it is normally assumed that such tax effects produce cashflows one year after the sale of the asset, when the tax liability is payable. Example Tax Effects from the Sale of an Asset Angle Co. is considering replacing an old forklift purchased six years ago for $50,000 with an estimated useful life of ten years. It has been depreciated on a straight-line basis to a salvage value of $10,000. Angle Co. has a 35% tax rate. Calculating the net book value of the forklift: Book value = Original Purchase Price accumulated depreciation $50,000 $10,000 = $50, = $26,000

21 Chapter 18: Capital Investment 387 Selling price scenarios: (i) The old forklift is sold for $30,000 (cash received now): Gain on sale = ($30,000 - $26,000) = $4,000 Tax payable = $4,000 x 0.35 = $1,400 (payable in 1 year s time) (ii) The old forklift is sold for $15,000 (cash received now): Loss on sale = ($26,000 - $15,000) = $11,000 Tax break received = $11,000 x 0.35 = $3,850 (received in 1 year s time) When the sale of an existing asset forms part of a CI proposal, both the cash received for the asset (i.e. its selling price) and the taxation implications of any gain or loss on sale must be taken into account in analysing the cashflows. Depreciation Although the purchase price of a CI is incurred at the outset of the investment, financial accounting practice is to spread this initial cost over the life of an asset via depreciation. When conducting NPV analysis, depreciation itself is meaningless. The initial cash outlay occurs when the asset is purchased in time 0, and the accounting treatment of the asset does not change that. However, as an asset is depreciated over its life, that depreciation is recognised as an expense in the income statement each year, thus reducing profit. And as we know, a reduction in profit, though looking bad from an accounting point of view, is good from a cashflow perspective as it means less tax! Different countries have different ways of allowing asset depreciation for taxation purposes. Some countries (like the UK) use writing down allowances which are established at a fixed rate. Other countries (including New Zealand) prescribe allowable depreciation rates which a business can use to expense different assets in the income statement. The following example shows an illustration of how depreciation allowances affect taxation cashflows. Example Depreciation and Taxation Cashflows An asset is purchased by Taylor Co. for $100,000, and has a useful life of four years. It is subject to a depreciation allowance of 25% on its diminishing value. Taylor Co. is subject to a 35% tax rate. Depreciation allowances: Tax effect (cash inflow) 1st year $100,000 x 0.25 = $25,000 $25,000 x 0.35 = $8,750 2nd year $75,000 x 0.25 = $18,750 $18,750 x 0.35 = $6,563 3rd year $56,250 x 0.25 = $14,063 $14,063 x 0.35 = $4,922

22 388 Financial Management and Decision Making 4th year $42,187 x 0.25 = $10,547 $10,547 x 0.35 = $3,691 The taxation cashflows resulting from the depreciation allowances would normally occur one year after the depreciation expense is recognised. So, if the first depreciation allowance occurs at the end of the first year of the asset s life, the timing of the taxation cashflows would be as follows: Cashflows: Initial outlay -$100,000 Time 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Depn tax effects - +$8,750 +$6,563 +$4,922 +$3,691 It is important to remember that if a CI project replaces an existing asset, then only the change in depreciation is relevant to the NPV analysis. For example, if an existing asset depreciated at $3,000 per year, is to be replaced with a new asset having annual depreciation of $5,000, then only the increase in depreciation of $2,000 per year is relevant to calculating taxation effects. The taxation cashflows resulting from depreciation allowances can have a significant impact on the NPV of a CI project. Therefore, it is important to identify any changes in depreciation allowances so that the amount and timing of tax payments can be correctly incorporated into the NPV analysis. Taxation Investment Incentives Sometimes Governments make special taxation provisions to encourage investment in particular types of capital assets. In these cases, depreciation allowances may be accelerated, or there may be special one-off tax credits in the year of the asset s purchase. It is in the interests of the CI decision maker to be aware of such incentives, as they could impact on the viability of a CI project. Taxation Effects - Summary Taxation affects the NPV of a CI by changing its cashflows. This occurs because real cash effects of a CI (e.g. revenues and costs) and the accounting treatment of CI effects (e.g. gains and losses on asset sale and depreciation) all impact on reported profit and therefore change tax liabilities. A CI proposal cannot be correctly analysed without taking these taxation issues into account. Inflation Inflation affects the value of cashflows by eroding their purchasing power. Investors want to be compensated for this reduced purchasing power of future cashflows, so inflation is built into the discount rate used in NPV analyses. A rate of return which includes an inflation component is a nominal rate. The real rate of return removes the inflation component. It is important to distinguish between real and nominal rates of return when discounting cashflows for NPV analysis. Both the rate and the cashflows used must be consistent. Therefore, if a

23 Chapter 18: Capital Investment 389 nominal rate of return is used as the discount rate, then it should be recognised that inflation will increase the nominal size of the cashflows over the life of the CI. Alternatively, if cashflows are assumed to stay constant over the life of the asset, then a real rate of return should be used. It is a common mistake to use inconsistent combinations of rates of return and cashflows, resulting in incorrect NPV analyses. If done properly, both approaches will provide the same result. Capital Rationing It has been assumed up to this point that a firm will have sufficient funds available to invest in any available project which has a positive NPV. However, due to externally imposed restrictions, (e.g. hard capital rationing) or internally imposed budgets (e.g. soft capital rationing) there may be only limited funds available to the firm for investment. Where this is the case, a choice must be made between positive NPV projects. Here, the profitability index (PI) is more useful than NPV. While NPV shows the value of an investment, PI expresses that value as a proportion of the initial outlay funds required. Therefore, where funds are scarce, a higher PI project would be preferred as it returns more per scarce dollar than a project with a lower PI. A more sophisticated approach to selecting CI projects under conditions of single or multi period capital rationing is the use of Linear Programming (LP). Linear programming is a (usually) computerised mathematical technique. It calculates optimal solutions where an objective (e.g. maximising NPV) is pursued under constrained conditions (e.g. capital rationing), and can in its more sophisticated forms, cope with probabilistic outcomes, multiple objectives and multiple constraints. Linear programming is also useful where minimum liquidity and profitability constraints must be met by a CI investment programme. Using NPV - Summary Real world complications make the financial analysis of CI projects difficult. However, once the impact of these factors is assessed the NPV analysis method (together with PI) can accommodate the effects of tax, depreciation and inflation and lead to correct decision making where mutually exclusive projects exist. As with most financial decision making, the hard part is predicting what the future holds, but no CI analysis method alone can address this problem! A comprehensive example to draw together the issues discussed, and to illustrate how to conduct an NPV analysis on a CI proposal, may now be helpful. Using NPV - An Extended Example In this example, there are two machines: an existing machine, and a new machine which could be purchased as a replacement. In approaching the information, it is helpful to consider a CI project as having three types of cashflows: 1. Initial outlay (occurring in Year 0 - now)

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