Chapter 19 Objectives

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2 Chapter 19 Objectives 1. Describe the difference between independent and mutually exclusive capital investment decisions. 2. Explain the roles of the payback period and accoun>ng rate of return in capital investment decisions. 3. Calculate the net present value for independent projects. 4. Compute the internal rate of return for independent projects. 5. Tell why net present value is befer than internal rate of return for choosing among mutually exclusive projects. 6. Convert gross cash flows to aier tax cash flows. 7. Describe capital investment for advanced technology and environmental impact sekngs.

3 Capital Investment Decisions Capital Investment Decisions Concerned with the process of planning, sekng goals and priori>es, arranging financing, and using certain criteria to select long- term assets Capital budge5ng the process of making capital investment decisions Two types of capital budge>ng projects: Independent Projects Projects that, if accepted or rejected, will not affect the cash flows of another project. Mutually Exclusive Projects Projects that, if accepted, preclude the acceptance of comple5ng projects. Objec>ve

4 Payback and Accounting Rate of Return: Nondiscounting Methods Payback Period: the >me required for a firm to recover its original investment. When the cash flows of a project are assumed to be even, the following formula can be used to compute the project s payback period: Payback period = original investment/annual cash flow If the cash flows are uneven, the payback period is computed by adding the annual cash flows un>l such >me as the original investment is recovered. Objec>ve

5 Payback and Accounting Rate of Return: Nondiscounting Methods Payback Analysis * At the beginning of Year 3, $60,000 is needed to recover the investment. Since a net cash inflow of $100,000 is expected, only 0.6 year ($60,000 $100,000) is needed to recover the $60,000. Thus, the payback period is 2.6 years ( ). Major deficiency: ignores the time value of money

6 Payback and Accounting Rate of Return: Nondiscounting Methods Accoun5ng Rate of Return (ARR) Measures the return on a project in terms of income, as opposed to using a project s cash flow Accoun5ng rate of return = Average income /Original investment Where: Average income = average annual net cash flows less average deprecia>on Original investment (or average investment) = (I+S)/2 (I is the original investment and S is the salvage value). Assume that the investment is uniformly consumed. The major deficiency of the accoun>ng rate of return is that it ignores the >me value of money. Objec>ve

7 The Net Present Value Method Net Present value is the difference between the present value of the cash inflows (Benefits) and ou^lows (Costs) associated with a project: Where: NPV = PW Benefits PW Costs PW Benefits = the present value of the project s future cash inflows (revenues & other benefits) PW Costs = the present value of the project s cost (usually the ini>al outlay) End of Project Salvage Value NPV measures the profitability of an investment. If the NPV is posi5ve, it measures the increase in wealth Objec>ve

8 The Net Present Value Method Decision Criteria for NPV If the NPV is posi>ve, it signals that 1) The ini>al investment has been recovered 2) The required rate of return has been recovered 3) A return in excess of (1) and (2) has been received Reinvestment Assump5on: The NVP model assumes that all cash flows generated by a project are immediately reinvested to earn the required rate of return throughout the life of the project. Objec>ve

9 The Net Present Value Method Polson Company has developed a new cell phone that is expected to generate an annual revenue of $750,000. Necessary production equipment would cost $800,000 and can be sold in five years for $100,000. Working capital is expected to increase by $100,000 and is expected to be recovered at the end of five years. Annual operating expenses are expected to be $450,000. The required rate of return is 12 percent.

10 The Net Present Value Method

11 The Net Present Value Method 12% NPV = PW Benefits PW Costs NPV = [750k(P/A,12%,5)+100k(P/F,12%,5)] [800k+100k+450k(P/A,12%,5)-100k(P/F,12%,5)] NPV = [750k (3.605) +100k (0.5674)]-[900k+450k(3.605)-100k(0.5674)] NPV = 2704k + 57k 900k -1622k + 57k NPV = $296,000 c difference due to rounding

12 The Net Present Value Method Decision Criteria for NPV If NPV > 0 at i=marr: 1. The initial investment has been recovered 2. The required rate of return (MARR) has been recovered For the cell phone project, NPV = $296,000 Polson should manufacture the cell phones.

13 Internal Rate of Return The internal rate of return (IRR) is the interest rate that sets the present value of a project s cash inflows equal to the present value of the project s cost. It is the interest rate that sets the project s NPV at zero. Objec>ve

14 Internal Rate of Return The internal rate of return (IRR) is the interest rate that sets the project s NPV at zero. Thus, PW Benefits = PW Costs at i = IRR. Example: A project requires a $240,000 investment and will return $99,900 at the end of each of the next three years. What is the IRR? P = ' A% & ( 1+ i) N 1$ N " i(1+ i) # for x % 15% i 0 $99,900 (P/A,i,3) = $240,000 (P/A,i,3) = $240,000 $99,900 = i =12% (from tables ) Note: Use linear interpolation to find IRR: (P/A,10%,3)=2.487 & at 15% = then, x/5= ( )/( ) find x=2 so IRR=12%

15 Internal Rate of Return Decision Criteria: If the IRR>Cost of Capital, the project should be accepted. If the IRR = Cost of Capital, acceptance or rejec>on is equal. If the IRR < Cost of Capital, the project should be rejected. Objec>ve

16 NPV versus IRR: Mutually Exclusive Projects 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 methods measures it as a percentage. Objec>ve

17 Computing After-Tax Cash Flows Two steps are needed to compute cash flows: 1. Forecas>ng revenues, expenses, and capital outlays 2. Adjus>ng these gross cash flows for infla>on and tax effects Objec>ve

18 Computing After-Tax Cash Flows To analyze tax effects, cash flows are usually broken into three categories: 1. The ini>al cash ou^lows needed to acquire the assets of the project 2. The cash flows produced over the life of the project (opera>ng cash flows) 3. The cash flows from the final disposal of the project Objec>ve

19 Computing After-Tax Cash Flows Disposition of Old Machine Book Value Sale Price M1 $ 600,000 $ 780,000 M2 1,500,000 1,200,000 Acquisition of Flexible System Purchase cost $7,500,000 Freight 60,000 Installation 600,000 Additional working capital 540,000 Total $8,700,000

20 Computing After-Tax Cash Flows Objec>ve

21 Computing After-Tax Cash Flows MACRS Deprecia5on The taxpayer can use either the straight- line or the modified accelerated cost recovery system (MACRS) to compute annual deprecia>on with a half year conven>on The tax laws classify most assets into the following three classes (class = allowable years for deprecia>on): Class 3: most small tools Class 5: cars, light trucks, computer equipment Class 7: machinery, office equipment Assumes zero salvage value for asset MACRS Deprec for year t = (Rate for year t given in table) x Cost Basis Objec>ve

22 Computing After-Tax Cash Flows MACRS Deprecia5on Rates Half the deprecia>on for the first year can be claimed regardless of when the asset is actually placed in service. The other half year of deprecia>on is claimed in the year following the end of the asset s class life If the asset is disposed of before the end of its class life, only half of the deprecia>on for that year can be claimed. Objec>ve

23 Computing After-Tax Cash Flows B=$ 60k N= 5 for SL dt = B / N 5-yr MACRS Property dt=rt x B 19-23

24 Capital Investment: Advanced Technology & Environmental Considerations How Es5mates of Opera5ng Cash Flows Differ A company is evalua>ng a poten>al investment in a flexible manufacturing system (FMS). The choice is to con>nue producing with its tradi>onal equipment, expected to last 10 years, or to switch to the new system, which is also expected to have useful life of 10 years. The company s discount rate is 12 percent. Objec>ve

25 Capital Investment: Advanced Technology & Environmental Considerations

26 Capital Investment: Advanced Technology & Environmental Considerations How Es5mates of Opera5ng Cash Flows Differ A company is evalua>ng a poten>al investment in a flexible manufacturing system (FMS). The choice is to con>nue producing with its tradi>onal equipment, expected to last 10 years, or to switch to the new system, which is also expected to have useful life of 10 years. The company s discount rate is 12 percent. Note: (P/A,12%,10) = Present value ($4,000,000 * 5.65) $22,600,000 Investment 18,000,000 Net Present Value $ 4,600,000 Objec>ve

27 Capital Investment: Advanced Technology & Environmental Considerations 19-27

Why Use Net Present Value? The Payback Period Method The Discounted Payback Period Method The Average Accounting Return Method The Internal Rate of

1 Why Use Net Present Value? The Payback Period Method The Discounted Payback Period Method The Average Accounting Return Method The Internal Rate of Return Problems with the IRR Approach The Profitability