Capital Expenditure Decisions

Transcription

1 hil68241_ch15_ indd Page 1 9/16/09 4:27:09 PM user-s180 /Volumes/MHRL-New/MHRL024/MHRL024-15web Chapter Fifteen Capital Expenditure Decisions FOCUS COMPANY This chapter s focus is on the City of Mountainview, British Columbia. Mountainview s mayor and city council face a variety of decisions that involve cash flows over several periods of time. The decision tool used in making such multiperiod decisions is called discounted-cash-flow analysis, because it takes account of the different timing of cash flows that occur in different time periods. Among the decisions that Mountainview s leadership makes is whether to purchase a new computer system for the city government. Since the City of Mountainview is not a profit-seeking enterprise, income taxes play no role in the decisions faced by the city s leadership. IN CONTRAST After completing this chapter, you should be able to: 1 Use the net-present-value method and the internal-rate-of-return method to evaluate an investment proposal. 2 Compare the net-presentvalue and internal-rate-of-return methods, and state the assumptions underlying each method. 3 Use both the total-cost approach and the incrementalcost approach to evaluate an investment proposal. 4 Use the payback method and accounting-rate-of-return method to evaluate capitalinvestment projects. 5 Discuss the difficulty of ranking investment proposals, and use the profitability index. 6 Determine the after-tax cash flows in an investment analysis. 7 Evaluate an investment proposal using a discountedcash-flow analysis, giving full consideration to income-tax issues. In contrast to the Mountainview city government setting, in which income taxes play no role in decisions, we turn our attention to High Country Department 8 Describe the impact of Stores. This chain of retail activity-based costing and department stores, located advanced manufacturing in Mountainview, also faces technology on capitalbudgeting decisions. some significant decisions involving multi-period cash flows. Since High Country is a profit-seeking enterprise, it does pay income taxes. Therefore, when the company s management uses discounted-cash-flow analysis, it must take taxes into account. Among the decisions faced by High Country s management is whether to purchase a new computerized checkout system.

2 2 Chapter 15 Capital Expenditure Decisions Managers in all organizations periodically face major decisions that involve cash flows over several years. Decisions involving the acquisition of machinery, vehicles, buildings, or land are examples of such decisions. Other examples include decisions involving significant changes in a production process or adding a major new line of products or services to the organization s activities. Decisions involving cash inflows and outflows beyond the current year are called capital-budgeting decisions. Managers encounter two types of capital-budgeting decisions. Acceptance-or-Rejection Decisions In acceptance-or-rejection decisions, managers must decide whether they should undertake a particular capital investment project. In such a decision, the required funds are available or readily obtainable, and management must decide whether the project is worthwhile. For example, the Mountainview city manager is faced with a decision on whether to replace one of the city s oldest streetcleaning machines. The funds are available in the city s capital budget. The question is whether the cost savings with the new machine will justify the expenditure. Capital-Rationing Decisions In capital-rationing decisions, managers must decide which of several worthwhile projects makes the best use of limited investment funds. To illustrate, suppose the Mountainview city council has recently passed a proposition mandating a cost-reduction program to trim administrative expenses. The council has obtained a loan from the province in the amount of $100,000 to finance the costreduction program. The mayor has in mind three cost-reduction programs, each of which would reduce administrative costs significantly over the next five years. However, the city can afford only two of the programs with the $100,000 of investment capital available. The mayor s decision problem is to decide which projects to pursue. Focus on Project Capital-budgeting problems tend to focus on specific projects or programs. Is it best for Mountainview to purchase the new street cleaner or not? Which cost-reduction programs will provide the city with the greatest benefits? Should a university buy a new electron microscope? Should a manufacturing firm acquire a computer-integrated manufacturing system? Over time, as managers make decisions about a variety of specific programs and projects, the organization as a whole becomes the sum total of its individual investments, activities, programs, and projects. The organization s performance in any particular year is the combined result of all the projects under way during that year. Discounted-Cash-Flow Analysis Learning Objective 1 Use the net-present-value method and the internal-rateof-return method to evaluate an investment proposal. How do managers evaluate capital investment projects? Our discussion will be illustrated by several decisions made by the Mountainview city government. The Mountainview city manager routinely advises the mayor and city council on major capital investment decisions. Currently under consideration is the purchase of a new street cleaner. The city manager has estimated that the old street-cleaning machine would last another five years. A new street cleaner, which also would last for five years, can be purchased for $50,470. It would cost the city $14,000 less each year to operate the new equipment than it costs to operate the old machine. The expected cost savings with the new machine are due to lower expected maintenance costs. Thus, the new street cleaner will cost $50,470 and save $70,000 over its five-year life ($70, $14,000 savings per year). Since the $70,000 in cost savings exceeds the $50,470 acquisition cost, one might be tempted to conclude that the new machine should be purchased. However, this analysis is flawed, since it does not account for the time value of money. The $50,470 acquisition cost will

3 Chapter 15 Capital Expenditure Decisions 3 occur now, but the cost savings are spread over a five-year period. It is a mistake to add cash flows occurring at different points in time. The proper approach is to use discounted-cash-flow analysis, which takes into account the timing of the cash flows. There are two widely used methods of discounted-cash-flow analysis: the net-presentvalue method and the internal-rate-of-return method. (Those who wish to review the basic concept of present value should read Appendix A at the end of this chapter.) Net-Present-Value Method The following four steps constitute a net-present-value analysis of an investment proposal: 1. Prepare a table showing the cash flows during each year of the proposed investment. 2. Compute the present value of each cash flow, using a discount rate that reflects the cost of acquiring investment capital. This discount rate is often called the hurdle rate or minimum desired rate of return. 3. Compute the net present value, which is the sum of the present values of the cash flows. 4. If the net present value (NPV) is equal to or greater than zero, accept the investment proposal. Otherwise, reject it. Exhibit 15 1 displays these four steps for the Mountainview city manager s street-cleaner decision. In step 2 the city manager used a discount rate of 10 percent. Notice that the cost savings are $14,000 in each of the years 1 through 5. Thus, the cash flows in those years make up a five-year, $14,000 annuity. The controller used the annuity discount factor to compute the present value of the five years of cost savings. (The discount factors are found in Appendix B at the end of this chapter.) The net-present-value analysis indicates that the city should purchase the new street cleaner. The present value of the cost savings exceeds the new machine s acquisition cost. We re key members of the decision making team when it comes to significant capital expenditure decisions. (15a) Ford Motor Company Internal-Rate-of-Return Method An alternative discounted-cash-flow method for analyzing investment proposals is the internal-rate-of-return method. An asset s internal rate of return (or time-adjusted CITY OF MOUNTAINVIEW Purchase of Street Cleaner (r.10, n 5) Exhibit 15 1 Net-Present-Value Method Step 1 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Acquisition cost $(50,470) Annual cost savings $14,000 $14,000 $14,000 Step 2 Present value of annuity $14,000(3.791) P resent value $(50,470) $53,074 Step 3 Net present value $2,604 $14,000 $14,000 Annuity discount factor for r.10 and n 5 from Table IV in Appendix B Step 4 Accept proposal, since net present value is positive.

4 4 Chapter 15 Capital Expenditure Decisions rate of return ) is the true economic return earned by the asset over its life. Another way of stating the definition is that an asset s internal rate of return (IRR) is the discount rate that would be required in a net-present-value analysis in order for the asset s net present value to be exactly zero. What is the internal rate of return on Mountainview s proposed street-cleaner acquisition? Recall that the asset has a positive net present value, given that the city s cost of acquiring investment capital is 10 percent. Would you expect the asset s IRR to be higher or lower than 10 percent? Think about this question intuitively. The higher the discount rate used in a net-present-value analysis, the lower the present value of all future cash flows will be. This is true, because a higher discount rate means that it is even more important to have the money earlier instead of later. Thus, a discount rate higher than 10 percent would be required to drive the new street cleaner s net present value down to zero. Finding the Internal Rate of Return How can we find this rate? One way is trial and error. We might experiment with different discount rates until we find the one that yields a zero net present value. We already know that a 10 percent discount rate yields a positive NPV. Let s try 14 percent. Discounting the five-year, $14,000 cost-savings annuity at 14 percent yields a negative NPV of $(2,408) $14,0002 $50,470 $12,4082 Annuity discount factor for r.14 and n 5 from Table IV in Appendix B. What does this negative NPV at a 14 percent discount rate mean? We increased the discount rate too much. Therefore, the street cleaner s internal rate of return must lie between 10 percent and 14 percent. Let s try 12 percent: $14,0002 $50,470 0 Annuity discount factor for r.12 and n 5 from Table IV in Appendix B. That s it. The new street cleaner s internal rate of return is 12 percent. With a 12 percent discount rate, the investment proposal s net present value is zero, since the street cleaner s acquisition cost is equal to the present value of the cost savings. We could have found the internal rate of return more easily in this case, because the street cleaner s cash flows exhibit a very special pattern. The cash inflows in years 1 through 5 are identical, as shown below. Year Cash flow $(50,470) $14,000 $14,000 $14,000 $14,000 $14,000 Initial cash outflow (acquisition cost) Equal cash inflows (operating-cost savings) When we have this special pattern of cash flows, the internal rate of return is determined in two steps, as follows: 1. Divide the initial cash outflow by the equivalent annual cash inflows: $ 210, Annuity discount factor $50,000

5 Chapter 15 Capital Expenditure Decisions 5 2. In Table IV, find the discount rate associated with the annuity discount factor computed in step 1, given the appropriate number of years in the annuity. From Table IV of Appendix B r 10% 12% 14% n = Decision Rule Now that we have determined the investment proposal s internal rate of return to be 12 percent, how do we use this fact in making a decision? The decision rule in the internal-rate-of-return method is to accept an investment proposal if its internal rate of return is greater than the organization s cost of capital (or hurdle rate). Thus, Mountainview s city manager should recommend that the new street cleaner be purchased. The internal rate of return on the proposal, 12 percent, exceeds the city s hurdle rate, 10 percent. To summarize, the internal-rate-of-return method includes the following three steps: 1. Prepare a table showing the cash flows during each year of the proposed investment. This table will be identical to the cash-flow table prepared under the net-present-value method. (See Exhibit 15 1.) 2. Compute the internal rate of return (IRR) for the proposed investment. This is accomplished by finding a discount rate that yields a zero net present value for the proposed investment. 3. If the IRR is equal to or greater than the hurdle rate (cost of acquiring investment capital), accept the investment proposal. Otherwise, reject it. Recovery of Investment The reason for purchasing an asset is an expectation that it will provide benefits in the future. Thus, Mountainview may purchase the new street cleaner because of expected future operating-cost savings. For a capital-investment proposal to be accepted, the expected future benefits must be sufficient for the purchaser to recover the investment and earn a return on the investment equal to or greater than the cost of acquiring capital. We can illustrate this point with Mountainview s street-cleaner acquisition. Exhibit 15 2 examines the investment proposal s cash flows from the perspective of recovering the investment and earning a return on the investment. Focus on the CITY OF MOUNTAINVIEW Purchase of Street Cleaner (r.12, n 5) Our role is to be internal management consultants for the key decisions facing management. (15b) Hewlett-Packard Exhibit 15 2 Recovery of Investment and Return on Investment Year 1 Year 2 Year 3 Year 4 Year 5 1. Unrecovered investment at beginning of year $50,470 $42,526 $33,629 $23,664 $12, Cost savings during year ,000 14,000 14,000 14,000 14, Return on unrecovered investment [12% amount in row (1)] ,056 5,103 4,035 2,840 1, Recovery of investment during year [row (2) amount minus row (3) amount] ,944 8,897 9,965 11,160 12, Unrecovered investment at end of year [row (1) amount minus row (4) amount] ,526 33,629 23,664 12,504 4* *We are left with an unrecovered investment of $4 because of accumulated rounding errors in the table. If we had carried out each number to cents, the table would have finished up with an unrecovered investment of zero.

6 6 Chapter 15 Capital Expenditure Decisions year 1 column in the exhibit. The street cleaner costs $50,470, so this is the unrecovered investment at the beginning of year 1. The operating-cost savings in year 1 are $14,000. Since the asset s internal rate of return is 12 percent, it must earn $6,056 during the first year (12% 3 $50,470). Therefore, $6,056 of the $14,000 cost savings represents a return on the unrecovered investment. This leaves $7,944 as a recovery of the investment during year 1 ($14,000 2 $6,056). Subtracting the year 1 recovery of investment from the unrecovered investment at the beginning of the year leaves an unrecovered investment of $42,526 at year-end ($50,470 2 $7,944). Uneven Cash Flows A complication that often arises in finding a project s internal rate of return is an uneven pattern of cash flows. In Mountainview s proposed streetcleaner acquisition, the cost savings are $14,000 per year for all five years of the machine s life. Suppose, instead, that the pattern of cost savings is as follows: Cost savings $14,000 $14,000 $12,000 $10,000 $8,000 Year 1 2 Such an uneven cost-savings pattern is quite plausible, since the maintenance costs could rise in the machine s latter years. When the cash-flow pattern is uneven, iteration must be used to find the internal rate of return. You can try various discount rates iteratively until you find the one that yields a zero net present value for the investment proposal. This sort of computationally intensive work is the kind of task for which computers are designed. Numerous computer software packages are available to find a project s IRR almost instantaneously Time Learning Objective 2 Compare the net-present-value and internal-rate-of-return methods, and state the assumptions underlying each method. Comparing the NPV and IRR Methods The decision to accept or reject an investment proposal can be made using either the net-present-value method or the internal-rate-of-return method. The different approaches used in the methods are summarized as follows: Net-Present-Value Method Internal-Rate-of-Return Method 1. Compute the investment proposal s net present value, using the organization s hurdle rate as the discount rate. 1. Compute the investment proposal s internal rate of return, which is the discount rate that yields a zero net present value for the project. 2. Accept the investment proposal if its net present value is equal to or greater than zero; otherwise reject it. 2. Accept the investment proposal if its internal rate of return is equal to or greater than the organization s hurdle rate; otherwise reject it. Notice that the hurdle rate is used in each of the two methods. Advantages of Net-Present-Value Method The net-present-value method exhibits two potential advantages over the internal-rate-of-return method. First, if the investment analysis is carried out by hand, it is easier to compute a project s NPV than its IRR. For example, if the cash flows are uneven across time, trial and error must be used to find the IRR. This advantage of the NPV approach is not as important, however, when a computer is used. A second potential advantage of the NPV method is that the analyst can adjust for risk considerations. For some investment proposals, the further into the future that a cash flow occurs, the less certain the analyst can be about the amount of the cash flow. Thus, the later a projected cash flow occurs, the riskier it may be. It is possible to adjust a net-present-value analysis for such risk factors by using a higher discount rate for later cash flows than earlier cash flows. It is not possible to include such a risk adjustment in the internal-rate-of-return method, because the analysis solves for only a single discount rate, the project s IRR.

7 Chapter 15 Capital Expenditure Decisions 7 Assumptions Underlying Discounted-Cash- Flow Analysis As is true of any decision model, discounted-cash-flow methods are based on assumptions. Four assumptions underlie the NPV and IRR methods of investment analysis. 1. In the present-value calculations used in the NPV and IRR methods, all cash flows are treated as though they occur at year-end. If the City of Mountainview were to acquire the new street cleaner, the $14,000 in annual operating-cost savings actually would occur uniformly throughout each year. The additional computational complexity that would be required to reflect the exact timing of all cash flows would complicate an investment analysis considerably. The error introduced by the year-end cash-flow assumption generally is not large enough to cause any concern. 2. Discounted-cash-flow analyses treat the cash flows associated with an investment project as though they were known with certainty. Although methods of capital budgeting under uncertainty have been developed, they are not used widely in practice. Most decision makers do not feel that the additional benefits in improved decisions are worth the additional complexity involved. As mentioned above, however, risk adjustments can be made in an NPV analysis to partially account for uncertainty about the cash flows. 3. Both the NPV and IRR methods assume that each cash inflow is immediately reinvested in another project that earns a return for the organization. In the NPV method, each cash inflow is assumed to be reinvested at the same rate used to compute the project s NPV, the organization s hurdle rate. In the IRR method, each cash inflow is assumed to be reinvested at the same rate as the project s internal rate of return. What does this reinvestment assumption mean in practice? In the case of Mountainview s proposed new street cleaner, the city must instantly reinvest the money saved each year either in some interest-bearing investment or in some other capital project. 4. A discounted-cash-flow analysis assumes a perfect capital market. This implies that money can be borrowed or lent at an interest rate equal to the hurdle rate used in the analysis. In practice, these four assumptions are rarely satisfied. Nevertheless, discountedcash-flow models provide an effective and widely used method of investment analysis. The improved decision making that would result from using more complicated models is seldom worth the additional cost of information and analysis. Choosing the Hurdle Rate The choice of a hurdle rate is a complex problem in finance. The hurdle rate is determined by management based on the investment opportunity rate. This is the rate of return the organization can earn on its best alternative investments of equivalent risk. In general, the greater a project s risk is, the higher the hurdle rate should be. Investment versus Financing Decisions In capital-expenditure decisions, the investment decision should be separated from the financing decision. The decision as to whether to invest in a project should be made first using a discounted-cash-flow approach with a hurdle rate based on the investment opportunity rate. If a project is accepted, then a separate analysis should be made as to the best way to finance the project.

8 8 Chapter 15 Capital Expenditure Decisions Cost of Capital How do organizations generate investment capital? Nonprofit organizations, such as city and provincial governments, and charitable organizations, often acquire capital through special bond issues or borrowing from financial institutions. In such cases, the cost of capital is based on the interest rate paid on the debt. Another source of capital for both nonprofit and profit-oriented organizations is invested funds, such as a university s endowment fund. In this case, the cost of using the capital for an investment project is the interest rate forgone on the original investment. For example, suppose your university s endowment earns interest at the rate of 10 percent. If the university uses a portion of these funds to buy new laboratory equipment, the cost of capital is the 10 percent interest rate that is no longer earned on the funds removed from the endowment. Profit-oriented enterprises fund capital projects by borrowing, by issuing stock, or by using invested funds. In most cases, capital projects are funded by all of these sources. Then the cost of capital should be a combination of the costs of obtaining money from each of these sources. Depreciable Assets When a long-lived asset is purchased, its acquisition cost is allocated to the time periods in the asset s life through depreciation charges. However, we did not include any depreciation charges in our discounted-cash-flow analysis. Both the NPV and IRR methods focus on cash flows, and periodic depreciation charges are not cash flows. Suppose that the Mountainview city manager depreciates assets using the straight-line method. If the city purchases the new street cleaner for $50,470, the depreciation charges will be recorded as follows: Acquisition cost $50,470 Annual straight-line depreciation (D) D = $10,094 D = $10,094 D = $10,094 D = $10,094 D = $10,094 Year 1 Year 2 Year 3 Year 4 Year 5 Time Acquisition cost is a cash outflow Depreciation charges are not cash flows The only cash flow in the diagram above is the $50,470 cash outflow incurred to acquire the street cleaner. The $10,094 annual depreciation charges are not cash flows. Thus, the acquisition cost is recorded as a cash flow in our investment analysis (Exhibit 15 1), but the annual depreciation charges are not. Nonprofit versus Profit-Oriented Organizations Suppose our illustration had focused on a profit-seeking enterprise instead of the City of Mountainview. For example, if the street-cleaner acquisition is contemplated by a theme-park company, would this change our treatment of the annual depreciation charges for the street cleaner? The depreciation charges still are not cash flows. However, in a profit-seeking enterprise, depreciation expense is deductible for income-tax purposes. Since tax payments are cash flows, the reduction in tax due to depreciation expense is a legitimate cash flow that should be included in an investment analysis. In a later section, we will study the tax implications of depreciable assets in detail. For now, let s return to our focus on the City of Mountainview. As a nonprofit enterprise, the city pays no income tax. Therefore, depreciation is irrelevant in our discountedcash-flow analysis.

9 Chapter 15 Capital Expenditure Decisions 9 Comparing Two Investment Projects We have developed all of the tools and concepts required to use discounted-cashflow analysis in an investment decision. Now we can expand on our discussion using an illustration that combines the net-present-value method of investment analysis with the concepts of relevant costs and benefits studied in Chapter 13. The first step in any investment analysis is to determine the cash flows that are relevant to the analysis. The computer system used by the City of Mountainview is outdated. The city council has voted to purchase a new computer system to be funded through a loan. The mayor has asked the city s manager to make a recommendation as to which of two computer systems should be purchased. The two systems are equivalent in their ability to meet the city s needs and in their ease of use. The mainframe system consists of one large mainframe computer with remote terminals and printers located throughout the city offices. The personal computer system consists of a much smaller mainframe computer, a few remote terminals, and a dozen personal computers, which will be networked to the small mainframe. Each system would last five years. The city manager has decided to use a 12 percent hurdle rate for the analysis. Exhibit 15 3 presents data pertinent to the decision. Examine these data carefully. Most of the items are self-explanatory. Item 9 is the annual cost of a data-link service. This service enables Mountainview to participate in a nationwide computer network, which allows cities to exchange information on such issues as crime rates, demographic data, and economic data. Item 10 is the revenue the city will receive from two timesharing customers. The Mountainview School District and the regional district each has agreed to pay the city in return for a limited amount of time on the city s computer. Before we begin the steps of the net-present-value method, let s examine the cashflow data in Exhibit 15 3 to determine if any of the data can be ignored as irrelevant. Notice that items 1 and 9 do not differ between the two alternatives. Regardless of which new computer system is purchased, certain components of the old system can be sold now for $25,000. Moreover, the data-link service will cost $20,000 annually, regardless of which system is acquired. If the only purpose of the NPV analysis is to Learning Objective 3 Use both the total-cost approach and the incrementalcost approach to evaluate an investment proposal. Exhibit 15 3 Data for Extended Illustration of Net-Present-Value Analysis

10 10 Chapter 15 Capital Expenditure Decisions CITY OF MOUNTAINVIEW Purchase of Computing System (r 5.12, n 5 5) Item Number (from Exhibit 15 3) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Mainframe System (2) Acquisition cost: Computer... $(400,000) (3) Acquisition cost: Software... (40,000) (4) System update... $ (40,000) (5) Salvage value... $ 50,000 (6), (7), (8) Operating costs... $(335,000) $(335,000) (335,000) $(335,000) (335,000) (10) Time-sharing revenue... 20,000 20,000 20,000 20,000 20,000 Total cash flow... $(440,000) $(315,000) $(315,000) $(355,000) $(315,000) $(265,000) 3 Discount factor Present value... $(440,000) $(281,295) $(251,055) $(252,760) $(200,340) $(150,255) Net present value of costs Sum $( 1575,, 705) Personal Computer System (2) Acquisition cost: Computer... $(300,000) (3) Acquisition cost: Software... (75,000) (4) System update... $ (60,000) (5) Salvage value... $ 30,000 (6), (7), (8) Operating costs... $(235,000) $(235,000) (235,000) $(235,000) (235,000) (10) Time-sharing revenue Total cash flow... $(375,000) $(235,000) $(235,000) $(295,000) $(235,000) $(205,000) 3 Discount factor Present value... $(375,000) $(209,855) $(187,295) $(210,040) $(149,460) $(116,235) Net present value of costs... Sum $( 1247,, 885) Difference in NPV of costs (favours personal computer system)... $ (327,820) Exhibit 15 4 Net-Present-Value Analysis: Total-Cost Approach determine which computer system is the least-cost alternative, items 1 and 9 can be ignored as irrelevant, since they will affect both alternatives NPVs equally. Total-Cost Approach Exhibit 15 4 displays a net-present-value analysis of the two alternative computer systems. The Exhibit uses the total-cost approach, in which all of the relevant costs of each computer system are included in the analysis. Then the net present value of the cost of the mainframe system is compared with that of the personal computer system. Since the NPV of the costs is lower with the personal computer system, that will be the city manager s recommendation to the Mountainview City Council. A decision such as Mountainview s computer-system choice, in which the objective is to select the alternative with the lowest cost, is called a least-cost decision. Rather than maximizing the NPV of cash inflows minus cash outflows, the objective is to minimize the NPV of the costs to be incurred. Incremental-Cost Approach Exhibit 15 5 displays a different net-present-value analysis of the city s two alternative computer systems. This Exhibit uses the incrementalcost approach, in which the difference in the cost of each relevant item under the two alternative systems is included in the analysis. For example, the incremental computer acquisition cost is shown in Exhibit 15 5 as $(100,000). This is the amount by which

11 Chapter 15 Capital Expenditure Decisions 11 CITY OF MOUNTAINVIEW Purchase of Computing System (r 5.12, n 5 5) Item Number (from Exhibit 15 3) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Incremental Cost of Mainframe System over Personal Computer System (2) Acquisition cost: Computer... $(100,000) (3) Acquisition cost: Software... 35,000 (4) System update... $ 20,000 (5) Salvage value... $ 20,000 (6), (7), (8) Operating costs... $(100,000) $(100,000) (100,000) $(100,000) (100,000) (10) Time-sharing revenue... 20,000 20,000 20,000 20,000 20,000 Incremental cash flow... $ (65,000) $ (80,000) $ (80,000) $ (60,000) $ (80,000) $ (60,000) 3 Discount factor Present value... $ (65,000) $ (71,440) $ (63,760) $ (42,720) $ (50,880) $ (34,020) Net present value of incremental costs (favours personal computer system)... Sum $( 327, 820) the acquisition cost of the mainframe system exceeds that of the personal computer system. The result of this analysis is that the NPV of the costs of the mainframe system exceeds that of the personal computer system by $327,820. Notice that this is the same as the difference in NPVs shown at the bottom of Exhibit The total-cost and incremental-cost approaches always will yield equivalent conclusions. Choosing between them is a matter of personal preference. Exhibit 15 5 Net-Present-Value Analysis: Incremental-Cost Approach Managerial Accountant s Role To use discounted-cash-flow analysis in deciding about investment projects, managers need accurate cash-flow projections. This is where the managerial accountant plays a role. The accountant often is asked to predict cash flows related to operatingcost savings, additional working-capital requirements, or incremental costs and revenues. Such predictions are difficult in a world of uncertainty. The managerial accountant often draws upon historical accounting data to help in making cost predictions. Knowledge of market conditions, economic trends, and the likely reactions of competitors also can be important in projecting cash flows. Postaudit The discounted-cash-flow approach to evaluating investment proposals requires cashflow projections. The desirability of a proposal depends heavily on those projections. If they are highly inaccurate, they may lead the organization to accept undesirable projects or to reject projects that should be pursued. Because of the importance of the capital-budgeting process, most organizations systematically follow up on projects to see how they turn out. This procedure is called a postaudit (or reappraisal ). In a postaudit, the managerial accountant gathers information about the actual cash flows generated by a project. Then the project s actual net present value or internal rate of return is computed. Finally, the projections made for the project are compared with the actual results. If the project has not lived up to expectations, an investigation may be warranted to determine what went awry. Sometimes a postaudit will reveal shortcomings in the cash-flow projection process. In such cases, action may be taken to improve future cash-flow predictions. Two types of errors can occur in discounted-cash-flow analyses: undesirable projects may be accepted and desirable projects may be rejected. The use of discounted cash flows improves decision making by requiring a more structured approach that addresses all factors that can affect the outcome of a project. (15c) British Columbia s Comptroller General

12 12 Chapter 15 Capital Expenditure Decisions Capital-investment decisions go through an elaborate capitalbudgeting process. This automated milling equipment cost tens of millions of dollars, and the capital expenditure decision was carefully analyzed. For what types of decisions would capital budgeting be used by the administration of the school you attend? The postaudit is a tool for following up on accepted projects. Thus, a postaudit helps to detect only the first kind of error, not the second. As in any performance-evaluation process, a postaudit should not be used punitively. The focus of a postaudit should provide information to the capitalbudgeting staff, the project manager, and the management team. Real Option Analysis One way managerial accountants can assist the management team is by assessing the consequences of changes in an investment decision that may develop after the project has been approved. In long-term projects, there is often considerable uncertainty about the future cash flows, due to uncertainty about future economic, political, or natural events. As a project unfolds, management may decide to alter the course of the project or even postpone it. Suppose, for example, that the City of Mountainview decides to build a new municipal water system that will take five years to build and is expected to last 75 years. The project involves collaboration with several private enterprises, other municipalities, and the provincial government. As the project develops and various uncertainties are resolved, it may be desirable to make changes in the water system or postpone certain parts of it. A capital-budgeting tool called real option analysis can be used to quantify and analyze the merits of such changes. Real option analysis is covered in more advanced cost management and finance courses. Alternative Methods for Making Investment Decisions Learning Objective 4 Use the payback method and accounting-rate-of-return method to evaluate capitalinvestment projects. HIGH COUNTRY DEPARTMENT STORES The best way to decide whether to accept an investment project is to use discounted-cash-flow analysis, as described in the preceding section. Both the NPV and the IRR methods will yield the correct accept-or-reject decision. The strength of these methods lies in the fact that they properly account for the time value of money. In spite of the conceptual superiority of discounted-cash-flow decision models, managers sometimes use other methods for making investment decisions. In some cases, these alternative methods are used in conjunction with a discounted-cash-flow analysis. Two of these alternative decision methods are described next. Our discussion is based on decisions faced by the management of High Country Department Stores. The firm operates two department stores in Mountainview. Payback Method The payback period of an investment proposal is the amount of time it will take for the cash inflows from the project to accumulate to an amount that covers the original investment. The following formula defines an investment project s payback period: Payback period Initial investment Annual cash inflow

13 Chapter 15 Capital Expenditure Decisions 13 There is no adjustment in the payback method for the time value of money. A cash inflow in year 5 is treated the same as a cash inflow in year 1. To illustrate the payback method, suppose High Country Department Stores management is considering the purchase of a new conveyor system for its warehouse. The two alternative machines under consideration have the following projected cash flows: Conveyor System Initial Investment Cash Flows: Years 1 through 7 Cash Flow When System Is Sold I... $(20,000)... $4, II... (27,000)... 4, $14,000 The payback period for each conveyor system is computed below. Conveyor System I... II... Initial Investment Annual Cash Inflow Payback Period $ 20, 000 $ 4, years $ 27, 000 $ 4, years According to the payback method, system I is more desirable than system II. System I will pay back its initial investment in five years, while system II requires six years. This conclusion is too simplistic, however, because it ignores the large salvage value associated with system II. Indeed, the NPV of system I is negative, while the NPV of system II is positive, as shown in the following analysis: Present Value of Cash Flows (10% discount factor) Cash Flows System I System II Initial investment $(20,000) $(20,000) $(27,000) $(27,000) Years 1 7 4, ,472 4, ,906 Cash inflow from sale 0 14, ,182 Net present value $ (528) $ 2,088 The net-present-value analysis demonstrates that only system II can generate cash flows sufficient to cover the company s cost of capital. The payback method makes it appear as though system I pays back its initial investment more quickly, but the method fails to consider the time value of money. Another shortcoming of the payback method is that it fails to consider an investment project s profitability beyond the payback period. Suppose High Country Department Stores management has a third alternative for its warehouse conveyor system. System III requires an initial investment of only $12,000 and will generate cash inflows of $6,000 in years 1 and 2. Thus, system III s payback period is two years, as computed below. $ 12, 000 System III payback period $ 6, years Strict adherence to the payback method would rank system III above systems I and II, due to its shorter payback period. However, suppose we add another piece of information. System III s useful life is only two years, and it has no salvage value after two years. It is true that system III will pay back its initial investment in only two years if we ignore the time value of money. But then what? It provides no further benefits beyond year 2. In spite of system III s short payback period, it is

14 14 Chapter 15 Capital Expenditure Decisions Exhibit 15 6 Payback Period with Uneven Cash Flows HIGH COUNTRY DEPARTMENT STORES HIGH COUNTRY DEPARTMENT STORES, INC. Parking Lot Expansion After-Tax Cash Flows Year Type of Cash Flow Outflows Inflows Accumulated Cash Flows (excluding initial investment) 0 Initial investment $(200,000) 1 Incremental sales* $60,000 $ 60,000 2 Incremental sales* 50, ,000 3 Incremental sales* 45, ,000 4 Incremental sales* 35, ,000 4 Repave parking lot (20,000) 170,000 Payback 5 Incremental sales* 30, ,000 period: 6 Incremental sales* 30, ,000 5 years 7 Incremental sales* 30, ,000 8 Incremental sales* 30, ,000 *Incremental sales, net of cost of goods sold. not a desirable investment proposal. The NPV of system III, $(1,584), is negative [$(1,584) 5 ( $6,000) 2 $12,000]. Payback Period with Uneven Cash Flows The simple payback formula given on page 12 will not work if a project exhibits an uneven pattern of cash flows. Instead, the cash flows must be accumulated on a year-to-year basis until the accumulation equals the initial investment. Suppose High Country Department Stores management is considering the expansion of the downtown store s parking facilities. Management expects that the additional parking will result in much greater sales initially. However, this benefit will gradually taper off, due to the reactions of competitors. The projected cash flows are shown in Exhibit 15 6, which also presents the payback calculation for the parking lot proposal. The project s payback period is five years. Payback: Pro and Con In summary, the payback method of evaluating investment proposals has two serious drawbacks. First, the method fails to consider the time value of money. Second, it does not consider a project s cash flows beyond the pay-back period. Despite these shortcomings, the payback method is used widely in practice, because it provides a tool for roughly screening investment proposals. If a project does not meet some minimal criterion for the payback period, management may wish to reject the proposal regardless of potential large cash flows predicted well into the future. For example, a young firm may experience a shortage of cash. For such a company, it may be crucial to select investment projects that recoup their initial investment quickly. A cash-poor firm may not be able to wait for the big payoff of a project with a long payback period. Even in these cases though, it is wise not to rely on the payback method alone. If the payback method is used, it should be in conjunction with a discounted-cash-flow analysis. Accounting-Rate-of-Return Method Discounted-cash-flow methods of investment analysis focus on cash flows and incorporate the time value of money. In contrast, the accounting-rate-of-return method focuses on the incremental accounting income that results from a project. Accounting income is based on accrual accounting procedures. Revenue is recognized during the

15 Chapter 15 Capital Expenditure Decisions 15 Exhibit 15 7 Accounting-Rate-of-Return Method HIGH COUNTRY DEPARTMENT STORES period of sale, not necessarily when the cash is received; expenses are recognized during the period they are incurred, not necessarily when they are paid in cash. The following formula is used to compute the accounting rate of return on an investment project. Average incremental Average incremental expenses revenue ( including depreciation) Accounting rate of return Initial investment To illustrate the accounting-rate-of-return method, suppose High Country Department Stores management is considering the installation of a small lunch counter in its downtown store. The required equipment and furnishings cost $210,000. The Excel spreadsheet shown in Exhibit 15 7 displays management s revenue and expense projections for the lunch counter. The total income projected over the project s 10-year useful life is $290,000. Thus, the average annual income is $29,000. The accounting rate of return on the lunch-counter proposal is computed as follows: $ 29, 000 Accounting rate of return $ 210, % (rounded) To compute the lunch-counter project s internal rate of return, let s assume that each year s sales revenue ($200,000), cost of goods sold ($100,000), and operating expenses ($50,000) are cash flows in the same year that they are recorded under accrual accounting. Recall that the depreciation expense is not a cash flow. Dividing the initial cash outflow by the equivalent annual cash inflows, we obtain the following: $210,000 $50, Annuity discount factor The internal rate of return on the lunch-counter proposal is nearly 20 percent. Notice that the project s accounting rate of return, at 13.8 percent, is much lower than its IRR of 20 percent.

16 16 Chapter 15 Capital Expenditure Decisions Use of the Average Investment Some managers prefer to compute the accounting rate of return using the average amount invested in a project for the denominator, rather than the project s full cost. The formula is modified as follows: Average Average incremental expenses incremental ( including depreciation Accounting rate of return revenue ( using average invesment) and income taxes) Average investment A project s average investment is the average accounting book value over the project s life. Refer again to High Country Department Stores lunch-counter data given in Exhibit The project s book value at the beginning of each year is tabulated as follows: Year Book Value at Beginning of Year Average Depreciation Book Value at End of Year (a) (b) 2 Book Value during Year 1... $210, $15, $195, $202, , , , , , , , , , , , , , , , , , , , , , , , , , , , The average investment over the project s useful life is the average of the amounts in the right-hand column, which is $84,000. Thus, the modified version of the project s accounting rate of return is 34.5 percent. (The average annual income of $29,000 divided by the average investment of $84,000 equals 34.5 percent, rounded.) Notice that this modified version of the accounting rate of return yields a significantly higher return than the project s internal rate of return, which we computed as 20 percent. As a general rule of thumb, the following relationships will be observed: Accounting rate of return Internal rate Accounting ( using initial investment) of return rate of return ( using average investment) Accounting Rate of Return: Pro and Con Like the payback method, the accountingrate-of-return method is a simple way of screening investment proposals. Some managers use this method because they believe it parallels financial accounting statements, which also are based on accrual accounting. However, like the payback method, the accounting-rate-of-return method does not consider the time value of money. Inconsistent Terminology Many different terms for the accounting rate of return are used in practice. Among these terms are simple rate of return, rate of return on assets, and unadjusted rate of return.

17 Chapter 15 Capital Expenditure Decisions 17 CAPITAL BUDGETING AT PHARMACEUTICAL FIRMS Among the many large companies making extensive use of capital budgeting are the big pharmaceutical companies. It can take 10 years or more to develop a new drug. It takes huge outlays of cash to develop a drug, test it, and then shepherd it through the governmental approval process. Yet much of what the drug companies claim as the cost of a new drug is actually the opportunity cost of tying up these big dollar outlays for many years before any revenue stream begins. Overall, the average tab for developing a new drug is $500 million to $880 million, the industry says. But the amount actually spent on any one marketable product is roughly one-quarter of that. To understand why, just look at the drug-development process. In the past, scientists made many variations of existing chemicals and tested them to see which ones had the ability to fight a particular disease. Now, with the advent of genetic engineering and greatly expanded knowledge of biology, the process has gotten more complicated and oddly enough, more difficult. Researchers try to identify the best target in a particular disease for instance, a damaged gene that causes cancer then they make a drug to hit the target and cure the disease. Since that process can take 10 years or more, that means that about half of the calculated $500 million to $880 million total isn t actually spent at all. Instead, it s the opportunity cost the measure of what the money tied up in the drug for so many years could have earned with alternative investments. This is where capital budgeting comes into play, since the NPV of a drug development project takes into account the opportunity cost associated with the time value of money. Pharmaceutical companies have upped research spending in recent years Pfizer spends $4.9 billion annually; Merck, about $2.6 billion but with no big payoff in productivity. Hefty up-front investments in genomics, in particular, have so far failed to yield a big crop of new compounds. The uncertainties big pharmaceutical companies confront are a large part of the problem. First, only a small percentage of drugs under development ever make it as far as human trials. And only 1 in 10 of those makes it through to wide-scale testing. Then there s the pricing uncertainty as well. How much will people pay for a new drug treatment? To take account of these uncertainties, many drug companies use simulation in conjunction with capital budgeting to decide whether to proceed with a drug s development. A discounted-cash-flow analysis is run many times with differing assumptions about the drug s success, its development costs, and its eventual pricing. Then a probability distribution is generated for the drug s NPV. Management can then make a decision about proceeding with development given the likelihood of a profitable drug. 1 M anagement A ccounting P ractice Pfizer and Merck Ranking Investment Projects Suppose a company has several potential investment projects, all of which have positive net present values. If a project has a positive net present value, this means that the return projected for the project exceeds the company s cost of capital. In this case, every project with a positive NPV should be accepted. In spite of the theoretical validity of this argument, practice often does not reflect this viewpoint. In practice, managers often attempt to rank investment projects with positive net present values. Then only a limited number of the higher-ranking proposals are accepted. The reasons for this common practice are not clear. If a discount rate is used that accurately reflects the firm s cost of capital, then any project with a positive NPV will earn a return greater than the cost of obtaining capital to fund it. One possible Learning Objective 5 Discuss the difficulty of ranking investment proposals, and use the profitability index.