Capital Investment. Decisions: An Overview Appendix. Introduction. Analyzing Cash Flows for Present Value Analysis

Transcription

1 f. Capital Invetment Deciion: An Overview Appendix Introduction Capital invetment deciion are the reponibility of manager of invetment center (ee Chapter 12). The analyi of capital invetment deciion i a major topic in corporate finance coure, o we do not dicu thee iue and method here in any detail. However, becaue cot accountant are involved in the development of performance meaurement technique for invetment center manager, we provide an outline of the iue and method of capital budgeting in thi appendix. ' Capital invetment often involve large um of money and coniderable rik. Specific invetment over a certain dollar amount, often in the $100,000 to $500,000 range (or le for mall companie), require approval by the board of director in many companie. Although the final deciion about aet acquiition i management' reponibility, accountant, economit, and other financial expert have developed capital invetment model to help manager make thoe deciion. Accountant have the particularly important role of etimating the amount and timing of the cah flow ued in capital invetment deciion model. Analyzing Cah Flow for Preent Value Analyi Capital invetment model are baed on the future cah flow expected from a particular aet invetment opportunity. The amount and timing of the cah flow from a capital invetment project determine it economic value. The timing of thoe flow i important becaue cah received earlier in time ha greater economic value than cah received later. A oon a cah i received, it can be reinveted in an alternative profit-making opportunity. Thu, any particular invetment project ha an opportunity cot for cah committed to it. Becaue the horizon of capital invetment deciion extend over many year, the time value of money i often a ignificant deciion factor for manager making thee deciion. To recognize the time value of money, the future cah flow aociated with a project are adjuted to their preent value uing a predetermined dicount rate. Summing the dicounted value of the future cah flow and ubtracting the initial invetment yield a time value of money Concept that cah received earlier i worth more than cah received later.

2 A-2 Appendix Capital Invetment Deciion: An Overview net preent value (NPV) Economic value of a project at a point in time. dicount rate Interet rate ued to compute net preent value. project' net preent value (NPV), which repreent the economic value of the project to the company at a given point in time. The deciion model ued for capital invetment attempt to optimize the economic value to the firm by maximizing the net preent value of future cah flow. If the net preent value of a project i poitive, the project will earn a rate of return higher than it dicount rate, which i the rate ued to compute net preent value. Ditinguihing between Revenue, Cot, and Cah Flow A timing difference often exit between revenue recognition and cah inflow on the one hand and the incurrence of a cot and the related cah outflow on the other hand. When thi occur, it i important to ditinguih cah flow from revenue and cot. Note that capital invetment analyi ue cah.flow, not revenue and cot. For example, revenue from a ale often i recognized on one date but not collected until later. In uch cae, the cah i not available for other invetment or conumption purpoe until it i collected. Net Preent Value preent value Amount of future cah flow dicounted to their equivalent worth today. The preent value of cah flow i the amount of future cah flow dicounted to their equivalent worth today. The net preent value of a project can be computed by uing the equation: where N NPV = :I, C, X (1 + d)-" n=o C, = Cah to be received or dibured at the end of time period 11 d = Appropriate dicount rate for the future cah flow n = Time period when the cah flow occur N = Life of the invetment, in year The term (I + d)-" i called a preent mlue factor. A financial calculator or computer preadheet i the mot efficient way to compute preent value factor and net preent value. Table of preent value factor are at the end of thi appendix in Exhibit A.8. An amwitv i a contant (equal) payment over a period of time. The preent value of an annuity can be computed by calculating the preent value of the individual payment and umming them over the annuity period. Alternatively, they can be computed by multiplying the annuity payment by the um of the preent value factor. The preent value factor for an annuity are hown in Exhibit A.9. If you ue the table in Exhibit A.8, look up the factor by referring to the appropriate year and dicount rate. For a dicount rate of 8 percent and a cah flow of S I at the end of two year, the preent value factor in Exhibit A.8 i.857. For a dicount rate of 8 percent and a cah flow ofsl at the end of each year for two year (an annuity), the preent value factor in Exhibit A.9 i (= , from Exhibit A.8). Applying Preent Value Analyi Conider two project. Each require an immediate cah outlay of S Project 1 will return $ at the end of two year: Project 2 will return $6.500 each year at the end of year I and 2. If the appropriate dicount rate i 15 percent. the net preent value of each project can be computed a follow:

3 Appendix Capital Invetment Deciion: An Overview A J Project 1 Cah inflow.... Cah outflow.... Net preent value... Project 2 Cah inflow.... Cah outflow.... Net preent value... $13,000 X (1 +.15)- 2 = $13,000 X.756 $6,500 X (1 +.15) $6,500 X (1 +.15)- 2 = $6,500 X $6,500 X.756 $ 9,828 (10,000) $ (172) $ 10,569 (1 0,000) $ 569 The tarting time for capital invetment project i aumed to be time 0. Therefore, any cah outlay required at the tart of the project are not dicounted. We enter them at their full amount. At a dicount rate of 15 percent. Project 2 i acceptable, but Project I i not. Project 2 will earn more than the required 15 percent return while Project I will earn le. The reaon i that, although both project returned a total of $13,000, Project 2 returned half of it one year earlier. You hould check for yourelf to ee that at a 20 percent dicount rate, the preent value of both project i negative. Therefore, if the required rate were 20 percent, neither project would meet the invetment criterion. Alternatively, at I 0 percent, both project have poitive net preent value and would be acceptable. Capital Invetment Analyi: An Example We preent the following numerical example to illutrate the baic of capital invetment analyi. The owner of Mezzo Diner are conidering an expanion, which will require ome additional equipment. Baic data for the invetment are hown in Exhibit A.l. Mezzo ue traight-line depreciation for tax purpoe. Equipment cot.... Economic and tax life.... Dipoal value.... Additional annual cah revenue.... Additional annual cah operating expene.... Increae in working capital required.... Tax rate.... Dicount rate.... $600,000 5 year $100,000 $400,000 $170,000 $120,000 40% 12% Exhibit A.l Selected Expanion Data-Mezzo Diner Thi ection outline a method for etimating cah flow for invetment project, which we illutrate uing the expanion project of Mezzo Diner. We tart by etting four major categorie of cah flow for a project: Invetment cah flow. Periodic operating cah flow. Cah flow from the depreciation tax hield. Diinvetment cah flow. Each category of cah flow require a eparate treatment. Categorie of Project Cah Flow

4 A 4 Appendix Capital Invetment Deciion: An Overview Invetment Cah Flow There are three type of invetment cah flow: 1. Aet acquiition, which include a. New equipment cot, including intallation (outflow). b. Proceed of exiting aet old, net of taxe (inflow). c. Tax effect ariing from a lo or gain (inflow or outflow). 2. Working capital commitment. 3. Invetment tax credit, if any. aet acquiition Cot of purchaing and intalling an aet including any reulting gain or lo on dipoal. working capital Cah, account receivable, and other hort-term aet required to maintain an act1vity invetment tax credit (ltc) Reduction in federal income taxe ariing from the purchae of certain aet Aet acquiition involve both the cot of purchaing and intalling new aet and the cah inflow that can reult from the proceed, net of taxe, of elling replaced equipment. Additionally, there could be a lo or gain from the difference between the ale proceed and the tax bai of the equipment being replaced. The primary outflow for mot capital invetment i the acquiition cot of the aet Acquiition cot can be incurred in time 0 and in later year. In ome cae, they are incurred over period of 10 to 20 year. All acquiition cot are lited a cah outflow in the year in which they occur. Intallation cot are alo conidered a cah outflow. If the depreciation tax bai of the replaced equipment doe not equal the proceed received from the ale of the replaced equipment, a gain or lo will occur and will affect the tax payment THe tax effect will be conidered a cah inflow (for a lo) or a cah outflow (for a gain). The calculation of thi category for Mezzo i traightforward becaue it i not dipoing of another aet. The initial outflow i the $600,000 purchae price of the equipment. In addition to the cah required for the purchae of long-term aet. many project require additional fund for working capital need; for example, a retail etablihment need to have cah available in a bank account becaue future cah payment often precede cah receipt. The working capital committed to the project normally remain contant over the life of the project, although it i ometime increaed becaue of inflation. Mezzo plan to commit an additional $120,000 in working capital at time 0 to maintain a cah balance in a bank account to cover future cah tranaction. The invetment tax credit (ITC) allow a credit againt the federal income tax liability baed on the cot of an acquired aet. Thi credit effectively reduce the cot of making invetment by giving companie a credit againt their corporate income taxe equal to, for example, 10 percent of the purchae price. The invetment tax credit ha been in effect at variou time ince the early Currently, there i no invetment tax credit for which Mezzo qualifie. Periodic Operating Cah Flow The primary reaon for acquiring long-term aet i uually to generate poitive periodic operating cah flow. Thee poitive flow can reult from revenue-generating activitie, uch a new product, and from cot-aving program. In either cae, actual cah inflow and outflow from operating the aet are uually determinable in a traightforward manner. The mot important tak i to identify and meaure the cah flow that will differ becaue of the invetment. If the revenue and cot are differential cah item, they are relevant for the capital invetment deciion. Periodic operating flow include the following: Period cah inflow ( +) and outflow (-) before taxe. Income tax effect of inflow (-) and outflow ( + ).

5 Appendix Capital Invetment Deciion: An Overview A S Cot that do not involve cah (depreciation, depletion, and amortization) are excluded. If cah cot in other department change a a reult of the project, the cot of the other department() hould be included in the differential cah flow chedule. Mezzo forecat annual increae in cah revenue of $400,000 and increaed cah operating expene of $170,000. After tax, thee will reult in net cah flow of $138,000 [ = ($400,000 - $170,000) X (1-40%)). Financing cot uch a interet cot on loan, principal repayment, and payment under financing leae are typically excluded under the aumption that the financing deciion i eparate from the aet-acquiition deciion. Under thi aumption, the deciion to acquire the aet i made firt. If the aet-acquiition deciion i favorable, a deciion will be made to elect the bet financing. For analyi purpoe, aet acquiition typically are recorded in the full amount when the cah purchae payment are made, regardle of how that cah wa acquired. The cot of financing i included in the dicount rate. The income tax effect of the periodic cah flow from the project are alo computed and conidered in the preent value analyi. Note that for purpoe of calculating the net preent value, only the tax effect related to differential project cah flow are conidered. The tep to compute the net operating cah flow for the project arerepeated for each year of the project' life. In ome cae, the computation can be implified by uing an annuity factor if the project i expected to yield identical cah flow for more than one year. Cah Flow from the Depreciation Tax Shield To meaure the income of an organization or one of it ubunit, depreciation i ued to allocate the cot of long-term aet over their ueful live. Thee depreciation charge are not cah cot and thu do not directly affect the net preent value of capital invetment. However, tax regulation permit depreciation write-off that reduce the required tax payment. The reduction in the tax payment i referred to a a tax hield. The depreciation deduction computed for thi tax hield i not necearily the m~e amount a the depreciation computed for financial reporting pwpoe. The predominant depreciation method for financial reporting ha been the traight-line method. With thi method, the cot of the aet, le any alvage value, i allocated equally to each year of the expected life of the aet. Income tax regulation allow depreciation write-off to be made fater. The tax allowance for depreciation i one of the primary incentive ued by tax policymaker to promote invetment in long-term aet. The fater an aet' cot can be written off for tax purpoe, the ooner the tax reduction are realized and, hence, the higher the net preent value of the tax hield. In recent year, tax depreciation ha been accelerated to allow write-off over very hort time period regardle of an aet' expected life. To maximize preent value, it i uually bet to claim depreciation a rapidly a poible. The depreciation tax hield affect the net preent value analyi in two way: Depreciation tax hield on acquired aet. Forgone depreciation tax hield on dipoed aet. Conider the tax depreciation chedule of the new equipment that Mezzo Diner i evaluating. It ha a depreciation tax bai of $500,000 over five year. Thi i computed a the outlay cot of the equipment ($600,000) le the etimated dipoal or alvage value of $100,000. The equipment i aumed to have a five-year life for tax purpoe, o uing traight-line depreciation, annual depreciation on the equipment i $100,000 (= $500, year). (All amount given in thi text are for illutrative purpoe only. They do not necearily reflect the amount of depreciation allowed by the tax regulation, which varie by type of aet and often change a Congre pae new "tax reform.") A a reult of depreciation expene, Mezzo' tax payment will be lower tax hield Reduction in tax payment becaue of depreciation deducted for tax purpoe.

6 A-6 Appendix Capital Invetment Deciion: An Overview by $40,000 ( = $] 00,000 X 40% tax rate) every year. It i important to note that the depreciation expene itelf i not included in the analyi. It i not a cah expene. (More important, we have already included the cot of the equipment in the initial outlay. To include the depreciation expene would be to double-count the equipment cot.) Diinvetment Cah Flow diinvetment flow Cah flow that take place at the termination of a capital project. Cah flow at the end of the life of the project are called diinvetment flow. The end of a project' life uually reult in ome or all of the following cah flow: Cah freed from working capital commitment (now a cah inflow). Salvage of the long-term aet (uually a cah inflow unle there are dipoal cot). Tax conequence for difference between alvage proceed and the remaining depreciation tax bai of the aet. Other cah flow, uch a employee everance payment and retoration cot. When a project end, ome inventory, cah, and other working capital item that were ued to upport operation are uually left over. Thee working capital item are then freed for ue elewhere or are liquidated for cah. Therefore, at the end of a project' life, the return of thee working capital item i hown a a cah inflow. In the example of Mezzo Diner. it will have $120,000 in working capital available for other ue, which i the money it put in the bank to facilitate cah tranaction. It i important not to double-count thee item. Suppoe that cah collected from a cutomer wa already recorded a a cah inflow to the company, but it wa left in the project' bank account until the end of the project' life. It hould not be counted again a a cah inflow at the project' encl. The return of working capital i recorded a an inflow when it i freed for ue in other organizational activitie. If that doe not occur until the end of the project' life, the cah inflow i included a part of diinvetment flow. tax bai Remaining tax-depreciable book value of an aet for tax purpoe. Ending a project often include the dipoal of it aet. Thee are uually old in econdhand market. In ome cae, more money can be pent diaembling the aet and dipoing of them than their ale gain. Any net outflow from the dipoal of a project' aet become tax deduction in the year of dipoal. The net almge l'([/ue (ometime negative) of an aet i lited a a cah inflow or outflow at the time it i expected to be realized (or incurred), regardle of it book value or tax bai. The difference between the book value (tax bai) and the net alvage value can reult in a taxable gain or lo. For an aet replacement deciion. the forgone alvage value (and related tax effect) from the old aet mut alo be conidered. For example, aume that "aet new" replaced "aet old" for the next five year. Aet old could be old for $2,000 at the end of five year; aet new could be old for $ at the end of five year. If aet new replace aet old, the $8.000 incremental alvage value hould be the diinvetment cah flow for the analyi. Any additional taxe paid (or tax payment reduced) becaue we are alvaging aet new intead of aet old hould be included in the analyi. Any difference between the tax bai of a project' aet (generally, the undepreciated balance) and the amount realized from project dipoal reult in a tax gain or lo. Therefore, a company' tax liability i affected in the year of dipoal. Tax law on aet dipoition are complex, o tax advice hould be ought well in advance of the propoed dipoal date. Here. we aume that any gain or loe on dipoal are treated a ordinary taxable income or loe. Suppoe that an aet i carried in the financial accounting record at a net book value of$80,000 and i alvaged for $30,000 cah. The tax bai of the aet i $10,000, and the tax rate i 40 percent. What are the cah flow from dipoal of thi aet?

7 Appendix Capital Invetment Deciion: An Overview A-7 Firt, the company receive the $30,000 a a cah inflow. Second, it report a $20,000 taxable gain, which i the difference between the $30,000 cah inflow and the $10,000 tax bai. Thi $20,000 gain i taxed at 40 percent, reulting in an $8,000 cah outflow. The net-of-tax cah inflow on dipoal i $22,000, the net of the $30,000 inflow and the $8,000 cah outflow, a follow: Cah inflow $30,000 Tax payment ($30,000 cah inflow - $10,000 tax bai) x 40% tax rate (8,000) Net-of-tax cah inflow $22,000 Mezzo Diner plan to dipoe of the equipment for $100,000, the dipoal value in Exhibit A.l. Becaue thi i the amount included when computing depreciation, there i no lo or gain on the dipoition and, therefore. no tax effect. The end of project operation can reult in a number of cot not directly related to the ale of aet. It could be neceary to make everance payment to employee. Sometime payment are required to retore the project area to it original condition. Some project incur regulatory cot when they are cloed. A cot analyt mut inquire about the conequence of dipoal to determine the cot that hould be included in the diinvetment flow for a project. Preparing the Net Preent Value Analyi A oon a the cah flow data have been gathered, they are aembled into a chedule that how the cah flow for each year of the project' life. Thee flow can be claified into the four categorie jut dicued: Invetment cah flow. Periodic operating cah flow. Cah flow from the depreciation tax hield. Diinvetment cah flow. A ummary chedule that how the total of the annual cah flow and the net preent value of the project i prepared. Thi ummary can be upported by a much detail a management deem neceary for making the invetment deciion. Exhibit A.2 contain the analyi for the invetment deciion for Mezzo Diner. The project i expected to earn more than the 12 percent ued to dicount the cah flow becaue the net preent value of the project i higher than zero. (If the net preent value of the project had been le than zero, the project would have been expected to earn le than the 12 percent ued to dicount the cah flow.) The poitive net preent value of the project ($46,430) i computed a the um of the preent value of each year' cah flow. Uing Microoft Excel to Prepare the Net Preent Value Analyi The computation hown in Exhibit A.2 illutrate how to compute net preent value uing the preent value factor in Exhibit A.8. However. thee calculation are built-in function in Excel, o there i no reaon to compute (or enter) individual preent value factor. We illutrate in the erie of exhibit below how to complete thi calculation uing Excel directly.

8 ~ -... A-8 Appendix Capital Invetment Deciion: An Overview Exhibit A.2 Cah Flow Schedule with Preent Value Computation-Mezzo Diner (3..:c.ccc -:.:c GCC S ~0. CCS ~ oco S loo,goc :;_ 78. CCC S l73.0c:j S..:.7S.O:JG S 39S,OCC _., 7i2 C.567 i :l 22 The firt tep i to modify the preadheet lightly to remove the preent value factor and et up the Excel calculation. The baic preadheet i hown in Exhibit A.3. In addition to removing the row with the preent value factor, we have introduced ome new cell: one with the dicount rate; one for the computation of the preent value of the cah inflow; one with the initial invetment amount; and one for the computation of the net preent value. Exhibit A.3 Spreadheet for Calculation of Net Preent Value Uing Microoft Excel Y.:::.::r :::3 lc.., ~.;} :~cc i~. CCC ; :..:c CCC :..:e,coo 38. CCC.. 38 '''"'.-.,...,,,,, ~_,,_ L'' '- ~. - ~ G, lf"'l J.G CCC...:c CCC '-\.. c cc l2 :;.e-: Jr:-1 c:f -.._:,::rl: -.~ ca:: :.;: 13,:troc~~d c~,.-; c :)c.:; 5 I...,""'i '"l /.;_[_,_ occ <::. T3 coc <:. l7g CCC 5 ~78. CGC 5 l7s r'"!f"1,..., ~"lf"l ~co 5 100, ceo i.)o_,i._ 5 39G ::co l6 I 72C. CCC

9 ,_II ~;;; ; :,' :~ Appendix Capital Invetment Deciion: An Overview A 9 Exhibit A.4 Inert-Function Dialog Box o,j --~/ H Jm.:; Inert functlon ;:.._utusurn R.;:.::.:ntl,. Finar-c\aP l : Q!G'li Ued.. cffe :T D~~ :_,_ L J Jkup '~'- r-.~atf; t.ior~ Tnne ~ P.:ftren-:c""" (.{ Tr1g ~ Fu;:,:iic.n-.- (.~ - I A r:np-te f_c:f.' G I : "'e"'''" "' f O " l.l \e\\ eq_, :r-,e--.: -.:...,::r~:_--,g caj::.:1 6 I -, ;.:,_.--,.-, -~-=~: c~--~ f,o._-_ 1 5 :~ ;' l i!f.f' ' - :,;;: -- c -?,.) cc.=.:...~-~; -,- c - c c,-.,-.,, ;_ '- ~ _:_;..:c - - c.c-c -,-,,..- c c CCC -",-,,-,,... i_,l,i.j cc;c J.8 ceo.::1-lr: ;., ~)::: --:-. e::y~.:;. -,: f-o,'_::; 12 ;:;_e: _Jr:-, of ".:c1r;.~~:-~~ c - - :),...,-.,.,_,,,_, :- - 78, cc::: ,-,(, ' :1C. CCC lcc.ccc 2.78, ec 398. CCC D~coun1 ra:e 18 PPICEC:l5: PFEEII~ T p. F.- TE The firt tep i to elect the cell (B 19) where the preent value of the cah inflow for period one through five will be computed. (Becaue the Excel function we ue aume that all cah flow occur at the end of the period, we have to compute the preent value of the cah inflow and then ubtract the initial cah invetment.) After electing cell B 19, elect the net preent value function. Thi i a built-in function in Excel that you can acce a follow. On the ribbon, elect the formula tab. Thi will reveal a et of "book" containing different type of formula in the "library." Click on the "Financial" book. Thi will how a drop-down lit of formula. Scroll down and elect "NPV" a hown in Exhibit A.4. A new dialog box will open a hown in Exhibit A.5. Thi dialog box will ak for two type of input. Firt, enter (or point to the cell with) the dicount rate. Click on the box labeled "Rate" and either enter the rate (12%) or point to the cell with the rate (B 17). (Notice how chooing cell B 17 reult in the rate ( 12%) being diplayed to the right of the box.) Next, point to the input box labeled "Value 1" and enter or point to the range with the cah inflow (C 14:G 14). (To enter the range, elect C 14

10 A 10 Appendix Capital Invetment Deciion: An Overview Exhibit A.S Enter the Data for the Calculation Home lncrt Page L1:1yout Fo1mula Data Review NPV Rate!817 Yaluel icli:g14l_ 0.12 {178000, ,178000, ,39( Value2 G \!e\ / equ~pr-n~n: 5., \iork:-ng cap :a:- 6 = Return the net preent value of an invetment baed on a dicount rate and a erie of future payment (negative value) and income (poitive value). Yaluel: value!, value2,... are 1 to 254 payment and income. equally paced in time and occurring at the end of each period. 5 S Opera!:~ng cah f. 0',',:'5 Formula reult = $ 766,484!. ooc 9 Dept ec..a:~0'1 :ax hield ' OK 1 [ Cancel 40,.QGD Help on thi function.. ld ~===== =====~==~ 12 R.;>: Jrn of wor:,'ng capc:a. 13 =>roceed5 or, d"poa: S l20.qod ,00-0 S 17S.OCC. 39S.OGC 18 19: ~re en: \".:t _.e c~ -J o. : and then, holding down the left moue button, drag the curor acro the range. topping at cell Gl4.) Once the two boxe are complete, elect "OK." The preent value of the cah flow will appear in the cell. Thi i hown in Exhibit A.6. Note two thing: I. The format of the cell might not match the formatting of the other cell (for example. the preent value might be diplayed with two decimal place). 2. There might be an error indicator that appear. In thi cae, the "error" i that an adjacent cell wa not ued (and hould not have been ued). It i poible to turn thi off. but. a it i the default operation, we have left it on. Finally, we ubtract the initial invetment (add the negative initial cah flow) to obtain the net preent value. Thi i hown in Exhibit A.7. (Note that we have formatted the cell to be conitent with the ret of the preadheet.) The reulting net preent value of S differ from what we calculated uing the net preent value factor ($46,430) becaue the net preent value factor have been rounded to three decimal place.

11 r ~~"' ---.., Appendix -'- Capital Invetment Deciion: An Overview A-11 Exhibit A.6 Reult of the Preent Value Calculation rear E 6,- i..3s.. CCG : ~c CCC " ~ 38, GOO E;S, GOO 5 4C. cnc 4C.COG 138, ceo " 3S, CCC 4G f'l""'l-, _,,_,,_, ~c CCC ~ J :;:e:ur:-t of :.:on::~.--~g cao::a ~3 =~rcceed o -! d oo:::a, '. 72C. CCC..:_; CCC 178, CCC :78 CCC ".:..2C... SCG.- ~CC. CCC :78 GGC c :;98. CCC ;::::...!._l._ _~_.~_! Exhibit A The Net Preent Value of the Invetment A :nve1r'"':t~n: fio.:.: 8 c :&cg ooo: c 1 D Year 2 E G 5 '.. \'orking cap~:a. 8 Operating cah fic\\-'5 9 :Jeprec!a: :on ia\!.-rie id lg 138. CDC J..OCCGO l3s,ooo 138,000 40,000 4C.. noo BS.OCC l38.gcc 40. CCC 5 J.G.CCC ~>~~~Jr~l of,."'jr~<"ng caf}o::ai..~...:;.='r~jceecj on dipcai 15 it 5 ~: 12c. Goe:: l73,c{c 17S.. DCC 178, ooc 128. CCG lcc. CGC ~ 7S,.OCC 398. CCC 766.~SJ. (720.GDOj

12 A 12 Appendix Capital Invetment Deciion: An Overview SeU-Study Quetion 1. Nu-Concept, Inc., a outheatern advertiing agency, dipoe of it exiting equipment, which i fully deprei conidering the purchae of new computer equip- ciated for tax purpoe. It can be old for an etimated ment and oftware to enhance it graphic capabilitie. $200 but would have no alvage value in four year. If Nu- Management ha been conidering everal alternative Concept doe not buy the new equipment, it would conytem, and a local vendor ha ubmitted a quote to tinue to ue the old graphic ytem for four more year. the company of $15,000 for the equipment plu $16,800 Management believe that it will realize improvefor oftware. Aume that the equipment can be de- ment in operation and benefit from the computer preciated for tax purpoe over three year a follow: ytem worth $16,000 per year before taxe. year i, $5,000; year 2, $5,000; year 3, $5,000. The oft- Nu-Concept ue a 10 percent dicount rate for ware can be written off immediately for tax purpoe. thi invetment and ha a marginal income tax rate of The company expect to ue the new machine for four 40 percent after conidering both tate federal taxe. year and to ue traight-line depreciation for financial a. Prepare a chedule howing the relevant cah flow reporting purpoe. The market for ued computer ytern i uch that Nu-Concept could ell the equipment for the project. b. Indicate whether the project ha a poitive or negahave no alvage value at that time. for $2,000 at the end of four year. The oftware would tive net preent value. Nu-Concept management believe that introduc- The olution to thi quetion i at the end of the appendix on tion of the computer ytem will enable the company to page A-16. Exhibit A.S Preent Value of $1 Year 5% 6% 8% 10% 12% 14% 15% 16% 18% 20% o Year 22% 24% 25% 26% 28% 30% 32% 34% 35% 40%

13 Appendix Capital Invetment Deciion: An Overview A 13 Exhibit A.9 Preent Value of an Annuity of $1 Year 5% 6% 8% 10% 12% 14% 15% 16% 18% 20% Year 22% 24% 25% 26% 28% 30% 32% 34% 35% 40% , Key Term aet acquiition, A-4 dicount rate, A-2 diinvetment flow, A -6 invetment tax credit (ITC), A-4 net preent value (NPV), A-2 preent value, A-2 tax bai, A-6 tax hield, A-5 time value of money, A-1 working capital, A-4 Review Quetion A-1. A-2. A-3. A-4. A-5. What are the two mot important factor an accountant mut etimate in the capital invetment deciion? What doe the time value of money mean? What i the difference between revenue and cah inflow? What i the difference between expene and cah outflow? What i the difference between depreciation and the tax hield on depreciation?

14 A-14 Appendix Capital Invetment Deciion: An Overview Critical Analyi and Dicuion Quetion Exercie A-6. A-7. A-8. A-9. Given two project with equal cah flow but different timing, how can we determine which (if either) project hould be elected for invetment? What are the four type of cah flow related to a capital invetment project and why do we conider them eparately? I depreciation included in the computation of net preent value'~ Explain. "The total tax deduction for depreciation i the ame over the life of the project regardle of depreciation method. Why then would one be concerned about the depreciation method for capital invetment analyi?" Comment. A-10. "Working capital i jut the temporary ue of money during the life of the project. What i initially contributed i retumed at the end. o it can be ignored in evaluating a project." Comment. connect iaccoui\itirjg A-11. Preent Value of Cah Flow Star City i conidering an invetment in the community center that i expected to return the following cah flow: Year Net Cah Flow $ 20,000 50,000 80,000 80, ,000 Thi chedule include all cah inflow from the project, which will alo require an immediate $180,000 cah outlay. The city i tax-exempt; therefore. taxe need not be conidered. Required a. What i the net pr~ent value of the project if the appropriate dicount rate i 20 percent? b. What i the net preent value of the project if the appropriate dicount rate i 12 percent'~ A-12. Preent Value of Cah Flow Ruh Corporation plan to acquire production equipment for $600,000 that will be depreciated for tax purpoe a follow: year I, $ ; year 2. $210,000: and in each of year 3 through 5. $ per year. An 8 percent dicount rate i appropriate for thi aet. and the company' tax rate i 40 percent. Required a. Compute the preent value of the tax hield reulting from depreciation. b. Compute the preent value of the tax hield from depreciation auming traight-line depreciation ($120,000 per year). A-13. Preent Value Analyi in Nonprofit Organization The Johnon Reearch Organization, a nonprofit organization that doe not pay taxe. i conidering buying laboratory equipment with an etimated life of even year o it will not have to ue outider' laboratorie for certain type of work. The following are all of the cah flow affected by the deciion: Invetment (outflow at time 0) $6,000,000 Periodic operating cah flow: Annual cah aving becaue outide laboratorie are not ued ,400,000 Additional cah outflow for people and upplie to operate the equipment ,000 Salvage value after even year, which i the etimated life of thi project ,000 Dicount rate %

15 Appendix Capital Invetment Deciion: An Overview A-15 Required Calculate the net preent value of thi deciion. (Refer to Exhibit A.2 in formatting your anwer.) Should the organization buy the equipment? Problem "l? A-14. Senitivity Analyi in Capital Invetment Deciion Square Manufacturing i conidering inveting in a robotic manufacturing line. Intallation of the line will cot an etimated $4.5 million. Thi amount mut be paid immediately even though contruction will take three year to complete (year 0, l, and 2). Year 3 will be pent teting the production line and, hence. it will not yield any poitive cah flow. If the operation i very ucceful, the company can expect after-tax cah aving of S3 million per year in each of year 4 through 7. After reviewing the ue of thee ytem with the management of other companie, Square' controller ha concluded that the operation will mot probably reult in annual aving of $2,100,000 per year for each of year 4 through 7. However, it i entirely poible that the aving could be a low a $900,000 per year for each of year 4 through 7. The company ue a 14 percent dicount rate. Required Compute the NPV under the three cenario. A-15. Compute Net Preent Value Dungan Corporation i evaluating a propoal to purchae a new drill pre to replace a le efficient machine preently in ue. The cot of the new equipment at time 0. including delivery and intallation, i $200,000. If it i purchaed, Dungan will incur cot of $5,000 to remove the preent equipment and revamp it facilitie. Thi $5,000 i tax deductible at time 0. Depreciation for tax purpoe will be allowed a follow: year l, $40.000: year 2, $70,000; and in each of year 3 through 5, $30,000 per year. The exiting equipment ha a book and tax value of $100,000 and a remaining ueful life of 10 year. However, the exiting equipment can be old for only $ and i being depreciated for book and tax purpoe uing the traight-line method over it actual life. Management ha provided you with the following comparative manufacturing cot data: Annual capacity (unit).... Annual cot: Labor.... Depreciation.... Other (all cah).... Total annual cot.... Preent Equipment 400,000 $30,000 10,000 48,000 $88,000 New Equipment 400,000 $25,000 14,000 20,000 $59,000 The exiting equipment i expected to have a alvage value equal to it removal cot at the end of l 0 year. The new equipment i expected to have a alvage value of $60,000 at the end of l 0 year. which will be taxable, and no removal cot. No change in working capital are required with the purchae of the new equipment. The ale force doe not expect any change in the volume of ale over the next 10 year. The company' cot of capital i 16 percent, and it tax rate i 40 percent. Required a. Calculate the removal cot of the exiting equipment net of tax et1ect. b. Compute the depreciation tax hield. c. Compute the forgone tax benefit of the old equipment. d. Calculate the cah inflow, net of taxe, from the ale of the new equipment in year 10. e. Calculate the tax benefit ariing from the lo on the old equipment. ( Compute the annual differential cah flow ariing from the invetment in year 1 through 10. g. Compute the net preent value of the project.

16 A-16 Appendix Capital Invetment Deciion: An Overview Solution to Self-Study Quetion 1. a. and b. Invetment flow New equipment... $(15,000) Software ($16,800 x 60%)"-... (10,080) Old equipment ($200 x 60%) Year Annual cah flow ($16,000 x 60%)... $9,600 $9,600 $ 9,600 $9,600 Depreciation tax hield ($5,000 x 40%). 2,000 2,000 2,000 Diinvetment flow ($2,000 x 60%)... 1,200 Total cah flow... $(24,960) $11,600 $11,600 $11,600 $10,800 Preent value factor at 10% Preent valueb... $(24,960) $10,544 $9,582 $8,712 $7,376 Net preent value... $ 11, % = 1-40% tax rate, which convert before-tax flow to after-tax flow. bpreent value factor hown i rounded to three place. Preent value factor are hown in Exhibit A.B.