Chapter Ten

Planning for Capital Investments

McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc. 2006

Capital Investment
Capital Investment - Purchases of long-term operational asset Once purchased, co is committed to these investments for an extended period of time.

Capital Investment Decisions

A decision to exchange current cash outflows for the expectation of receiving future cash inflows
Understanding the time value of money concept will help you make a rational capital investment decision.

Time Value of Money

This concept recognizes that the present value of a dollar received in the future is less than todays dollar. The further into the future the receipt is expected to occur, the smaller its present value. When a company invests in capital assets, it sacrifices present dollars in exchange for the opportunity to receive future dollars.

Time Value of Money

The present value of cash inflows decrease as the time expected receipt increases because: 1. Lost opportunity to earn interest 2. Risk 3. Inflation

Converting Future Cash Inflows to Their Equivalent Present Values

EZ Rental is considering adding LCD projectors to its product line. If EZ requires a rate of return of 12% on their investment, how much is the company willing to spend today to have $200,000 at the end of the first year?

Investment + (0.12 Investment) = Future cash inflow 1.12 Investment = $200,000

Investment = $178,571

Using algebra can be cumbersome when an investment is expected to produce many cash inflows over a prolonged period of time. Using interest tables can simply the computation.

Multiplying the expected future cash inflow by this factor produces the following present value:
$200,000 * 0.892857 = $178,571

Converting Future Cash Inflows to Their Equivalent Present Values

Present Value Table for Single-Amount Cash Inflows
Period 1 2 3 4 5 Present Value Factor 10% 12% 0.909091 0.892857 0.826446 0.797194 0.751315 0.711780 0.683013 0.635518 0.620921 0.567427 for $1 14% 0.877193 0.769468 0.674972 0.592080 0.519369

Investing $607,470 today at a 12% return is equivalent to receiving $200,000 each year for the next four years.

PV of $200,000 Cash Inflows Received for 4 Years Period FV Factor Amount 1 $ 200,000 0.892857 = $ 178,571 2 200,000 0.797194 = 159,439 3 200,000 0.711780 = 142,356 4 200,000 0.635518 = 127,104 $ 607,470

Present Value Table for Annuities

An annuity is a series of cash flows that meet three criteria: (1) equal payment amounts, (2) equal time intervals between payments, and (3) a constant rate of return.
$200,000 3.037349 = $607,470 (rounded)
Period 1 2 3 4 5 Present Value Factor for an Annuity of $1 8% 10% 12% 14% 0.925926 0.909091 0.892857 0.877193 1.783265 1.735537 1.690051 1.646661 2.577097 2.486852 2.401831 2.321632 3.312127 3.169865 3.037349 2.913712 3.992710 3.790787 3.604776 3.433081

Example
Wald Corp is considering purchasing a new machine that costs $50,000. Wald expects the machine to increase annual net cash flow by $12,500 for each of the next five years. The machine has a $2,000 salvage value. What is the present value of the future cash flows?

Capital Investment Proposals

Net Present Value
Subtracting the cost of the investment from the present value of future cash inflows determines the net present value of the investment opportunity.

A positive net present value indicates the investment will yield a rate of return higher than the required return. A negative net present value means the return is less than the required return.

Capital Investment Proposals

EZ Rentals mgmt is willing to pay $607,470 today to obtain $200,000 per year over the next four years. Cost = $582,742 To determine whether EZ Rentals should invest, mgmt must compare the present value of the future cash inflows to the cost of the projectors.

Capital Investment Proposals

Net Present Value = PV of Future Cash Flows Cost of Investment $607,470 582,742 = $24,728

Example
Wald Corp is considering purchasing a new machine that costs $50,000. Wald expects the machine to increase annual net cash flow by $12,500 for each of the next five years. The machine has a $2,000 salvage value. What is the net present value of the investment?

Minimum Rate of Return

Most companies consider the cost of capital to be the minimum expected return on investment opportunities. Creditors expect interest payments; in most companies, owners expect dividends and increased stock value. The blend of creditors and owners costs is considered the cost of capital for an organization.

Example
The management team at Savage Corp. is evaluating two alternative capital investment opportunities. First Alt. modernize the co.s current machinery cost = $45,000; modernization will reduce annual net cash outflows by $12,500 per year

Second Alt. purchase a new machine that cost $56,500 ; new machine is expected to have a five-year useful life and a $4,000 salvage value. Mgmt estimates the new machine will generate cash inflows of $15,000 per year. Cost of Capital = 10%

What is the present value of the cash flow savings expected from the modernization program?
$12,500 * 3.790787 $47,385

Net Present Value

Present value of future cash inflows (Cost of investment) Net Present Value What is the NPV of the modernization project? $47,385 - $45,000 = $2,385

Net Present Value

What is the NPV of investing in a new machine? 1st Find the present value of cash inflows $15,000 * 3.790787 = $56,862 $4,000 * .620921 = $ 2,484 PV of cash inflows = $59,346

Net Present Value

PV of Cash Inflows (Cost of Investment) NPV $ 59,346 (56,500) $ 2,846

Comparing Alternative Capital Investment Opportunities

PV index = PV of cash inflows PV of cash outflows
$47,385 $45,500 $59,346 $56,500 = 1.053

Alternative 1 =

Alternative 2 =

= 1.050

Alternative 1 yields a higher return than Alternative 2.

Measuring Investment Cash Flows

Incremental Revenues

Release of Working Capital Cash Inflows Salvage Value

Cost Savings

Measuring Investment Cash Flows

Initial Investment Working Capital Requirements Cash Outflows Increases in Operating Expenses

Internal Rate of Return

The internal rate of return is the rate at which the present value of cash inflows equals cash outflows.
The rate that will produce a zero NPV.

IRR - Example
Medina Manufacturing Co. has an opportunity to purchase some technologically advanced equipment that will reduce the companys cash outflow for operating expenses by $68,641 per year. The cost of the equipment is $200,000. Medina expects it to have a 4year useful life and zero salvage value. The company has established an investment hurdle rate of 12%.

Internal Rate of Return

We compute a present value factor by dividing the cost of the investment by the annual cash inflow.
$200,000 / $68,641 = 2.913712
Period 1 2 3 4 5 Present Value Factor for an Annuity of $1 8% 10% 12% 14% 0.925926 0.909091 0.892857 0.877193 1.783265 1.735537 1.690051 1.646661 2.577097 2.486852 2.401831 2.321632 3.312127 3.169865 3.037349 2.913712 3.992710 3.790787 3.604776 3.433081

Relevance and the Time Value of Money

You have an opportunity to invest in one of the two projects shown below. Both require an investment of $6,000, and return total cash inflows of $8,000.
2006 2007 2008 2009 Total Project 1 $ 3,500 3,000 1,000 500 $ 8,000 Project 2 $ 2,000 2,000 2,000 2,000 $ 8,000

If you have a desired rate of return of 10%, in which project would you invest?

Relevance and the Time Value of Money

Period 1 2 3 4 PV of cash inflows PV of cash outflows NPV of Project 1 PV of cash inflows PV of cash outflows Project 1 Cash Inflow $ 3,500 $ 3,000 $ 1,000 $ 500 PV Factor 0.909091 0.826446 0.751315 0.683013 = = = = PV $ 3,182 2,479 751 342 $ 6,754 (6,000) $ 754

Project 2 $ 2,000

3.169865 = $ 6,340 (6,000) $ 340

Project 1 is clearly preferable to Project 2.

Tax Considerations
Taxes affect the amount of cash flows generated by investments. In the following example, Wu Company purchases an asset for $240,000. The asset has a four-year useful life, no salvage value, and straightline depreciation is used. The asset is expected to generate incremental revenues of $90,000 per year. Wus income tax rate is 40%, and the company has a desired after tax return of 10%.

Tax Considerations
Cash revenue Depreciation expense (noncash) Income before taxes Income tax at 40% Income after tax Depreciation add back Annual cash inflows Period 1 $ 90,000 (60,000) 30,000 (12,000) 18,000 60,000 $ 78,000 Period 2 $ 90,000 (60,000) 30,000 (12,000) 18,000 60,000 $ 78,000 Period 3 $ 90,000 (60,000) 30,000 (12,000) 18,000 60,000 $ 78,000 Period 4 $ 90,000 (60,000) 30,000 (12,000) 18,000 60,000 $ 78,000

Net PV Annual cash annuity depreciation expense $ 78,000 You add back PV of annuity of $1, 4 periods, 10% 3.169865 because it is a noncash charge to PV of annual cash annuity 247,249 income. The only cash flow impact is PV of cash outflow (240,000) the reduction payable. Net present value in income taxes $ 7,249

Techniques That Ignore the Time Value of Money

This is a simple and easy approach to looking at the recovery of an investment.
Payback = period
Net cost of investment Annual net cash inflows

Payback Method

Payback Method
Winston Cleaners can purchase a piece of equipment for $100,000 that will reduce labor costs by $40,000 per year over a four-year useful life. Lets calculate the payback period.
Payback = period Payback = period
Net cost of investment Annual net cash inflows $100,000 $40,000

= 2.5 years

Generally, the shorter the payback period, the better.

Payback Method Unequal Cash Flows

The payback method requires adjustment when cash flows are unequal. Lets assume a company purchases a machine for $6,000, with the cash inflows shown below:
2006 $ 3,000 2007 $ 1,000 2008 $ 2,000
Annual Amount $ 3,000 $ 1,000 $ 2,000

2009 $ 1,000

2010 $ 500

Year 2006 2007 2008

Cumulative Amount $ 3,000 $ 4,000 $ 6,000

Payback Method Unequal Cash Flows

Another approach is to calculate the average annual cash inflows to compute the payback period.
Year 2006 2007 2008 2009 2010 Total Average Annual Amount $ 3,000 1,000 2,000 1,000 500 7,500 5 $ 1,500

Payback = period

$6,000 $1,500

= 4 years

Unadjusted Rate of Return

Investment cash flows are not adjusted to reflect the time value of money. The return is computed as follows: Average incremental increase in annual net income (Cost of original investment / 2)

Unadjusted rate of return

Unadjusted Rate of Return

The accuracy of this method suffers from the failure to recognize the recovery of invested capital. Lets look at an example. A company can purchase a depreciable asset with a twoyear life and no salvage value for $1,000. The asset produces incremental revenue of $600 per year. The income statement for the first year would look like this:
Income Statement Revenue $ 600 Depreciation Expense (500) Net Income $ 100

Unadjusted Rate of Return

Given the pattern of cash flows over the life of the investment, the amount of invested capital will range from a beginning balance of $1,000 to an ending balance of zero. On average, the company will have $500 invested in the asset. The unadjusted rate of return should be calculated as follows: Unadjusted $100 = 20% = rate of return $500

Post Audits
A post audit is conducted at the completion of a capital investment project, using the same analytical technique that was used to justify the original investment. The focus should be on continuous improvement in the capital expenditure process.

End of Chapter Ten