Capital Expenditure
Decisions
McGraw-Hill/Irwin
Learning
Objective
1
McGraw-Hill/Irwin
Discounted-Cash-Flow Analysis
Plant expansion
Equipment selection
Cost reduction
Equipment replacement
Lease or buy
1-3
Net-Present-Value Method
o
o
o
1-4
Net-Present-Value Method
Mattson Co. has been offered a five year contract to
provide component parts for a large manufacturer.
Cost and revenue information
Cost of special equipment
$160,000
Working capital required
100,000
Relining equipment in 3 years
30,000
Salvage value of equipment in 5 years
5,000
Annual cash revenue and costs:
Sales revenue from parts
750,000
Cost of parts sold
400,000
Salaries, shipping, etc.
270,000
1-5
Net-Present-Value Method
At the end of five years the working capital
will be released and may be used elsewhere
by Mattson.
Mattson uses a discount rate of 10%.
1-6
Net-Present-Value Method
Annual net cash inflows from operations
Sales revenue
Cost of parts sold
Gross margin
Less out-of-pocket costs
Annual net cash inflows
$ 750,000
400,000
350,000
270,000
$ 80,000
1-7
Net-Present-Value Method
Investment in equipment
Working capital needed
Annual net cash inflows
Relining of equipment
Salvage value of equip.
Working capital released
Net present value
Years
Now
Now
1-5
3
5
5
Cash
Flows
$(160,000)
(100,000)
80,000
(30,000)
5,000
100,000
10%
Factor
1.000
1.000
3.791
0.751
0.621
0.621
Present
Value
$ (160,000)
(100,000)
303,280
(22,530)
3,105
62,100
$ 85,955
Internal-Rate-of-Return Method
The internal rate of return is the true
economic return earned by the asset over its
life.
The internal rate of return is computed by
finding the discount rate that will cause the
net present value of a project to be zero.
1-9
Internal-Rate-of-Return Method
Black Co. can purchase a new machine at a
cost of $104,320 that will save $20,000 per
year in cash operating costs.
The machine has a 10-year life.
1-10
Internal-Rate-of-Return Method
Future cash flows are the same every year in
this example, so we can calculate the
internal rate of return as follows:
Investment required
Net annual cash flows
$104, 320
$20,000
= 5.216
1-11
Internal-Rate-of-Return Method
The present value factor (5.216) is located on
the Table IV in the Appendix. Scan the 10period row and locate the value 5.216. Look
at the top of the column and you find a rate of
14% which is the internal rate of return.
$104, 320
$20,000
5.216
1-12
Internal-Rate-of-Return Method
Heres the proof . . .
Investment required
Annual cost savings
Net present value
Year
Now
1-10
Amount
$(104,320)
20,000
14%
Factor
1.000
5.216
Present
Value
(104,320)
104,320
$
-
1-13
Learning
Objective
2
McGraw-Hill/Irwin
1-15
1-16
Assumptions Underlying
Discounted-Cash-Flow Analysis
All cash flows are
treated as though
they occur at year end.
Assumes a
perfect
capital
market.
Cash inflows are
immediately
reinvested at
the required
rate of return.
1-17
1-18
Learning
Objective
3
McGraw-Hill/Irwin
1-20
Total-Cost Approach
Each system would last five years.
12 percent hurdle rate for the analysis.
MAINFRAME
PC _
Salvage value old system
$ 25,000
$ 25,000
Cost of new system
(400,000)
(300,000)
Cost of new software
( 40,000)
( 75,000)
Update new system
( 40,000)
( 60,000)
Salvage value new system
50,000
30,000
================================================
Operating costs over 5-year life:
Personnel
(300,000)
(220,000)
Maintenance
( 25,000)
( 10,000)
Other costs
( 10,000)
( 5,000)
Datalink services
( 20,000)
( 20,000)
Revenue from time-share
25,000
1-21
Total-Cost Approach
MAINFRAME ($)
Acquisition cost computer
Acquisition cost software
System update
Salvage value
Operating costs
Time sharing revenue
Total cash flow
X Discount factor
Present value
Today
(400,000)
( 40,000)
Year 1
Year 2
Year 3
Year 4
Year 5
( 40,000)
50,000
(335,000) (335,000) (335,000) (335,000) (335,000) (335,000)
20,000
20,000 20,000
20,000 20,000 20,000
440,000 (315,000) (315,000) (355,000) (315,000) (265,000)
X 1.000 X .893 X .797 X .712 X .636 X .567
(440,000) (281,295) (251,055) (252,760) (200,340) (150,255)
SUM = ($1,575,705)
PERSONAL COMPUTER ($)
Acquisition cost computer
Acquisition cost software
System update
Salvage value
Operating costs
Time sharing revenue
Total cash flow
X Discount factor
Present value
Today
(300,000)
( 75,000)
Year 1
Year 2
Year 3
Year 4
Year 5
( 60,000)
50,000
(235,000) (235,000) (235,000) (235,000) (235,000) (235,000)
-0-0-0-0-0-0_
375,000 (235,000) (235,000) (295,000) (235,000) (205,000)
X 1.000 X .893 X .797 X .712 X .636 X .567
(375,000) (209,855) (187,295) (210,040) (149,460) (116,235)
SUM = ($1,247,885)
1-22
Total-Cost Approach
($1,575,705)
($ 327,820)
Incremental-Cost Approach
INCREMENTAL ($)
Acquisition cost computer
Acquisition cost software
System update
Salvage value
Operating costs
Time sharing revenue
Total cash flow
X Discount factor
Present value
Today
(100,000)
35,000
Year 1
Year 2
Year 3
Year 4
Year 5
20,000
20,000
(100,000) (100,000) (100,000) (100,000) (100,000)
20,000
20,000 20,000
20,000 20,000
20,000
( 65,000) ( 80,000) ( 80,000) ( 80,000) ( 80,000) ( 60,000)
X 1.000 X .893 X .797 X .712 X .636 X .567
( 65,000) ( 71,440) ( 63,760) ( 42,720) ( 50,880) ( 34,020)
SUM = ($ 327,820)
1-24
Total-Incremental Cost
Comparison
Total Cost:
Net cost of purchasing Mainframe system
($1,575,705)
($ 327,820)
Incremental Cost:
Net Present Value of costs
($ 327,820)
1-27
Learning
Objective
4
McGraw-Hill/Irwin
1-29
Revenue
$ 1,000,000
Expenses
(475,000)
525,000
(210,000)
315,000
Learning
Objective
5
McGraw-Hill/Irwin
3-year
33.33%
44.45%
14.81%
7.41%
5-year
20.00%
32.00%
19.20%
11.52%
11.52%
5.76%
7-year
14.29%
24.49%
17.49%
12.49%
8.93%
8.92%
8.93%
4.46%
1-32
Learning
Objective
6
McGraw-Hill/Irwin
1-34
Extended Illustration
For a complete present value analysis for an
investment decision facing High Country
Department Stores, Inc., see the textbook.
High Country
Department
Stores
1-35
Learning
Objective
7
McGraw-Hill/Irwin
Project B
$ 100,000
$ 30,000
40,000
50,000
$ 120,000
The total cash flows are the same, but the pattern of
the flows is different.
1-37
Project A
$(100,000)
$ 50,000
40,000
30,000
PV Factor
1.000
0.909
0.826
0.751
PV
$(100,000)
45,450
33,040
22,530
$ 1,020
Project B
$(100,000)
$ 30,000
40,000
50,000
PV Factor
1.000
PV
$(100,000)
0.909
0.826
0.751
27,270
33,040
37,550
$ (2,140)
Learning
Objective
8
McGraw-Hill/Irwin
Payback
=
period
$20,000
$4,000
= 5 years
1-41
Accounting-Rate-of-Return
Method
Discounted-cash-flow method focuses on
cash flows and the time value of money.
1-43
Accounting-Rate-of-Return
Method
The following formula is used to calculate the
accounting rate of return:
Accounting
rate of
return
Average
incremental
revenues
Average
incremental expenses,
including depreciation &
income taxes
Initial investment
1-44
Accounting-Rate-of-Return
Method
Meyers Company wants to install an espresso bar
in its restaurant.
The espresso bar:
Cost $140,000 and has a 10-year life.
Will generate incremental revenues of $100,000 and
incremental expenses of $80,000 including
depreciation.
Accounting-Rate-of-Return
Method
Accounting
=
rate of return
$100,000 - $80,000
$140,000
= 14.3%
1-46
Learning
Objective
9
McGraw-Hill/Irwin
1-48
Time
horizons
are too
short
Hurdle
rates are
too high
Benefits
difficult to
quantify
Bias
towards
incremental
projects
Greater
cash flow
uncertainty
1-49
Learning
Objective
10
McGraw-Hill/Irwin
Inflation Effects
Nominal Dollars
Real dollars
1-51
End of Chapter 16
1-52