Capital Expenditure Decisions FOCUS COMPANY PDF

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Chapter Fifteen Capital Expenditure Decisions FOCUS COMPANY After completing this chapter, you should be able to: This chapter’s focus is on the City of Mountainview, British Columbia. Mountainview’s mayor and city council face a variety of decisions 1 Use the net-present-value that involve cash flo...

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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.

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Chapter 15 Capital Expenditure Decisions

M

anagers 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.

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.

Focus on Project

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 ($70,000 5 5 3 $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

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Chapter 15 Capital Expenditure Decisions

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 Exhibit 15–1

CITY OF MOUNTAINVIEW Purchase of Street Cleaner (r .10, n 5)

Net-Present-Value Method

Step 1 Year 0 Acquisition cost Annual cost savings

Year 1

Year 2

Year 3

Year 4

Year 5

$14,000

$14,000

$14,000

$14,000

$14,000

$(50,470)

⎫ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎭ Present value of annuity

Step 2

$14,000(3.791) Annuity discount factor for r .10 and n 5 from Table IV in Appendix B

Present value

$(50,470)

$53,074

⎫ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎭

Step 3 Net present value Step 4 Accept proposal, since net present value is positive.

$2,604

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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. 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).

Finding the Internal Rate of Return

13.4332 1$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: 13.6052 1$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

0 $(50,470)

1 $14,000

2 $14,000

3 $14,000

4 $14,000

5 $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: $ 210,000 ⫽ 4 . 200 ⫽ Annuity discount factorr $50,000

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Chapter 15 Capital Expenditure Decisions

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 n=5

10%

r 12%

14%

3.791

3.605

3.433

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. 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

Recovery of Investment

Exhibit 15–2

CITY OF MOUNTAINVIEW Purchase of Street Cleaner (r .12, n 5)

1. Unrecovered investment at beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . 2. Cost savings during year . . . . . . . . . . . . . . . . . . . . 3. Return on unrecovered investment [12% amount in row (1)] . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4. Recovery of investment during year [row (2) amount minus row (3) amount] . . . . . . . . . . . . . . . . . . . . . . 5. Unrecovered investment at end of year [row (1) amount minus row (4) amount] . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

“Our role is to be internal management consultants for the key decisions facing management.” (15b) Hewlett-Packard

Recovery of Investment and Return on Investment

Year 1

Year 2

Year 3

Year 4

Year 5

$50,470 14,000

$42,526 14,000

$33,629 14,000

$23,664 14,000

$12,504 14,000

6,056

5,103

4,035

2,840

1,500

7,944

8,897

9,965

11,160

12,500

42,526

33,629

23,664

12,504

*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.

4*

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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). 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: Uneven Cash Flows

Cost savings

$14,000

$14,000

$12,000

$10,000

$8,000

1

2

3

4

5

Time Year

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. 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 1. Compute the investment proposal’s net present value, using the organization’s hurdle rate as the discount rate. 2. Accept the investment proposal if its net present value is equal to or greater than zero; otherwise reject it.

Internal-Rate-of-Return Method 1.

2.

Compute the investment proposal’s internal rate of return, which is the discount rate that yields a zero net present value for the project. 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-pres...