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Cost Management

Measuring, Monitoring, and Motivating Performance

Chapter 12 Strategic Investment Decisions

Prepared by Gail Kaciuba Midwestern State University


Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e

John Wiley & Sons, 2005

Slide # 1

Chapter 12: Strategic Investment Decisions

Learning objectives
Q1: How are strategic investment decisions made? Q2: What cash flows are relevant for strategic investment decisions? Q3: How is net present value (NPV) analysis performed and interpreted? Q4: What are the uncertainties and limitations of NPV analysis? Q5: What alternative methods (IRR, payback, and accrual accounting rate of return) are used for long-term decision making? Q6: What additional issues should be considered for strategic investment decisions? Q7: How do income taxes affect strategic investment decision cash flows? Q8: How are the real and nominal methods used to address inflation in NPV analysis (Appendix 12A)
Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e Slide # 2

John Wiley & Sons, 2005

Q1: Process for Making Strategic Investment Decisions

The process used to compare and analyze long-term investment projects is called capital budgeting. The capital budgeting process includes the following stages:
Identify decision alternatives. Identify relevant cash flows. Apply the appropriate quantitative techniques. Perform sensitivity analysis. Identify and analyze qualitative factors. Consider quantitative and qualitative factors and make a decision.
Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e Slide # 3

John Wiley & Sons, 2005

Q1: Capital Budgeting Quantitative Techniques

Methods that consider the time value of money: Net present value (NPV) method Internal rate of return (IRR) method
Methods that do not consider the time value of money: Payback method Accounting rate of return method
John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e Slide # 4

Q2: Relevant Cash Flows in Capital Budgeting

Relevant cash flows occur in the future and are different across the alternatives. Examples of relevant cash outflows include: Initial investment outlay Future operating costs Project closing and cleanup costs Examples of relevant cash inflows include: Future revenues Decreased operating costs Salvage value of assets at projects end
John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e Slide # 5

Q3: Net Present Value (NPV) Analysis

The NPV of a project is the sum of the projects discounted cash flows:
NPV =

n t=0

Expected cash flow , where 1 r


t t

t = year of the projects life in which cash flow occurs n = life of the project r = discount, or hurdle rate If a projects NPV > 0, it is acceptable
John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e Slide # 6

Q3: NPV Analysis and Project Ranking

NPV analysis is often used to screen projects as to whether they are acceptable.
After screening, acceptable projects may be ranked according to their profitability index.
Profitability index = Present value of benefits Present value of costs

The profitability index allows for rankings of projects of various sizes.


John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e Slide # 7

Q3: NPV Example


Joseph Leasing is considering an investment in a new apartment building. The Lindie Lane building will cost $450,000 and the net annual cash inflows are expected to be $45,000 for 7 years. At the end of the 7th year, Joseph expects to be able to sell Lindie Lane building for $400,000. Joseph demands a minimum required rate of return of 8% on all investments. Assume all cash inflows occur at the end of each year. Compute the NPV of the Lindie Lane building. Is it an acceptable investment?

PV of cash inflows: Annuity of cash inflows: $45,000 x PV annuity factor of 5.206 $234,270 Sale of building: $400,000 x PV of $1 factor of 0.583 233,200 467,470 PV of cash outflows: Initial investment 450,000 NPV $17,470
John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e

Yes, the NPV > 0, so the investment is acceptable

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Q3: NPV Example


Joseph Leasing is also looking at the purchase of a lot with a double-wide trailer on it. The cost is $65,000 and the expected net cash inflows are $6,800 per year for 10 years. At the end of the 10th year, Joseph expects to be able to sell the lot and trailer for $45,000. Compute the NPV of the trailer investment. Is it an acceptable investment?

PV of cash inflows: Annuity of cash inflows: $6,800 x PV annuity factor of 6.710 Sale of lot and trailer: $45,000 x PV of $1 factor of 0.463 PV of cash outflows: Initial investment NPV

$45,628 20,835 66,463 65,000 $1,463


Yes, the NPV > 0, so the investment is acceptable

John Wiley & Sons, 2005

Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e

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Q3: NPV Example


Compare the two investments for Joseph using the profitability index, and describe to him what the index means. Which investment (or both) should he make?

Profitability index Lindie Lane building: PV of cash inflows PV of cash outflows Trailer: PV of cash inflows PV of cash outflows 467,470 = 450,000 66,463 = 65,000 1.0388

1.0225

The Lindie Lane yields a slightly greater PV for each invested dollar than does the trailer.

If Joseph has sufficient capital, he should invest in both unless he has alternatives that have even greater profitability indices.
John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e Slide # 10

Q4: Limitations of NPV Analysis

The uncertainty about future cash flows increases the further the cash flow is in the future, but NPV analysis uses only one discount rate for all future periods.
Individuals providing information about the future cash flows are likely to have a vested interest in the projects acceptance.

John Wiley & Sons, 2005

Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e

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Q5: Internal Rate of Return (IRR) Method

The IRR method computes the discount rate required to set the NPV to zero.
For projects with equal annual cash inflows where the only cash outlay is the initial investment, the IRR can be determined by computing the PV of an annuity factor and solving for the interest rate.
Initial investment = PV of an annuity factor Annual cash inflow

Then the discount rate is found by locating the column for the PV factor, given n.
John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e Slide # 12

Q5: IRR Example


Graham Enterprises is considering the purchase of a new machine. The cost is $100,000 and the machine is expected to generate cost savings of $17,700 each year for 10 years. The machine is not expected to have any salvage value at the end of its life. Assume the cost savings are realized at the end of the year. Graham requires a 10% rate of return on all new investments. Compute the IRR for the proposed machine. Should Graham purchase the machine? Locate the 5.65 factor in the present $100,000 = 5.650 value of an annuity table, using n = $17,700 10 years and note that it is found in the 12% column, so the IRR = 12%.

Since the machines IRR exceeds Grahams minimum rate of return, the machine is an acceptable investment, but of course should still be compared to other, potentially better, investments.
Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e

John Wiley & Sons, 2005

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Q5: Payback Method

The payback method computes the number of years before the initial investment is recovered. If cash inflows are the same each year and the project has only one initial outlay, the payback period is computed as:
Payback period in years =
Initial investment Annual cash inflow

For projects where annual cash inflows are not equal, the payback period is computed by merely counting the years required before the initial investment is recovered.
John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e Slide # 14

Q5: Payback Method

The payback method is widely used because of its simplicity. However, the payback method is flawed because:
It ignores the time value of money. It ignores cash flows that occur after the payback period.

If used at all, the payback method should be used in conjunction with the NPV or IRR methods to help assess project risk.
John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e Slide # 15

Q5: Payback Method Example


Graham Enterprises is considering the purchase of a new machine. The cost is $100,000 and the machine is expected to generate cost savings of $17,700 each year for 10 years. The machine is not expected to have any salvage value at the end of its life. Compute the payback period for the proposed machine.

$100,000 = 5.650 years $17,700

Notice that the payback period is the same as the PV factor computed in the IRR example.

John Wiley & Sons, 2005

Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e

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Q5: Payback Method Example


Cophil, Inc. is considering the purchase of a new machine. There are two alternatives, and the cash flow information is given below. Compute the payback period for each and comment on your findings.

Time Cash Flow period Machine A Machine B The payback period for 0 ($100,000) ($100,000) Machine B is 2 years. The 1 $10,000 $50,000 payback period for Machine A 2 $20,000 $50,000 is 3.5 years ($60,000 covered after 3 years, and $40,000 is 3 $30,000 of year 4s cash inflow). 4 $80,000 5 $80,000 The payback method shows Machine B to be 6 $80,000 preferable to Machine A, but ignores the large cash inflows of Machine A that occur after the payback period.
Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e

John Wiley & Sons, 2005

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Q5: Accrual Accounting Rate of Return Method

The accrual accounting rate of return computes the projects rate of return using operating income in place of cash flows.
Accrual accounting rate of return
= Operating income Annual cash inflow

This method is widely used because the financial accounting information is readily available, but is is flawed because it ignores the time value of money.
John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e Slide # 18

Q5: Accrual Accounting Rate of Return Method Example


Blanche Manufacturing is considering the purchase of a new machine. The cost is $100,000 and it is expected to last 5 years and have no salvage value. The machine is expected to generate cost savings of $32,000 per year. Ignoring income tax effects, compute the accrual accounting rate of return for this investment.

Annual cost savings

$32,000

Annual depreciation expense ($100,000/5 years)


Effect on annual operating income Accrual accounting rate of return
John Wiley & Sons, 2005

20,000
$12,000

$12,000 $100,000

= 12%

Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e

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Q6: Additional Considerations in Strategic Investment Decisions

Qualitative issues that may arise in capital budgeting include:


the effects of the decision on the companys reputation, the effects on the quality of the companys products and services, the effects on the companys community, and the effects on employees.

After a capital budgeting decision is made, a post-investment audit should be performed to assess the decision process.
John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e Slide # 20

Q7: Income Tax Considerations

All cash flows should first be converted to an after-tax amount. The tax savings that result from the depreciation deduction is called the depreciation tax shield.

John Wiley & Sons, 2005

Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e

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Q7: Capital Budgeting and Income Tax Considerations (NPV) Example


Colby Products is considering the purchase of a new machine. The cost is $180,000 and it is expected to last 6 years and have no salvage value. The machine is expected to generate cost savings of $50,000 per year. Colbys tax rate is 30% and its discount rate is 10%. For simplification, suppose that Colby uses straight-line depreciation for both books and taxes. Compute the IRR of this machine. Cash inflows after taxes [$50,000 x (1 30%)] Tax savings from depreciation [$30,000 x 30%] Net after-tax annual cash inflows $35,000 9,000 $44,000

NPV = $44,000 x PV factor of an annuity - $180,000 = $44,000 x 4.355 - $180,000 = $11,620

John Wiley & Sons, 2005

Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e

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Q7: Capital Budgeting and Income Tax Considerations (IRR) Example


Colby Products is considering the purchase of a new machine. The cost is $180,000 and it is expected to last 6 years and have no salvage value. The machine is expected to generate cost savings of $50,000 per year. Colbys tax rate is 30% and its discount rate is 10%. For simplification, suppose that Colby uses straight-line depreciation for both books and taxes. Compute the IRR of this machine. Cash inflows after taxes [$50,000 x (1 30%)] Tax savings from depreciation [$30,000 x 30%] Net after-tax annual cash inflows $180,000 $44,000 $35,000 9,000 $44,000

= PV of an annuity factor = 4.091

Locate the 4.091 factor in the present value of an annuity table, using n = 6 years and note that it is found between the 12% & 13% columns, so the IRR is just over 12%.
John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e Slide # 23

Q7: Capital Budgeting and Income Tax Considerations (Payback) Example


Colby Products is considering the purchase of a new machine. The cost is $180,000 and it is expected to last 6 years and have no salvage value. The machine is expected to generate cost savings of $50,000 per year. Colbys tax rate is 30% and its discount rate is 10%. For simplification, suppose that Colby uses straight-line depreciation for both books and taxes. Compute the payback period of this machine. Cash inflows after taxes [$50,000 x (1 30%)] Tax savings from depreciation [$30,000 x 30%] Net after-tax annual cash inflows $35,000 9,000 $44,000

$180,000 $44,000

= Payback period = 4.91 years.

John Wiley & Sons, 2005

Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e

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Q7: Capital Budgeting and Income Tax Considerations (Accrual Accounting ROR) Example
Colby Products is considering the purchase of a new machine. The cost is $180,000 and it is expected to last 6 years and have no salvage value. The machine is expected to generate cost savings of $50,000 per year. Colbys tax rate is 30% and its discount rate is 10%. For simplification, suppose that Colby uses straight-line depreciation for both books and taxes. Compute the accrual accounting rate of return of this machine. Cash inflows after taxes [$50,000 x (1 30%)] Tax savings from depreciation [$30,000 x 30%] Net after-tax annual increase in operating income $44,000 $180,000 $35,000 9,000 $44,000

= 24.44% accrual accounting ROR

John Wiley & Sons, 2005

Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e

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Q8: Inflation and NPV Analysis

When the purchasing power of the dollar declines over time, it is known as inflation. The real rate of interest does not consider changes in the purchasing power of a dollar.

The nominal rate of interest is the rate that investors demand when inflation is taken into consideration in their decisions.
John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e Slide # 26

Q8: Inflation and NPV Analysis

The risk-free rate is the rate of interest that is paid on long-term government bonds. The risk premium is the additional rate of return investors demand to compensate them for taking risk. The risk premium increases for riskier investments.

The real rate of interest is the nominal rate plus the risk premium demanded for that investment.
John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e Slide # 27

Q8: Nominal and Real Methods of NPV Analysis

The real and nominal rates of interest are related as follows:


Nominal rate of = interest
(1 + real rate) x (1 + inflation rate) -1

Nominal future cash flows are real cash flows inflated to future dollars:
Nominal cash flow = Real cash flow x (1 + i)t, where i = rate of inflation, and t = the number of time periods in the future the cash flow occurs
John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e Slide # 28

Q8: Nominal and Real Methods of NPV Analysis

In the real method of NPV analysis, future cash flows are state in real dollars (without considering changes in the purchasing power of the dollar) and a real rate of interest is used as the discount rate.
In the nominal method of NPV analysis, future cash flows and the terminal project value must be inflated to future dollars and a nominal rate of interest is used as the discount rate.
John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e Slide # 29

Q8: Real Method of NPV Analysis

The depreciation tax shield is calculated in 3 steps:


1.Calculate the annual depreciation deduction for tax purposes, 2.Convert each years depreciation deduction from year zero dollars to real dollars by dividing by (1 + inflation rate)t, 3.Multiply the real value of the depreciation deduction times the tax rate.

Calculate the NPV for the incremental cash flows, including the tax savings from depreciation, using the real rate of interest.
John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e Slide # 30

Q8: Real Method of NPV Analysis Example


Stiles, Inc. is considering the purchase of a new machine. The cost is $400,000 and it is expected to last 6 years and have a salvage value of $80,000. Stiles tax rate is 30%, the risk-free rate is 3%, the expected inflation rate is 2%, and Stiles believes that a risk premium of 5% for this machine is appropriate. The machine qualifies as 5-year MACRS property for tax purposes, which means that the depreciation deduction is taken over 6 years at 20%, 32%, 19.2%, 11.52%, 11.52%, and 5.76% of asset cost, respectively. Compute the depreciation tax shield in real dollars for this machine. *this is the nominal depreciation over (1.02)t
MACRS rate Depreciation deduction (nominal) Depreciation deduction (real)* Tax savings (real)
John Wiley & Sons, 2005

1 20.00%

2 32.00%

3 19.20% $76,800 $72,370 $21,711

4 4 11.52% 11.52% $46,080 $46,080 $42,571 $42,571 $12,771 $12,771

5 5 11.52% 11.52% $46,080 $46,080 $41,736 $41,736 $12,521 $12,521

6 6 5.76% 5.76% $23,040 $23,040 $20,459 $20,459 $6,138 $6,138


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$80,000 $128,000 $78,431 $123,030 $23,529 $36,909

Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e

Q8: Real Method of NPV Analysis Example


Compute the tax on the gain on the sale of the machine, in real dollars.
Asset cost Depreciation taken Tax basis of asset Proceeds from sale of asset Gain on sale Tax rate Taxes on gain $400,000 $400,000 $0 $80,000 $80,000 30% $24,000

Note that the tax will be paid in the same year as the disposal, so the $24,000 is already in real dollars. On the prior slide, depreciation deductions taken in years 2 6 are based on an investment stated in year 1 dollars, so they were not in real dollars and needed to be deflated.
John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e Slide # 32

Q8: Nominal Method of NPV Analysis

Incremental cash inflows and the terminal cash flow must be adjusted (inflated) for inflation.
Calculate the gain on asset disposal as the historical cost compared to the nominal depreciation deduction. The nominal and real methods yield the same NPV when the inflation rate is constant over the investments life.
John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e Slide # 33

Q8: Nominal Method of NPV Analysis Example


Stiles, Inc. is considering the purchase of a new machine. The cost is $400,000 and it is expected to last 6 years and have a salvage value of $80,000. Stiles tax rate is 30%, the risk-free rate is 3%, the expected inflation rate is 2%, and Stiles believes that a risk premium of 5% for this machine is appropriate. The machine qualifies as 5-year MACRS property for tax purposes, which means that the depreciation deduction is taken over 6 years at 20%, 32%, 19.2%, 11.52%, 11.52%, and 5.76% of asset cost, respectively. Compute the depreciation tax shield in nominal dollars for this machine.
1 2 32.00% $38,400 3 19.20% $76,800 $23,040 4 11.52% $46,080 $13,824 5 11.52% $46,080 $13,824 6 5.76% $23,040 $6,912

MACRS rate Depreciation deduction


Tax savings

20.00% $24,000

$80,000 $128,000

John Wiley & Sons, 2005

Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e

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Q8: Nominal Method of NPV Analysis Example


Compute the tax on the gain on the sale of the machine, in nominal dollars.

Disposal value Inflation factor Inflated disposal value Tax basis of asset Gain on sale Tax rate Taxes on gain

$80,000 1.12616 $90,093 $0 $90,093 30% $27,028

= (1.02)6

$400,000 cost less depreciation taken of $400,000

John Wiley & Sons, 2005

Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e

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Q8: Nominal Method of NPV Analysis Example


Suppose the machine generates cost savings of $60,000 per year for 6 years. Compute the NPV of the machine using the nominal method.
Time period Cash inflows Inflated cash inflows Taxes on cash inflows Taxes on gain Depreciation tax savings $24,000 Net cash inflows PV factor (nominal) PV of annual net cash flow Initial outlay NPV $66,840 0.90777 $60,675 $38,400 $82,097 0.82405 $67,652 $23,040 $67,611 0.74805 $50,576 $13,824 $59,286 0.67905 $40,258 $13,824 0.61643 $37,106 1 $60,000 $61,200 2 $60,000 $62,424 3 $60,000 $63,672 4 $60,000 $64,946 5 $60,000 $66,245 6 $60,000 $67,570 $90,093 $6,912 0.55957 $65,624 $321,892 $400,000 ($78,108) Total $360,000 $386,057 $90,093 $120,000 $453,305

($18,360) ($18,727) ($19,102) ($19,484) ($19,873) ($20,271) ($115,817) ($27,028) ($27,028) $60,195 $117,276

Terminal cash flow, inflated

John Wiley & Sons, 2005

Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e

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