Part 1SportsMax sells sporting goods equipment at 100 stores throughout North America. Robert Manning is the manager of one SportsMax retail store in Chicago. The company is in the planning phase of e
Saylor URL: http://www.saylor.org/books Saylor.org
472 Chapter 8
How Is Capital Budgeting Used to Make Decisions?
Julie Jackson is the president and owner of Jackson’s Quality Copies, a store that makes
photocopies for its customers and that has several copy machines. Julie has the following
discussion with Mike Haley, the company’s accountant:
Julie: Mike, I think it’s time to buy a new copy machine. Our volume of copies has increased dramatically over the last year, and we need a copier
that does a better job of handling the big jobs.
Mike: Do you have any idea how much the new machine will cost?
Julie: We can purchase a new copier for $50,000, maintenance costs will total $1,000 a year, and the copier is expected to last 7 years. Since the new
machine is quicker and will require less attention by our employees, we should save about $11,000 a year in labor costs.
Mike: Will it have any salvage value at the end of seven years?
Julie: Yes. The salvage value should be about $5,000.
Mike: How soon do you want to do this?
Julie: As soon as possible. From what I can tell, this is a winning proposition. The cash inflows of $82,000 that we will get from the labor cost savings
and the salvage value exceed the cash outflows of $57,000 that we expect to spend on the machine and annual maintenance costs. What do you
think?
Mike: Let me take a look at the numbers before we jump into this. We have to consider more than just total cash inflows and outflows. I’ll get back to
you by the end of the week.
Julie: Okay, thanks for your help!
Jackson’s Quality Copies is facing a decision common to many organizations: whether to invest
in equipment that will last for many years or to continue with existing equipment. This type of
decision differs from the decisions c overed in the previous chapter because long - term investment
decisions affect organizations for several years. We will return to Julie’s plan to purchase a new
copier after we provide background information on long - term investment decisions.
8.1 Capital Budgeting and Decision Making
L E A R N I N G O B J E C T I V E
1. Apply the concept of the time value of money to capital budgeting decisions.
Question: What is the difference between management decisions made in and management
decisions made in this chapter? Saylor URL: http://www.saylor.org/books Saylor.org
473 Answer: The types of decisions covered in this chapter and are similar in that they require an
analysis of differential revenues and costs. However,involves short - run operating decisions (e.g.,
special orders from customers), while this chapter focuses on long - run capacity decisions (e.g.,
purchasing long - lived assets to increase capacity for many years).
Organizations make a variety of long - run investment decisions. The San Francisco
Symphony invests in stage risers for its orchestra members. McDonald’s inv ests in new
restaurants. Honda Motor Co. invests in new manufacturing facilities. Bank of America invests
in new branches. These examples have one common feature: all of these companies are investing
in assets that will affect the organization for several years.
Question: The process of analyzing and deciding which long - term investments to make is called
a capital budgeting decision , also known as a capital expenditure decision. Capital budgeting
decisions involve using company funds (capital) to invest in long - term assets. How does the
evaluation of these types of capital budgeting decisions differ from short - term operating
decisions discussed in ?
Answer: When looking at capital budgeting decisions that affect future years, we must consider
the time valu e of money. The time value of money concept is the premise that a dollar received
today is worth more than a dollar received in the future. To clarify this point, suppose a friend
owes you $100. Would you prefer to receive $100 today or 3 years from today? The money is
worth more to you if you receive it today because you can invest the $100 for 3 years.
For capital budgeting decisions, the issue is how to value future cash flows in today’s dollars.
The term cash flow refers to the amount of cash received o r paid at a specific point in time. The
term present value describes the value of future cash flows (both in and out) in today’s dollars.
Business in Action 8.1
Capital Budgeting Decisions at JCPenney and Kohl’s
JCPenney Company has over 1,000 department stores in the United States,
and Kohl’s Corporation has over 800. Both companies cater to a “middle market.” In
October 2006, Kohl’s announced plans to open 65 new stores. At about the same time, Saylor URL: http://www.saylor.org/books Saylor.org
474 JCPenney announced plans to open 2 0 new stores, 17 of which would be stand - alone
stores. This was a departure from JCPenney’s typical approach of serving as an anchor
store for regional shopping malls.
The decision to open new stores is an example of a capital budgeting decision because
ma nagement must analyze the cash flows associated with the new stores over the long
term.
Source: James Covert, “Chasing Mr. and Mrs. Middle Market: J.C. Penney, Kohl’s Open
85 New Stores,” The Wall Street Journal , October 6, 2006.
When managers evaluate investments in long - term assets, they want to know how much cash
would be spent on the investment and how much cash would be received as a result of the
investment. The investment proposal is likely rejected if cash inflows do not ex ceed cash
outflows. (Think about a personal investment. If you would receive only $700 in the future from
an investment of $1,000 today, you undoubtedly would not make the investment because you
would lose $300!) If cash inflows are expected to exceed cash outflows, managers must
consider when the cash inflows and outflows occur before taking on the investment. (Again,
consider an investment of $1,000 today. If you expect to receive $1,050 in 20 years rather than at
the end of 1 year, you would probably thi nk twice before investing because it would take 20
years to make $50!)
Question: We use two methods to evaluate long - term investments, both of which consider the
time value of money. What are these two methods?
Answer: The first is called the net present value (NPV) method , and the second is called
the internal rate of return method . Before presenting these two methods, let’s discuss the time
value of money (present value) concepts.
The Present Value Formula
Question: Suppose you invest $1,000 for 1 year at an interest rate of 5 percent per year, as
shown in the following timeline. How much will you have at the end of 1 year (or what is
the future value of the investment)? Saylor URL: http://www.saylor.org/books Saylor.org
475
Answer: You will have $1,050:
$1,050 = $1,000 × (1 + .05)
Question: Let’s change course and find the present value of the same future cash flow. If you
receive $1,050 in 1 year, how much is that worth in today’s dollars assuming an annual interest
rate of 5 percent? Saylor URL: http://www.saylor.org/books Saylor.org
476
Answer: The present value is $1,000, calcul ated as follows:
$1, 000 = $1, 0 5 0 ( 1 + .0 5 )
Question: Let’s go back to finding a future value. Assume you invest $1,000 today at an annual
rate of 5 percent for 2 years. How much will you have at the end of 2 years? Saylor URL: http://www.saylor.org/books Saylor.org
477
Answer: At the end of 1 year, you will have $1,050 (= $1,000 × [1 + .05]). At the end of the
second year, you will have $1,102.50, which is $1,050 × (1 + .05). The equation is
$1,102.50 = $1,000 × (1 + .05) × (1 + .05)or$1,102.50 = $1,000 × (1 + .05) 2
Question: Again, let’s change course and f ind the present value of the same future cash flow. If
you receive $1,102.50 in 2 years, how much is that worth in today’s dollars assuming an annual
interest rate of 5 percent? Saylor URL: http://www.saylor.org/books Saylor.org
478
Answer: The present value is $1,000, calculated as follows:
$1, 000 = $1,1 0 2 . 5 0 ( 1 + .0 5 ) 2
These examples show that one equation can be used to find the present value of a future cash
flow. The equation is
Key Equation
P = F n ( 1 + r ) n
where
P = Present value of an amountF n = Amount received n years in the future r = Annual interest
rate n = Number of years Saylor URL: http://www.saylor.org/books Saylor.org
479
Question: Let’s use this formula to solve for the following: Assume $500 will be received 4 years
from today, and the annual interest rate is 10 percent. What is the present value of this cash
flow?
Answer: The present value is $341.51, calculated as follows:
P = F n ( 1 + r ) n = $5 00 ( 1 +. 1 0 ) 4 = $5 00 1 . 4641 = $341 . 51
Present Value Tables
Question: Although most managers use spreadsheets, such as Excel, to perform present value
calculations (discussed later in this chapter), you can also use the present value tables in the
appendix to this chapter, labeled and , for these calculations. simply provides the present value Saylor URL: http://www.saylor.org/books Saylor.org
480 of $1 (i.e., F = $1) given the number of years ( n ) and the interest rate ( r ). How are these tables
used to calculate present value amounts?
Answer: Let’s look at an example to see how these tables work. Assume $1 will be received 4
years from today ( n = 4), and the interest rate is 10 percent ( r = 10 percent) . What is the present
value of this cash flow? Look atin the appendix. Find the column labeled 10 percent and the row
labeled 4 . The present value is $0.6830, or $0.68 rounded. The table amount given is often called
a factor . The factor in this example is 0.6830 (note that the formula to find this factor is shown at
the top of ).
Now assume all the same facts, except that $500 rather than $1 will be received in 4 years. To
find the present value, simply multiply the factor found in by $500, as follows:
Pres ent value = Amount received in the future × Present value factor = $5 00 × 0. 683 0 = $341 . 5 0
Notice that this present value is the same as the one we calculated using the formula P = F n ÷ (1
+ r ) n , with the exception of a small difference due to rounding the factor in . Next, we use
present value concepts to evaluate projects with the NPV method.
K E Y T A K E A W A Y
Present value calculations tell us the value of future cash flows in today’s
dollars. The present value of a cash flow can be calculated by using the
for mula P = F n ÷ (1 + r ) n . It can also be calculated by using the tables in the
appendix of this chapter. Simply find the factor in given the number of
years ( n ) and annual interest rate ( r ). Then multiply the factor by the future
cash flow, as follows:
Prese nt value = Amount received in the future × Present value factor
R E V I E W P R O B L E M 8 . 1
For each of the following independent scenarios, calculate the present value of the
cash flow described. Round to the nearest dollar.
1. You will receive $5,000, 5 years from t oday, and the interest rate is 8 percent. Saylor URL: http://www.saylor.org/books Saylor.org
481 2. You will receive $80,000, 9 years from today, and the interest rate is 10 percent.
3. You will receive $400,000, 20 years from today, and the interest rate is 20 percent.
4. You will receive $250,000, 10 years from toda y, and the interest rate is 15 percent.
Solution to Review Problem 8.1
Two approaches can be used to find the present value of a cash flow. The first
requires using the formula P = F n ÷ (1 + r ) n . The second requires usingin the appendix
to find the present value factor and inserting it in the following formula:
Present value = Amount received in the future × Present value factor (from )
We show both approaches in the following solutions.
1. Using the formula P = F n ÷ (1 + r ) n , we get
$3,4 0 3 = $5, 000 ÷( 1 + .0 8 ) 5
Using , we get
Present value$3,4 0 3 = Future value × Present value factor = $5, 000 × 0. 68 0 6
2. Using the formula P = F n ÷ (1 + r ) n , we get
$33,928 = $8 0,000 ÷( 1 +. 1 0 ) 9
Using , we get
Present value$33,928 = Future value × Present value factor = $8 0,000 × 0. 4241
3. The small difference between the two approaches is due to rounding the
factor in .
Using the formula P = F n ÷ (1 + r ) n , we get
1 0 ,434 = $4 00,000 ÷( 1 +. 2 0 ) 20
Using , we get
Present value$1 0 ,44 0 = Future value × Present value factor = $4 00,000 × 0.0 261
4. The small difference betw een the two approaches is due to rounding the
factor . Saylor URL: http://www.saylor.org/books Saylor.org
482 Using the formula P = F n ÷ (1 + r ) n , we get
$61,796 = $25 0,000 ÷( 1 +. 15 ) 10
Using , we get
Present value$61,8 00 = Future value × Present value factor = $25 0,000 × 0. 2472
8.2 Net Present Value
L E A R N I N G O B J E C T I V E
1. Evaluate investments using the net present value (NPV) approach.
Question: Now that we have the tools to calculate the present value of future cash flows, we can
use this information to make decisions about long - term investment opportunities. How does this
information help companies to evaluate long - term investments?
Answer: The net present value (NPV) method of evaluating investments adds the present value
of all cash inflows and subtracts the present value of all cash outflows. The term discoun ted cash
flows is also used to describe the NPV method. In the previous section, we described how to find
the present value of a cash flow. The term net in net present value means to combine the present
value of all cash flows related to an investment (bot h positive and negative).
Recall the problem facing Jackson’s Quality Copies at the beginning of the chapter. The
company’s president and owner, Julie Jackson, would like to purchase a new copy machine. Julie
feels the investment is worthwhile because the cash inflows over the copier’s life total $82,000,
and the cash outflows total $57,000, resulting in net cash inflows of $25,000 (= $82,000 –
$57,000). However, this approach ignores the timing of the cash flows. We know from the
previous section that the further into the future the cash flows occur, the lower the value in
today’s dollars.
Question: How do managers adjust for the timing differences related to future cash flows?
Answer: Most managers use the NPV approach. This approach requires three steps to evaluate
an investment: Saylor URL: http://www.saylor.org/books Saylor.org
483 Step 1. Identify the amount and timing of the cash flows required over the life of the
investment.
Step 2. Establish an appropriate interest rate to be used for evaluating the investment,
typically called the required rate of ret urn . (This rate is also called the discount rate or hurdle
rate .)
Step 3. Calculate and evaluate the NPV of the investment.
Let’s use Jackson’s Quality Copies as an example to see how this process works.
Step 1. Identify the amount and timing of the cash flows required over the life of the
investment.
Question: What are the cash flows associated with the copy machine that Jackson’s Quality
Copies would like to buy?
Answer: Jackson’s Quality Copies will pay $50,000 for the new copier, which is expected t o last
7 years. Annual maintenance costs will total $1,000 a year, labor cost savings will total $11,000
a year, and the company will sell the copier for $5,000 at the end of 7 years. Figure 8.1 "Cash
Flows for Copy Machine Investment by Jackson’s Quality Copies"summarizes the cash flows
related to this investment. Amounts in parentheses are cash outflows. All other amounts are cash
inflows.
Figure 8.1 Cash Flows for Copy Machine Investment by Jackson’s Quality Copies
Saylor URL: http://www.saylor.org/books Saylor.org
484 Step 2. Establish an appropriate interest rate to be used for evaluating the investment.
Question: How do managers establish the interest rate to be used for evaluating an investment?
Answer: Although managers often estimate the interest rate, this estimate is typically based on
the organization’s cost of capital . The cost of capital is the weighted average costs associated
with debt and equity used to fund long - term investments. The cost of debt is simply the interes t
rate associated with the debt (e.g., interest for bank loans or bonds issued). The cost of equity is
more difficult to determine and represents the return required by owners of the organization. The
weighted average of these two sources of capital repres ents the cost of capital (finance textbooks
address the complexities of this calculation in more detail).
The general rule is the higher the risk of the investment, the higher the required rate of return
(assume required rate of return is synonymous with interest rate for the purpose of calculating the
NPV). A firm evaluating a long - term investment with risk similar to the firm’s average risk will
typically use the cost of capital. However, if a long - term investment carries higher than average
risk for the firm, the firm will use a required rate of return higher than the cost of capital.
The accountant at Jackson’s Quality Copies, Mike Haley, has established the cost of capital for
the firm at 10 percent. Since the proposed purchase of a copy machine is of average risk to the
company, Mike will use 10 percent as the required rate of return.
Step 3. Calculate and evaluate the NPV of the investment.
Question: How do managers calculate the NPV of an investment?
Answer: Figure 8.2 "NPV Calculation for Copy M achine Investment by Jackson’s Quality
Copies" shows the NPV calculation for Jackson’s Quality Copies. Examine this table carefully.
The cash flows come from Figure 8.1 "Cash Flows for Copy Machine Investment by Jackson’s
Quality Copies". The present value factors come from Figure 8.9 "Present Value of $1 Received
at the End of " in the appendix ( r = 10 percent; n = year). The bottom row, labeled present
value is calculated by multiplying the total cash in (out) × present value factor, and it represents Saylor URL: http://www.saylor.org/books Saylor.org
485 tot al cash flows for each time period in today’s dollars. The bottom right of Figure 8.2 "NPV
Calculation for Copy Machine Investment by Jackson’s Quality Copies" shows the NPV for the
investment, which is the sum of the bottom row labeled present value .
Figu re 8.2 NPV Calculation for Copy Machine Investment by Jackson’s Quality Copies
The NPV is $1,250. Because NPV is > 0, accept the investment. (The investment provides a
return greater than 10 percent.)
The NPV Rule
Question: Once the NPV is calculated, how do managers use this information to evaluate a long -
term investment?
Answer: Managers apply the following rule to decide whether to proceed with the investment:
NPV Rule: If the NPV is greater than or equal to zero, accept the investment; otherwise, reject
the investment.
As summarized in Figure 8.3 "The NPV Rule" , if the NPV is greater than zero, the rate of return
from the investment is higher than the required rate of return. If the NPV is zero, the rate of
return from th e investment equals the required rate of return. If the NPV is less than zero, the rate
of return from the investment is less than the required rate of return. Since the NPV is greater
than zero for Jackson’s Quality Copies, the investment is generating a return greater than the
company’s required rate of return of 10 percent.
Figure 8.3 The NPV Rule Saylor URL: http://www.saylor.org/books Saylor.org
486
Note that the present value calculations in Figure 8.3 "The NPV Rule" assume that the
cash flows for years 1 through 7 occur at the end of each year. In reality, these cash flows
occur throughout each year. The impact of this assumption on the NPV calculation is
typically negligible.
Business in Action 8.2
Cost of Capital by Industry
Cost of capital can be estimated for a single company or for entire industries. New
York University’s Stern School of Business maintains cost of capital figures by
industry. Almost 7,000 firms were included in accumulating this information. The
following sampling o f industries compares the cost of capital across industries. Notice
that high - risk industries (e.g., computer, e - commerce, Internet, and semiconductor)
have relatively high costs of capital.
Air transportation 11.48 percent
Auto and truck 11.04 percent
Auto parts 9.56 percent
Beverage (soft drinks) 8.16 percent
Computer 14.49 percent
E - commerce 15.65 percent Saylor URL: http://www.saylor.org/books Saylor.org
487 Grocery 9.79 percent
Internet 15.98 percent
Retail store 9.30 percent
Semiconductor 19.03 percent
Source: New York University’s Stern Business School, “Home
Page,” http://pages.stern.nyu.edu .
Annuity Tables
Question: Notice in Figure 8.1 "Cash Flows for Copy Machine Investment by Jack son’s Quality
Copies" that the rows labeled maintenance cost and labor savings have identical cash flows from
one year to the next. Identical cash flows that occur in regular intervals, such as these at
Jackson’s Quality Copies, are called an annuity . How can we use annuities in an alternate
format to calculate the NPV?
Answer: In Figure 8.4 "Alternative NPV Calculation for Jackson’s Quality Copies" , we
demonstrate an alternative approach to calculating the NPV.
Figure 8.4 Alternative NPV Calculation for J ackson’s Quality Copies
*Because this is not an annuity, use Figure 8.9 "Present Value of $1 Received at the End of " in
the appendix. Saylor URL: http://www.saylor.org/books Saylor.org
488 **Because this is an annuity, use Figure 8.10 "Present Value of a $1 Annuity Received at the
End of Each Period for " in the appendix. The number of years ( n ) equals seven since identical
cash flows occur each year for seven years.
Note: the NPV of $1,250 is the same as the NPV in Figure 8.2 "NPV Calculation for Copy
Machine Investment by Jackson’s Quality Copies".
The pu rchase price and salvage value rows in Figure 8.4 "Alternative NPV Calculation for
Jackson’s Quality Copies" represent one - time cash flows, and thus we use Figure 8.9 "Present
Value of $1 Received at the End of " in the appendix to find the present value f actor for these
items (these are not annuities). The annual maintenance costs and annual labor savings rows
represent cash flows that occur each year for seven years (these are annuities). We use Figure
8.10 "Present Value of a $1 Annuity Received at the En d of Each Period for " in the appendix to
find the present value factor for these items (note that the number of years, n , equals seven since
the cash flows occur each year for seven years). Simply multiply the cash flow shown in
column (A) by the present value factor shown in column (B) to find the present value for each
line item. Then sum the present value column to find the NPV. This alternative approach results
in the same NPV shown inFigure 8.2 "NPV Calculation for Copy Machine Investment by
Jackson’s Quality Copies".
Business in Action 8.3
Winning the Lottery
Like many other states, California pays out lottery winnings in installments over several
years. For example, a $1,000,000 lottery winner in California will receive $50,000 each
year for 20 years.
Does this mean that the State of California must have $1,000,000 on the day the winner
claims the prize? No. In fact, California has approximately $550,000 in cash to pay
$1,000,000 over 20 years. Thi s $550,000 in cash represents the present value of a
$50,000 annuity lasting 20 years, and the state invests it so that it can provide
$1,000,000 to the winner over 20 years. Saylor URL: http://www.saylor.org/books Saylor.org
489 Source: California State Lottery, “California State Lottery Home
Page,” http://www.calottery.com .
K E Y T A K E A W A Y
Present value calculations tell us the value of cash flows in today’s dollars. The NPV
method adds the present value of all cash inflows and subtracts the present value of
all cash outflows related to a long - term investment. If the NPV is greater than or
equal to zero, accept the investment; otherwise, reject the investment.
R E V I E W P R O B L E M 8 . 2
The management of Chip Manufacturing, Inc., would l ike to purchase a specialized
production machine for $700,000. The machine is expected to have a life of 4 years,
and a salvage value of $100,000. Annual maintenance costs will total $30,000. Annual
labor and material savings are predicted to be $250,000. The company’s required rate
of return is 15 percent.
1. Ignoring the time value of money, calculate the net cash inflow or outflow resulting
from this investment opportunity.
2. Find the NPV of this investment using the format presented in Figure 8.2 "NPV
Calcul ation for Copy Machine Investment by Jackson’s Quality Copies" .
3. Find the NPV of this investment using the format presented in Figure 8.4 "Alternative
NPV Calculation for Jackson’s Quality Copies" .
4. Should Chip Manufacturing, Inc., purchase the specialized p roduction machine?
Explain.
Solution to Review Problem 8.2
1. The net cash inflow, ignoring the time value of money, is $280,000,
calculated as follows: Saylor URL: http://www.saylor.org/books Saylor.org
490
2. The NPV is $(14,720), calculated as follows:
3. The alternative format used for calculating the NPV is shown as follows. Note
that the NPV here is identical to the NPV calculated previously in part 2 .
*Because this is not an annuity, use Figure 8.9 "Present Value of $1 Received
at the End of " in the appendix.
**Because this is an annuity, use Figure 8.10 "Present Value of a $1 Annuity
Received at the End of Each Period for " in the appendix. The number of
years ( n ) equals four since identical cash flows occur each year for four
years. Saylor URL: http://www.saylor.org/books Saylor.org
491 4. Because the NPV is less th an 0, the return generated by this investment is less than
the company’s required rate of return of 15 percent. Thus Chip Manufacturing, Inc.,
should not purchase the specialized production machine.
8.3 The Internal Rate of Return
L E A R N I N G O B J E C T I V E
1. Evaluate investments using the internal rate of return (IRR) approach.
Question: Using the internal rate of return (IRR) to evaluate investments is similar to using the
net present value (NPV) in that both methods consider the time value of money. However, the
IRR provides additional information that helps companies evaluate long - term investments. What
is the IRR, and how does it help managers make decisions related to long - term investments?
Answer: The internal rate of return (IRR) is the rate required ( r ) to get an NPV of zero for a
series of cash flows. The IRR represents the time - adjusted rate of return for the investment being
considered. The IRR decision rule states that if the IRR is greater than or equal to the company’s
required rate of return (reca ll that this is often called the hurdle rate ), the investment is accepted;
otherwise, the investment is rejected.
Most managers use a spreadsheet, such as Excel, to calculate the IRR for an investment (we
discuss this later in the chapter). However, we can also use trial and error to approximate the
IRR. The goal is simply to find the rate that generates an NPV of zero. Let’s go back to the
Jackson’s Quality Copies example. provides the projected cash flows for a new copy machine
and the NPV calculation usi ng a rate of 10 percent. Recall that the NPV was $1,250, indicating
the investment generates a return greater than the company’s required rate of return of 10
percent.
Although it is useful to know that the investment’s return is greater than the company’s required
rate of return, managers often want to know the exact return generated by the investment. (It is
often not enough to state that the exact return is something higher than 10 percent!) Managers
also like to rank investment opportunities by the retu rn each investment is expected to generate.
Our goal now is to determine the exact return — that is, to determine the IRR. We know from that Saylor URL: http://www.saylor.org/books Saylor.org
492 the copy machine investment generates a return greater than 10 percent. summarizes this
calculation with the 2 column s under the 10 percent heading.
The far right side of shows that the NPV is $(2,100) if the rate is increased to 12 percent (recall
our goal is to find the rate that yields an NPV of 0). Thus the IRR is between 10 and 12 percent.
Next, we try 11 percent. A s shown in the middle of , 11 percent provides an NPV of $(469).
Thus the IRR is between 10 and 11 percent; it is closer to 11 percent because $(469) is closer to
0 than $1,250. (Note that as the rate increases , the NPV decreases , and as the rate decreases , the
NPV increases .)
Figure 8.5 Finding the IRR for Jackson’s Quality Copies
*Because this is not an annuity, use in the appendix.
**Because this is an annuity, use in the appendix. The number of years ( n ) equals seven since
identical cash flows occur each year for seven years.
Note: the NPV of $(469) is closest to 0. Thus the IRR is close to 11 percent.
This trial and error approach allows us to approximate the IRR. As stated earlier, if the IRR is
greater than or equal to th e company’s required rate of return, the investment is accepted;
otherwise, the investment is rejected. For Jackson’s Quality Copies, the IRR of approximately 11 Saylor URL: http://www.saylor.org/books Saylor.org
493 percent is greater than the company’s required rate of return of 10 percent. Thus the investme nt
should be accepted.
Computer Application
Using Excel to Calculate NPV and IRR
Let’s use the Jackson’s Quality Copies example presented at the beginning of the chapter
to illustrate how Excel can be used to calculate the NPV and IRR. Two steps are required
to calculate the NPV and IRR using Excel. All cell references are to the following
spreadsheet shown.
Step 1. Enter the data in the spreadsheet.
Rows 1 through 7 in the spreadsheet show the cash flows associated with t he proposal to
purchase a new copy machine at Jackson’s Quality Copies (first presented in ).
Step 2. Input the functions to calculate NPV and IRR. Saylor URL: http://www.saylor.org/books Saylor.org
494 We selected cell H16 to calculate the NPV, so this is where the NPV function is input.
Cell E16 shows the fu nction in detail with dialogue boxes provided for clarification.
Notice that the resulting NPV of $1,250 shown in cell H16 is the same as the NPV
calculated in and .
We selected cell H28 to calculate the IRR, so this is where the IRR function is input. Cell
E28 shows the function in detail. Notice that the resulting IRR of 10.72 percent shown
in cell H28 is very close to our approximation of slightly less than 11 percent shown in .
As an alternative to entering a function directly into the spreadsheet, the NPV function
under the Formulas menu in Excel can be used. Simply select the cell in the spreadsheet
where you would like the answer to appear (H16 in this case), and go to
the F ormulas menu. Click on the fx symbol or Insert Function on the formula bar.
Search for the function by typing in NPV , select NPV where it appears in the box, then
select OK . When asked for the Rate , enter the cell where the rate appears (B10). Then
under Va lue 1 enter the cells containing the series of cash flows, starting with year 1
(shown as C7:I7, which means C7 through I7). Select OK . Now go back and add the cash
flow at time 0 (B7) to the end of the NPV function. The resulting formula will look like
th e formula shown in E16, and the answer will appear in the cell where the function is
entered (H16).
The IRR function can be inserted into a cell using the same process presented
previously. Select the cell in the spreadsheet where you would like the answer to appear
(H28), and go to the Formulas menu. Click on the fx symbol or Insert Function on the
formula bar. Search for the function by typing in IRR , select IRR where it appears in the
box below, then select OK . When asked for Values , enter the cells cont aining the series
of cash flows, starting with time 0 (shown as B7:I7, which means B7 through I7). When
asked for a Guess , enter your best guess as to what the IRR might be (this provides the
system with a starting point), then select OK . The resulting for mula will look like the
formula shown in E28, and the answer will appear in the cell where the function is
entered (H28).
K E Y T A K E A W A Y Saylor URL: http://www.saylor.org/books Saylor.org
495 The IRR is the rate required ( r ) to get an NPV of zero for a series of cash flows and
represents the time - adjusted rate of return for an investment. If the IRR is greater
than or equal to the company’s required rate of return (often called the hurdle rate),
the investment is accepted; otherwise, the investment is rejected.
R E V I E W P R O B L E M 8 . 3
This review problem is a continuation of , and uses the same information. The
management of Chip Manufacturing, Inc., would like to purchase a specialized
production machine for $700,000. The machine is expected to have a life of 4 years,
and a salvage value of $100,000. Annual maintenance costs will total $30,000. Annual
labor and material savings are predicted to be $250,000. The company’s required rate
of return is 15 percent.
1. Based on your answer to , use trial and error to appro ximate the IRR for this
investment proposal.
2. Should Chip Manufacturing, Inc., purchase the specialized production machine?
Explain.
Solution to Review Problem 8.3
1. In , the NPV was calculated using 15 percent (the company’s required rate of
return). Knowing that 15 percent results in an NPV of $(14,720), and
therefore seeing the return is less than 15 percent, we decreased the rate
to 13 percent. As shown in the following figure, this resulted in an NPV of
$15,720, which indicates the return is higher than 1 3 percent. Using a rate
of 14 percent results in an NPV very close to 0 at $224. Thus the IRR is close
to 14 percent.
Saylor URL: http://www.saylor.org/books Saylor.org
496 *Because this is not an annuity, use in the appendix.
**Because this is an annuity, use in the appendix. The number of years ( n )
equals four since identical cash flows occur each year for four years.
2. Because the IRR of 14 percent is less than the company’s required rate of return of 15
percent, Chip Manufacturing, Inc., should not purchase the specialized production
machine.
8.4 Other Fact ors Affecting NPV and IRR Analysis
L E A R N I N G O B J E C T I V E
1. Understand the impact of cash flows, qualitative factors, and ethical issues on long -
term investment decisions.
Question: We have described the net present value (NPV) and internal rate of return (IRR)
approaches to evaluating long - term investments. With both of these approaches, there are
several important issues that must be considered.What are these important issues?
Answer: These issues include focusing on cash flows, factoring in inflation, assessi ng
qualitative factors, and ethical considerations. All are described next.
Focusing on Cash Flows
Question: Which basis of accounting is used to calculate the NPV and IRR for long - term
investments, cash or accrual?
Answer: Both methods of evaluating long - term investments, NPV and IRR, focus on the amount
of cash flows and when the cash flows occur. Note that the timing of revenues and costs in
financial accounting using the accrual basis is often not the same as when the cash inflows and
outflows occur. A sale can be recorded in one period, and the cash be collected in a future
period. Costs can occur in one period, and the cash be paid in a future period. For the purpose of
making NPV and IRR calculations, managers typically use the time period when the c ash flow
occurs. Saylor URL: http://www.saylor.org/books Saylor.org
497 When a company invests in a long - term asset, such as a production building, the cash outflow for
the asset is included in the NPV and IRR analyses. The depreciation taken on the asset in future
periods is not a cash flow and is not include d in the NPV and IRR calculations. However, there is
a cash benefit related to depreciation (often called a depreciation tax shield ) since income taxes
paid are reduced as a result of recording depreciation expense. We explore the impact of income
taxes on NPV and IRR calculations later in the chapter.
Factoring in Inflation
Question: Is inflation included in cash flow projections when calculating the NPV and IRR?
Answer: Most managers make cash flow projections that include an adjustment for inflation.
W hen this is done, a rate must be used that also factors in inflation over the life of the
investment. As discussed earlier in the chapter, the required rate of return used for NPV
calculations is based on the firm’s cost of capital, which is the weighted a verage cost of debt and
equity. Since the cost of debt and equity already includes the effect of inflation, no inflation
adjustment is necessary when establishing the required rate of return.
The important point here is that cash flow projections must incl ude adjustments for inflation to
match the required rate of return, which already factors in inflation. If cash flows are not adjusted
for inflation, managers are likely underestimating future cash flows and therefore
underestimating the NPV of the investm ent opportunity. This is particularly pronounced for
economies that have relatively high rates of inflation.
For the purposes of this chapter, assume all cash flows and required rates of return are adjusted
for inflation.
Be Aware of Qualitative Factors
Qu estion: So far, this chapter has focused on using cash flow projections and the time value of
money to evaluate long - term investments. Using these quantitative factors to make decisions
allows managers to support decisions with measurable data. For example , the investment
opportunity at Jackson’s Quality Copies presented at the beginning of the chapter was accepted Saylor URL: http://www.saylor.org/books Saylor.org
498 because the NPV of $1,250 was greater than 0, and the IRR of 11 percent was greater than the
company’s required rate of return of 10 percent. Wh y do most companies also consider
nonfinancial factors, often called qualitative factors, when making a long - term investment
decision?
Answer: Although using quantitative factors for decision making is important, qualitative factors
may outweigh the quan titative factors in making a decision. For example, a large manufacturer
of medical devices recently invested several million dollars in a small start - up medical device
firm. When asked about the NPV analysis, the manager responsible for the investment ind icated,
“My staff did a quick and dirty NPV analysis, which indicated we should not invest in the
company. However, the technology they were using for their device was of such strategic
importance to us, we could not pass up the investment.” This is an exa mple of qualitative factors
(strategic importance to the company) outweighing quantitative factors (negative NPV).
Similar situations often arise when companies must invest in long - term assets even though NPV
and IRR analyses indicate otherwise. Here are a few examples:
Investing in new production facilities may be essential to maintaining a reputation as the
industry leader in innovation, even though the quantitative analysis (NPV and IRR)
points to rejecting the investment. (It is difficult to quantify th e benefits of being the
“industry leader in innovation.”)
Investing in pollution control devices for an oil refinery may provide social benefits even
though the quantitative analysis (NPV and IRR) points to rejecting the investment.
(Although a reduction i n fines and legal costs may be quantifiable and included in the
analyses, it is difficult to quantify the social benefits.)
Investing in a new product line of entry - level automobiles may increase foot traffic at the
showroom, resulting in increased sales o f other products, even though the quantitative
analysis (NPV and IRR) points to rejecting the investment. (It is difficult to quantify the
impact of the new product line on sales of existing product lines.) Saylor URL: http://www.saylor.org/books Saylor.org
499 Clearly, managers must look at the financial info rmation and analysis when considering
whether to invest in long - term assets. However, the analysis does not stop with financial
information. Managers and decision makers must also consider qualitative factors.
Ethical Issues
Question: Our discussion of NPV and IRR methods implies that managers can easily make
capital budgeting decisions once NPV and IRR analyses are completed and qualitative factors
have been considered. However, managers sometimes make decisions that are not in the best
interest of the com pany. Why might managers make decisions that are not in the best interest of
the company?
Answer: Several examples are provided next.
Short - Term Incentives Affect Long - Term Decisions
Managers are often evaluated and compensated based on annual financial r esults. The financial
results are typically measured using financial accounting data prepared on an accrual basis.
Suppose you are a manager considering an investment opportunity to start a new product line
that has a positive NPV. Because the NPV is posit ive, you should accept the investment
proposal. However, revenues and related cash inflows are not significant until after the second
year. In the first two years, revenues are low and depreciation charges are high, resulting in
significantly lower overall company net income than if the project were rejected. Assuming you
are evaluated and compensated based on annual net income, you may be inclined to reject the
new product line regardless of the NPV analysis.
Many companies are aware of this conflict betwe en the manager’s incentive to improve short -
term results and the company’s goal to improve long - term results. To mitigate this conflict, some
companies offer managers part ownership in the company (e.g., through stock options), creating
an incentive to inc rease the value of the company over the long run.
Modifying Cash Flow Estimates to Get Approval Saylor URL: http://www.saylor.org/books Saylor.org
500 Managers often have a vested interest in getting proposals approved regardless of NPV and IRR
results. For example, assume a manager spent several years develop ing a plan to construct a new
production facility. Because of the significant work involved, and the projected benefits of
building a new facility, the manager wants to see the proposal approved. However, the NPV
analysis indicates the production facility proposal does not meet the company’s minimum
required rate of return. As a result, the manager decides to inflate projected cash inflows to get a
positive NPV, and the project is approved.
Clearly, a conflict exists between the company’s desire to accept p rojects that meet or exceed the
required rate of return and the manager’s desire to get approval for a “pet” project regardless of
its profitability. Again, having part ownership in a company provides an incentive for managers
to reject proposals that will not increase the value of the company.
Another way to mitigate this conflict is to conduct a postaudit , which compares the original
capital budget with the actual results. Managers who provide misleading capital budget analyses
are identified through this process. Postaudits provide an incentive for managers to provide
accurate estimates.
K E Y T A K E A W A Y
Although accountants are responsible for providing relevant and objective
financial information to help managers make decisions, several important
factors play a significant role in the decision - making process as described
here:
o NPV and IRR analyses use cash flows to evaluate long - term investments
rather than the accrual basis of accounting.
o Cash flow projections must include adjustments for inflatio n to match the
required rate of return, which already factor in inflation.
o Using quantitative factors to make decisions allows managers to support
decisions with measurable data. However, nonfinancial factors (often called
qualitative factors) must be cons idered as well. Saylor URL: http://www.saylor.org/books Saylor.org
501 o Circumstances sometimes exist that cause managers to make decisions that
are not in the best interest of the company. For example, managers may be
evaluated on short - term financial results even though it is in the best
interest of the compa ny to invest in projects that are profitable in the long
term. Thus projects that reduce short - term profitability in lieu of significant
long - term profits may be rejected.
R E V I E W P R O B L E M 8 . 4
1. Why must cash flow projections include adjustments for inflation?
2. Why is it important for organizations to consider qualitative factors when making
capital budgeting decisions?
3. Assume the manager of Best Electronics earns an annual bonus based on
meeting a certain level of net income. The company is currently considerin g
expanding by adding a second retail store. The second store is expected to
become profitable three years after opening. The manager is responsible
for making the final decision as to whether the second store should be
opened and would be in charge of bot h stores.
1. Why might the manager refuse to invest in the new store even though the
investment is projected to achieve a return greater than the company’s
required rate of return?
2. What can the company do to mitigate the conflict between the manager ’s
interest of achieving the bonus and the company’s desire to accept
investments that exceed the required rate of return?
Solution to Review Problem 8.4
1. Projected cash flows must include an adjustment for inflation to match the required
rate of return. Th e required rate of return is based on the company’s weighted
average cost of debt and equity. The cost of debt and equity already factors in
inflation. Thus the cash flows must also factor in inflation to be consistent with the
required rate of return. Saylor URL: http://www.saylor.org/books Saylor.org
502 2. Alt hough managers prefer to make capital budgeting decisions based on quantifiable
data (e.g., using NPV or IRR), nonfinancial factors may outweigh financial factors. For
example, maintaining a reputation as the industry leader may require investing in
long - t erm assets, even though the investment does not meet the minimum required
rate of return. The management believes the qualitative factor of being the industry
leader is critical to the company’s future success and decides to make the investment.
3. Best Elect ronics is considering opening a second store.
1. The manager’s bonus is based on achieving a certain level of net income
each year, and the new store will likely cause net income to decrease in the
first two years. Thus the manager may not be able to achieve the net
income necessary to qualify for the bonus if the company invests in the new
store.
2. To mitigate this conflict, Best Electronics can offer the manager part
ownership in the company (perhaps through stock options). This would
provide an incentive for the manager to increase profit — and therefore
company value — over many years. The company may also adjust the net
income required to earn a bonus to account for the losses expected in the
new store for the first two years.
8.5 The Payback Method
L E A R N I N G O B J E C T I V E
1. Evaluate investments using the payback method.
Question: Although the net present value (NPV) and internal rate of return (IRR) methods are
the most commonly used approaches to evaluating investments, some managers also use the
payback method. What is the payback method, and how does it help managers make decisions
related to long - term investments? Saylor URL: http://www.saylor.org/books Saylor.org
503 Answer: The payback method evaluates how long it will take to “pay back” or recover the initial
investment. The payback period , typically stated in years , is the time it takes to generate enough
cash receipts from an investment to cover the cash outflows for the investment.
Managers who are concerned about cash flow want to know how long it will take to recover the
initial investment. The payback method pr ovides this information. Managers may also require a
payback period equal to or less than some specified time period. For example, Julie Jackson, the
owner of Jackson’s Quality Copies, may require a payback period of no more than five years,
regardless of the NPV or IRR.
Note that the payback method has two significant weaknesses. First, it does not consider the time
value of money. Second, it only considers the cash inflows until the investment cash outflows are
recovered; cash inflows after the payback per iod are not part of the analysis. Both of these
weaknesses require that managers use care when applying the payback method.
Payback Method Example
Question: What is the payback period for the proposed purchase of a copy machine at Jackson’s
Quality Copies?
Answer: The payback period is five years. Here’s how we calculate it. Figure 8.6 "Summary of
Cash Flows for Copy Machine Investment by Jackson’s Quality Copies" repeats the cash flow
estimates for Julie Jackson’s planned purchase of a copy machine for Jackson’s Quality Copies,
the example presented at the beginning of the chapter.
Figure 8.6 Summary of Cash Flows for Copy Machine Investment by Jackson’s Quality Copies
Saylor URL: http://www.saylor.org/books Saylor.org
504 The payback method answer s the question “how long will it take to recover my initial $50,000
investment?” With annual cash inflows of $10,000 starting in year 1, the payback period for this
investment is 5 years (= $50,000 initial investment ÷ $10,000 annual cash receipts). This
c alculation is relatively simple when one investment is made at the beginning, and annual cash
inflows are identical. However, some investments require cash outflows at different points
throughout the life of the asset, and cash inflows can vary from one ye ar to the next. Table 8.1
"Calculating the Payback Period for Jackson’s Quality Copies" provides a format to help
calculate the payback period for these more complex investments. Note that the review problem
at the end of this segment provides an example o f how to calculate the payback period to the
nearest month when uneven cash flows are expected.
Table 8.1 Calculating the Payback Period for Jackson’s Quality Copies
Investment (Cash Outflow) Cash Inflow Unrecovered Investment Balance
Year 0 $(50,000) - $(50,000) a
Year 1 - $10,000 (40,000) b
Year 2 - 10,000 (30,000) c
Year 3 - 10,000 (20,000)
Year 4 - 10,000 (10,000)
Year 5 - 10,000 0
Year 6 - 10,000 0
Year 7 - 15,000 0
a
$(50,000) = $(50,000) initial investment.
b
$(40,000) = $(50,000) unrecovered investment balance + $10,000 year 1 cash Saylor URL: http://www.saylor.org/books Saylor.org
505 Investment (Cash Outflow) Cash Inflow Unrecovered Investment Balance
inflow.
c
$(30,000) = $(40,000) unrecovered investment balance at end of year 1 +
$10,000 year 2 cash inflow.
Weaknesses of the Payback Method
Question: Why is it a problem to ignore the time value of money when calculating the payback
period?
Answer: Suppose you have 2 investments of $10,000 to choose from. The first investment
generates cash inflows of $8,000 in year 1, $2,000 i n year 2, and $1,000 in year 3. The second
investment generates cash inflows of $2,000 in year 1, $8,000 in year 2, and $1,000 in year 3.
The two investments are summarized here:
Investment I Investment II
Year 0 $(10,000) $(10,000)
Year 1 8,000 2,000
Year 2 2,000 8,000
Year 3 1,000 1,000
Both investments have a payback period of two years. Does this mean both investments are of
equal value? No because the first investment generates far more cash in year 1 than the second
investment. In fact, it would be preferable to calculate the IRR to compare these two
investments. The IRR for the first investment is 6 percent, and the IRR for the second investment
is 5 percent. Saylor URL: http://www.saylor.org/books Saylor.org
50 6 Question: Why is it a problem to ignore the cash flows after the payback period?
Answer: Suppose $50,000 can be invested in 2 separate investments with the following cash
flows:
Investment I Investment II
Year 0 $(50,000) $(50,000)
Year 1 25,000 2,000
Year 2 25,000 2,000
Year 3 3,000 46,000
Year 4 0 35,000
The first investment has a payback period of two years, and the second investment has a payback
period of three years. If the company requires a payback period of two years or less, the first
investment is preferable. However, the first investment generates only $3,000 in cash after its
payback period while the second investment generates $35,000 after its payback p eriod. The
payback method ignores both of these amounts even though the second investment generates
significant cash inflows after year 3. Again, it would be preferable to calculate the IRR to
compare these two investments. The IRR for the first investment is 4 percent, and the IRR for the
second investment is 18 percent.
Although the payback method is useful in certain situations where companies are concerned
about recovering investments as quickly as possible (e.g., companies on the verge of
bankruptcy), it is not a measure of profitability. The NPV and IRR methods compare the
profitability of each investment by considering the time value of money for all cash flows related
to the investment.
Wrap - Up of Chapter Example Saylor URL: http://www.saylor.org/books Saylor.org
507 In the Jackson’s Quality Copies example featured throughout this chapter, the company is
considering whether to purchase a new copy machine for $50,000. A week has passed since
Mike Haley, accountant, discussed this investment with Julie Jackson, president and owner.
Refer to Figure 8.2 "NPV Calculation for Copy Machine Investment by Jackson’s Quality
Copies", Figure 8.4 "Alternative NPV Calculation for Jackson’s Quality Copies", and Figure 8.5
"Finding the IRR for Jackson’s Quality Copies", andTable 8.1 "C alculating the Payback Period
for Jackson’s Quality Copies" as you learn what Mike’s findings are.
Julie: Hi Mike, any news on the copy machine proposal?
Mike: I ran the numbers for the new copy machine, and I think you’ll like the results. It’s
not as simple as looking at the difference between cash outflows of $57,000 and
cash inflows of $82,000 over the life of the asset. We also have to see when the cash
flows occur and convert them into today’s dollars.
Julie: OK. What did you find?
Mike: The NPV is $1,250 using a required rate of return of 10 percent. This means the
investment will generate a return of more than 10 percent after converting the cash
flows into today’s dollars.
Julie: Great! I realize the return is expected to be above 10 percent. Do you have a sense
of how far above 10 percent?
Mike: Yes. The IRR is about 11 percent. I also calculated the payback period to give you
an idea of how long it will take to recover our initial $50,000 investment.
Julie: Good idea. My hope is that we won’t be waiting too long to recover the original
investment.
Mike: It will take 5 years to fully recover the $50,000 investment.
Julie: Wow! That seems like a long time. Saylor URL: http://www.saylor.org/books Saylor.org
508 Mike: It is. But realize we bring in an additional $25,000 after the payback period. Also,
the payback method does not measure the profitability of the investment, it simply
tells us how long before the initial investment is recovered. Unless we anticipate
cash fl ow problems, I wouldn’t place too much importance on the payback period.
The NPV and IRR calculations are the best for evaluating this investment.
Julie: Good point. We don’t expect to have cash flow problems. We have plenty of capital,
and the business has generated positive cash flow for the past 10 years. Let’s order
the new machine!
Business in Action 8.4
Capital Budgeting at Fortune 1000 Companies
Studies completed over the past 40 years have indicated that ma nagers prefer to use
IRR and payback methods over NPV when evaluating long - term investments. However,
a recent survey of Fortune 1000 chief financial officers indicates that NPV is now the
most preferred method. According to this survey, the percentage of firms
that always or often use each method is as follows:
NPV 85 percent
IRR 77 percent
Payback 53 percent
This survey also shows that companies with capital budgets exceeding $500,000,000
are more likely to use these methods than are companies with smaller capital budgets.
This is probably because larger companies have more specialized personnel in their
finance and accounting departments, which enables them to use more sophisticated
approaches in e valuating long - term investments.
Source: Patricia A. Ryan and Glenn P. Ryan, “Capital Budgeting Practices of the Fortune
1000: How Have Things Changed?” Journal of Business and Management 8, no. 4
(2002).
K E Y T A K E A W A Y Saylor URL: http://www.saylor.org/books Saylor.org
509 The payback method evaluates how long it will take to “pay back” or recover the
initial investment. The payback period, typically stated in years, is the time it takes to
generate enough cash receipts from an investment to cover the cash outflow(s) for
the investment. Although this method is useful for managers concerned about cash
flow, the major weaknesses of this method are that it ignores the time value of
money, and it ignores cash flows after the payback period.
R E V I E W P R O B L E M 8 . 5
This review problem is a continu ation of Note 8.22 "Review Problem 8.3" and Note
8.26 "Review Problem 8.4" and uses the same information. The management of Chip
Manufacturing, Inc., would like to purchase a specialized production machine for
$700,000. The machine is expected to have a lif e of 4 years and a salvage value of
$100,000. Annual maintenance costs will total $30,000. Annual labor and material
savings are predicted to be $250,000.
1. Use the format in Table 8.1 "Calculating the Payback Period for Jackson’s Quality
Copies" to calculat e the payback period. Clearly state your conclusion.
2. Describe the two major weaknesses of the payback method.
Solution to Review Problem 8.5
1. The payback period is slightly more than three years since only $40,000 is left
to be recovered after three years, as shown in the following table.
Investment (Cash Outflow) Cash Inflow Unrecovered Investment Balance
Year 0 $(700,000) - $(700,000)
Year 1 - $220,000 a
(480,000)
Year 2 - 220,000 a
(260,000)
Year 3 - 220,000 a
(40,000)
Year 4 - 320,000 b
0 Saylor URL: http://www.saylor.org/books Saylor.org
510 a
$220,000 = $250,000 annual savings – $30,000 annual costs.
b
$320,000 = $250,000 annual savings – $30,000 annual costs + $100,000 salvage
value.
2. A more precise calculation can be performed assuming the $220,000 cash
inflow for year 4 occurs evenly throughout the year and the $100,000
salvage value cash inflow occurs at the end of year 4. With these
assumptions, we simply need to calculate how many months are required in
year 4 to r ecover the remaining $40,000. $40,000 divided by $220,000
equals 0.18 (rounded). Thus 0.18 of a year, or approximately 2 months (=
0.18 × 12 months), is required to recover the remaining $40,000. This more
precise calculation results in a payback period of three years and two
months. Note that the salvage value is ignored as this cash inflow occurs at
the end of year 4 when the machine is sold.
3. First, the payback method does not consider the time value of money (no present
value or IRR calculations are perf ormed). Second, it only considers the cash inflows
until the investment cash outflows are recovered; cash inflows after the payback
period are not part of the analysis. For Chip Manufacturing, Inc., the payback period is
three years and two months. However , significant cash inflows totaling $280,000
occur after the payback period and therefore are ignored ($280,000 = $320,000 year
4 cash inflows – $40,000 remaining investment recovered in the first 2 months of year
4).
8.6 Additional Complexities of Estimat ing Cash Flows
L E A R N I N G O B J E C T I V E
1. Evaluate investments with multiple investment and working capital cash flows.
Question: The examples in this chapter are intended to help you learn the basics of evaluating
investments using the net present value (NPV), in ternal rate of return (IRR), and payback
methods. However, there are two additional items related to estimating cash flows that must be Saylor URL: http://www.saylor.org/books Saylor.org
511 considered: investment cash outflows and working capital. How do these two items impact long -
term investment decisions?
Answer: These items impact the analysis of long - term investments as described next.
Investment Cash Outflows
The examples thus far have assumed that cash outflows for the investment occur only at the
beginning of the investment. However, some investments require cash outflows at varying points
throughout the life of the project. For example, suppose the JCPenney Company plans
to open a new store, which requires a $10,000,000 in vestment at the beginning of the project for
construction of the building. However, the building will be expanded at the end of year 4, at a
cost of $2,000,000, to meet an expected increase in demand. The $2,000,000 cash outflow must
be included in the cas h flows of the project for year 4 when calculating the NPV, IRR, and
payback period.
Working Capital
Working capital is defined as current assets (cash, accounts receivable, inventory, and the like)
minus current liabilities (accounts payable, wages payabl e, and accrued liabilities, for instance).
Many long - term investments require working capital. For example, JCPenney will need cash in
its registers when it opens the new store. Working capital is also required to fund inventory and
accounts receivable. Wo rking capital necessary for long - term investments should be included as
a cash outflow, typically at the beginning of the project.
Some long - term investments have an expected life, at the end of which working capital is
returned to the company for investme nt elsewhere. When this happens, the working capital is
included in the cash flow analysis as a cash outflow at the beginning of the project and a
cash inflow at the end of the project.
K E Y T A K E A W A Y
Investment proposals often include investment cash outflo ws at
varying points throughout the life of the project. These cash flows Saylor URL: http://www.saylor.org/books Saylor.org
512 must be included when evaluating investment proposals using NPV,
IRR, and payback period methods. Many investments include working
capital cash flows required to fund items such as i nventory and
accounts receivable. Working capital is included as a cash outflow,
typically at the beginning of the project, and is often returned back to
the company as a cash inflow later in the project.
R E V I E W P R O B L E M 8 . 6
The management of Environmental Engineering, Inc. (EEI), would like to open an
office for 6 years in a high - growth area of Las Vegas. The initial investment required
to purchase an office building is $250,000, and EEI needs $50,000 in working capital
for the new office. Working capital w ill be returned to EEI at the end of 6 years. EEI
expects to remodel the office at the end of 3 years at a cost of $200,000.
Annual net cash receipts from daily operations (cash receipts minus cash payments)
are expected to be as follows:
Year 1 $ 6 0,000
Year 2 $ 80,000
Year 3 $120,000
Year 4 $150,000
Year 5 $160,000
Year 6 $110,000
Although the company’s cost of capital is 8 percent, management set a required rate
of return of 12 percent due to the high risk associated with this project.
1. Find the NPV of this investment using the format presented in .
2. Use trial and error to approximate the IRR for this investment proposal.
3. Based on your answers to 1 and 2 , should EEI op en the new office? Explain. Saylor URL: http://www.saylor.org/books Saylor.org
513 4. Use the format in to calculate the payback period.
Solution to Review Problem 8.6
1. The NPV is $27,571, as shown in the following figure.
Note: The NPV is $27,571. Because NPV is > 0, accept the investment.
(The investment provides a return greater than 12 percent.)
2. The IRR is between 14 and 15 percent (approximately 14.5
percent). The IRR is the rate that generates a NPV of zero.
Because the NPV is positive at 12 percent, the return is higher
than 12 percent. The NPV is cal culated as follows using a rate
of 14 percent, NPV = $5,007, and 15 percent, NPV = $(5,446).
Thus the IRR is between 14 and 15 percent.
NPV at 14 percent is
NPV at 15 percent is Saylor URL: http://www.saylor.org/books Saylor.org
514
3. Yes. The NPV is positive at $27,571, and the IRR of 14.5 percent is hi gher than the
company’s required rate of return of 12 percent. Thus EEI should open the office in
Las Vegas.
4. The payback period is approximately 4.5 years. This approximation assumes
the $90,000 unrecovered investment at the end of year 4 will be recovered
about halfway through year 5.
Investment (Cash
Outflow) Cash Inflow Unrecovered Investment
Balance
Year 0 $(300,000) - $(300,000)
Year 1 - $ 60,000 (240,000) a
Year 2 - 80,000 (160,000) b
Year 3 (200,000) 120,000 (240,000) c
Year 4 - 150,000 (90,000)
Year 5 - 160,000 0
Year 6 - 160,000 0 Saylor URL: http://www.saylor.org/books Saylor.org
515
a
$(240,000) = $(300,000) unrecovered investment + $60,000 year 1 cash inflow.
b
$(160,000) = $(240,000) unrecovered investment at end of year 1 + $80,000
year 2 cash inflow.
c
$(240,000) = $(160,000) unrecovered investment at end of year 2 – $200,000
year 3 investment + $120,000 year 3 cash inflow.
5. A more precise calculation can be p erformed assuming the $160,000 cash
inflow for year 5 occurs evenly throughout the year. Simply calculate how
many months are required in year 5 to recover the remaining $90,000.
$90,000 divided by $160,000 equals 0.56 (rounded). Thus 0.56 of a year, or
ap proximately 7 months (= 0.56 × 12 months), is required to recover the
remaining $90,000. This more precise calculation results in a payback
period of four years and seven months.
8.7 The Effect of Income Taxes on Capital Budgeting Decisions
L E A R N I N G O B J E C T I V E
1. Understand the impact that income taxes have on capital budgeting decisions.
Question: Throughout the chapter, we assumed no income taxes were involved. This is a
reasonable assumption for not - for - profit entities and governmental agencies. However, firms
that pay income taxes must consider the impact income taxes have on cash flows for long - term
investments. How do for - profit organizations include income taxes in their analysis when making
long - term investment decision s?
Answer: Let’s look at an example to help explain how this works. The management of Scientific
Products, Inc. (SPI), is considering a five - year contract to build scientific instruments for a large
school district. The initial investment required to purc hase production equipment is $400,000 (to
be depreciated over 5 years using the straight - line method, with no salvage value). An additional
$50,000 in working capital is required for the contract. Working capital will be returned to SPI at Saylor URL: http://www.saylor.org/books Saylor.org
516 the end of five years. Annual net cash receipts from daily operations (cash receipts minus cash
payments) are shown as follows. Since depreciation expense is not a cash outflow, it
is not included in these amounts.
Year 1 $ 50,000
Year 2 $ 60,000
Year 3 $120,000
Year 4 $200,000
Year 5 $130,000
Management established a required rate of return of 10 percent for this proposal. The company’s
tax rate is 40 percent. (The complexities of government tax codes have a significant impact on
the tax rate used. For simplicity, we use a tax rate of 40 percent for this example.)
When taxes are involved, it is important to understand which cash flows are affected by the tax
rate and which are not. We look at this by addressing the following capital bu dgeting items:
Investment cash outflows
Working capital cash outflows and inflows
Revenue cash inflows and expense cash outflows
Depreciation
Provides a detailed example of how companies adjust for income taxes when evaluating long -
term investments. Examin e carefully, including the footnotes, as we explain each of these items.
Figure 8.7 NPV Calculation with Income Taxes for Scientific Products, Inc. Saylor URL: http://www.saylor.org/books Saylor.org
517
Note: the NPV is $(56,146).
Since NPV is < 0, reject the investment. (The investment provides a return les s than 10 percent.)
a Initial investment purchase price and working capital do not directly affect net income and
therefore are not adjusted for income taxes.
b Amount equals net cash receipts before taxes × (1 – tax rate). For year 1, $30,000 = $50,000 ×
(1 – 0.40); for year 2, $36,000 = $60,000 × (1 – 0.40); and so forth.
c Depreciation tax savings = Depreciation expense × Tax rate. Depreciation expense is $80,000
(= $400,000 cost ÷ 5 year useful life). Thus annual depreciation tax savings is $32,000 (=
$80,000 depreciation expense × 0.40 tax rate).
1. Investment Cash Outflows. The initial investment in production equipment of $400,000
is not adjusted for income taxes because it does not directly affect net income. Thus this
amount is included in full in .
2. Working Capital Cash Outflows and Inflows. Working capital of $50,000 is not adjusted
for income taxes since it does not affect net income. Thus this amount is included in full
as a cash outflow at the beginning of the project and again in full when return ed to the
company at the end of the project, as shown in .
3. Revenues and Expenses. When a company must pay income taxes, all revenue cash
inflows and expense cash outflows affect net income and therefore affect income taxes
paid. The goal is to determine th e after - tax cash flow. This is calculated in the equation
that follows.The tax rate for Scientific Products, Inc., is 40 percent. Thus net cash Saylor URL: http://www.saylor.org/books Saylor.org
518 receipts (revenue cash inflows minus expense cash outflows) are multiplied by 0.60 (= 1
– 0.40). This results in an after - tax cash flow, as shown in .
Key Equation
After - tax revenue cash inflow = Before - tax cash inflow × (1 – tax rate)After -
tax expense cash outflow = Before - tax cash outflow × (1 – tax rate)
4. Depreciation. Although depreciation expense is not a cash ou tflow, it does reduce taxable
income and thereby reduces taxes that are paid (recall that the entry to record
depreciation for financial accounting purposes does not affect cash; debit depreciation
expense and credit accumulated depreciation). The term use d to describe this tax savings
is depreciation tax shield . The tax savings resulting from depreciation are calculated as
follows:
Key Equation
Depreciation tax savings cash inflow = Depreciation expense × Tax rate
The production equipment, which has a purch ase price of $400,000, has a useful life of 5 years
and no salvage value. SPI uses the straight - line method, which depreciates the original cost
evenly over the useful life of the asset. Thus depreciation expense is $80,000 (= $400,000 ÷ 5
years). This is multiplied by the tax rate of 40 percent to get the annual tax savings of $32,000 (=
$80,000 × 0.40), as shown in .
Question: Based on the information presented in , should SPI accept the investment proposal?
Answer: As you can see in , the NPV is negati ve ($[56,146]), so SPI’s management should
reject the investment proposal. provides a summary of how income taxes influence cash flows
for long - term investments. (Note that this section is intended to give you a general overview of
how income taxes effect capital budgeting decisions. Finance textbooks provide more detail
regarding how to adjust cash flows for income taxes in more complex situations.)
Figure 8.8 How Income Taxes Affect Capital Budgeting Cash Flows Saylor URL: http://www.saylor.org/books Saylor.org
519
K E Y T A K E A W A Y
Companies that pay income tax es must consider the impact income taxes have on
cash flows for long - term investments, and make the necessary adjustments.
Investment and working capital cash flows are not adjusted because these cash flows
do not affect taxable income. Revenue cash inflow s and expense cash outflows are
adjusted by multiplying the cash flow by (1 – tax rate). Although depreciation expense
is not a cash outflow, it provides tax savings. The tax savings is calculated by
multiplying depreciation expense by the tax rate. Once t hese adjustments are made,
we can calculate the NPV and IRR.
R E V I E W P R O B L E M 8 . 7
Car Repair, Inc., would like to purchase a new machine for $400,000. The machine will
have a life of 4 years with no salvage value, and is expected to generate annual cash
r evenue of $180,000. Annual cash expenses, excluding depreciation, will total
$20,000. The company uses the straight - line depreciation method, has a tax rate of
30 percent, and requires a 10 percent rate of return.
1. Find the NPV of this investment using the format presented in .
2. Should the company purchase the machine? Explain.
Solution to Review Problem 8.7
1. The NPV is $50,112 as shown in the following figure. Saylor URL: http://www.saylor.org/books Saylor.org
520
a
Initial investment purchase price does not directly affect net income and
therefore is not adjusted for income taxes.
b
Amount equals cash revenue before taxes × (1 – tax rate); $126,000 =
$180,000 × (1 – 0.30).
c
Amount equals cash expense before taxes × (1 – tax rate); $14,000 =
$20,000 × (1 – 0.30).
d
Depreciation tax savings = Depreciation e xpense × Tax rate. Depreciation
expense is $100,000 (= $400,000 cost ÷ 4 year useful life). Thus annual
depreciation tax savings is $30,000 (= $100,000 depreciation expense × 0.30
tax rate).
2. Yes, the company should purchase the machine. The positive NPV of $50,112 shows
the return of this proposal is above the company’s required rate of return of 10
percent.
8.8 Appendix: Present Value Tables
Figure 8.9 Present Value of $1 Received at the End of n Periods Saylor URL: http://www.saylor.org/books Saylor.org
521
Note: Factor = 1 ( 1 + r ) n
Figure 8.10 Present Value of a $1 Annuity Received at the End of Each Period
for n Periods Saylor URL: http://www.saylor.org/books Saylor.org
522
Note: Factor = 1 − ( 1 + r ) − n r
E N D - OF - C H A P T E R E X E R C I S E S
Questions
1. What is the difference between capital budgeting decisions covered in this chapter
and management decisions covered in ?
2. What concept must be considered when looking at cash flows over several years for a
long - term investment? Explain.
3. What is meant by the term present value ? Saylor URL: http://www.saylor.org/books Saylor.org
523 4. What is the formula used to calculate the present value of a future cash flow?
Describe each component.
5. Describe the three steps required to evaluate investments using the net present value
method.
6. How do most firms establish the required rate of return used to calculate the net
present value?
7. What is meant by the term internal rate of return ? Explain the IRR decisi on rule?
8. For the purpose of calculating net present value and internal rate of return, do
companies use the accrual basis of accounting? Explain.
9. Why might a firm choose to accept a long - term investment even if the net present
value is below zero?
10. What mig ht cause a manager to reject a long - term investment even though the net
present value is positive?
11. Describe the two steps required to calculate net present value and internal rate of
return when using Excel.
12. What is the payback method, and why do managers use this method?
13. What are the two weaknesses associated with the payback method?
14. Refer to What method of evaluating long - term investments is most popular? Why do
you think the payback method is the least - used method?
15. What does the term working capital refe r to, and how does working capital affect the
evaluation of long - term investments?
16. Assume a company pays income taxes. How are revenue and expense cash flows
adjusted for income taxes when calculating the net present value?
17. Assume a company pays income tax es. How does depreciation expense affect cash
flows even though it is a noncash expense?
Brief Exercises
18. Investment Decision at Jackson’s Quality Copies. Refer to the dialogue at Jackson’s
Quality Copies presented at the beginning of the chapter. What is J ulie Jackson Saylor URL: http://www.saylor.org/books Saylor.org
524 proposing? What information did Mike, the accountant, get from Julie to evaluate the
proposal?
19. Present Value Calculations. For each of the following independent
scenarios, use in the appendix to calculate the present value of the cash
flow des cribed.
1. $10,000 will be received 4 years from today. The rate is 10 percent.
2. $10,000 will be received 4 years from today. The rate is 20 percent.
3. $50,000 will be received 15 years from today. The rate is 12 percent.
4. $50,000 will be received 15 years fro m today. The rate is 6 percent.
20. Present Value Calculations (Annuities). For each of the following
independent scenarios, use in the appendix to calculate the present value
of the cash flow described. Round to the nearest dollar.
1. $1,000 will be received at the end of each year for 6 years. The rate is 12
percent.
2. $1,000 will be received at the end of each year for 6 years. The rate is 15
percent.
3. $10,000 will be received at the end of each year for 6 years. The rate is 7
percent.
4. $250,000 will be received at the end of each year for 4 years. The rate is 10
percent.
21. Net Present Value Calculations. Freefall, Inc., has two independent
investment opportunities, each requiring an initial investment of $65,000.
The company’s required rate of return is 8 percent. Th e cash inflows for
each investment are provided as follows. Saylor URL: http://www.saylor.org/books Saylor.org
525
Required:
a. Without resorting to calculations, which investment will have the
highest net present value? Explain.
b. Calculate the net present value for each investment (remember to include
the initial investment cash outflow in your calculation). Should the company
invest in either investment? Round to the nearest dollar.
Internal Rate of Return Calculation. An investment costing $50,000 today will
result in cash savings of $5,000 per year for 1 5 years. Use trial and error to
approximate the internal rate of return for this investment proposal.
Evaluating Qualitative Factors. Chem, Inc., produces chemical products. The
company recently decided to invest in expensive pollution control devices even
though the negative net present value pointed toward rejecting this investment.
What qualitative factor likely led the company to make the investment in spite of the
negative net present value?
Ethical Issues in Making a Capital Budgeting Decision. Assume the
manager of a store earns an annual bonus based on meeting a certain level
of net income, which has been achieved consistently over the past five
years. The company is currently considering the addition of a second store,
which is expected to become pr ofitable after two years. The manager is
responsible for making the final decision whether the second store should
be opened and would receive an annual bonus only if a certain level of net
income were achieved for both stores combined. Saylor URL: http://www.saylor.org/books Saylor.org
526 Why might the manag er refuse to invest in the new store even though the
investment is projected to achieve a return greater than the company’s
required rate of return?
Net Present Value Calculation Using Excel. An investment costing $200,000 today
will result in cash savings of $85,000 per year for 3 years. The company’s required
rate of return is 11 percent. Use Excel to calculate the net present value of this
investment in a format similar to the one in the Computer Application box in the
chapter.
Payback Period Calculation . Textile Services, Inc., plans to invest $80,000 in a new
machine. Annual cash inflows from this investment will be $25,000, and annual cash
outflows will be $5,000. Determine the payback period for this investment.
Net Present Value Analysis with Multipl e Investments. A project requiring an
investment of $20,000 today and $10,000 one year from today, will result in cash
savings of $4,000 per year for 15 years. Find the net present value of this investment
using a rate of 10 percent. Round to the nearest d ollar.
Net Present Value Calculation with Taxes. An investment costing $200,000 today
will result in cash savings of $85,000 per year for 3 years. The company has a tax rate
of 40 percent, and requires an 11 percent rate of return. Find the net present val ue of
this investment using the format shown in . Round to the nearest dollar.
Exercises: Set A
29. Net Present Value Analysis. Architect Services, Inc., would like to purchase
a blueprint machine for $50,000. The machine is expected to have a life of 4
years, and a salvage value of $10,000. Annual maintenance costs will total
$14,000. Annual savings are predicted to be $30,000. The company’s
required rate of return is 11 percent.
Required:
a. Ignoring the time value of money, calculate the net cash inflow or
outflow resulting from this investment opportunity. Saylor URL: http://www.saylor.org/books Saylor.org
527 b. Find the net present value of this investment using the format presented
in .
c. Should the company purchase the blueprint machine? Explain.
Internal Rate of Return Analysis. Architect Services, Inc., would like
to purchase a blueprint machine for $50,000. The machine is expected to
have a life of 4 years, and a salvage value of $10,000. Annual maintenance
costs will total $14,000. Annual savings are predicted to be $30,000. The
company’s required rate of return is 11 percent (this is the same data as the
previous exercise).
Required:
a. Use trial and error to approximate the internal rate of return for this
investment proposal. Round to the nearest dollar.
b. Should the company purchase the blueprint machine? Explain.
Payback Period Calculation. Architect Services, Inc., would like to purchase a
blueprint machine for $50,000. The machine is expected to have a life of 4 years, and
a salvage value of $10,000. Annual maintenance costs will total $14,000. Annual
s avings are predicted to be $30,000 (this is the same data as the previous exercise).
Determine the payback period for this investment using the format shown in .
Net Present Value Analysis with Multiple Investments, Alternative
Format. Conway Construction Corporation would like to purchase a fleet of
trucks at a cost of $260,000. Additional equipment needed to maintain the
fleet of trucks will be purchased at the end of year 2 for $40,000. The trucks
are expected to have a life of 8 years, and a salvage val ue of $20,000.
Annual costs for maintenance, insurance, and other cash expenses will total
$42,000. Annual net cash receipts resulting from this purchase are
predicted to be $135,000. The company’s required rate of return is 14
percent.
Required:
a. Find the net present value of this investment using the format presented in . Saylor URL: http://www.saylor.org/books Saylor.org
528 b. Should the company purchase the new fleet of trucks? Explain.
Calculating NPV and IRR Using Excel. Wood Products Company would
like to purchase a computerized wood lathe for $100,000. The machine is
expected to have a life of 5 years, and a salvage value of $5,000. Annual
maintenance costs will total $20,000. Annual net cash receipts resulting
from this machine are predicted to be $45,000. The company’s required
rate of return is 15 percen t.
Required:
a. Use Excel to calculate the net present value and internal rate of return in a
format similar to the Computer Application spreadsheet shown in the chapter.
b. Should the company purchase the wood lathe? Explain.
Net Present Value Analysis with Taxes. Timberline Company would
like to purchase a new machine for $100,000. The machine will have a life
of 5 years with no salvage value, and is expected to generate annual cash
revenue of $50,000. Annual cash expenses, excluding depreciation, will
total $24,000. The company uses the straight - line depreciation method, has
a tax rate of 40 percent, and requires a 12 percent rate of return.
Required:
a. Find the net present value of this investment using the format presented in .
Round to the nearest dollar.
b. S hould the company purchase the machine? Explain.
Exercises: Set B
35. Net Present Value Analysis. Wood Products Company would like to
purchase a computerized wood lathe for $100,000. The machine is
expected to have a life of 5 years, and a salvage value of $5 ,000. Annual
maintenance costs will total $20,000. Annual net cash receipts resulting
from this machine are predicted to be $45,000. The company’s required
rate of return is 15 percent.
Required: Saylor URL: http://www.saylor.org/books Saylor.org
529 a. Ignoring the time value of money, calculate the net cash inf low or outflow
resulting from this investment opportunity.
b. Find the net present value of this investment using the format presented
in . Round to the nearest dollar.
c. Should the company purchase the wood lathe? Explain.
Internal Rate of Return Analysis. Wood Products Company would like
to purchase a computerized wood lathe for $100,000. The machine is
expected to have a life of 5 years, and a salvage value of $5,000. Annual
maintenance costs will total $20,000. Annual net cash receipts resulting
from this machine are predicted to be $45,000. The company’s required
rate of return is 15 percent (this is the same data as the previous exercise).
Required:
a. Use trial and error to approximate the internal rate of return for this
investment proposal.
b. Should the co mpany purchase the wood lathe? Explain.
Payback Period Calculation. Wood Products Company would like to purchase a
computerized wood lathe for $100,000. The machine is expected to have a life of 5
years, and a salvage value of $5,000. Annual maintenance co sts will total $20,000.
Annual net cash receipts resulting from this machine are predicted to be $45,000. The
company’s required rate of return is 15 percent (this is the same data as the previous
exercise). Determine the payback period for this investment using the format shown
in .
Net Present Value Analysis and Qualitative Factors, Alternative
Format. Pete’s Plumbing Supplies would like to expand into a new
warehouse at a cost of $500,000. The warehouse is expected to have a life
of 20 years, and a sal vage value of $100,000. Annual costs for maintenance,
insurance, and other cash expenses will total $60,000. Annual net cash
receipts resulting from this expansion are predicted to be $115,000. The
company’s required rate of return is 12 percent. Saylor URL: http://www.saylor.org/books Saylor.org
530 Required:
a. Find the net present value of this investment using the format presented in .
Round to the nearest dollar.
b. Should the company purchase the new warehouse? Explain.
c. Provide one qualitative factor that might cause the company to reach a
different conclusion than the one reached in requirement b .
Calculating NPV and IRR Using Excel. Pete’s Plumbing Supplies would
like to expand into a new warehouse at a cost of $500,000. The warehouse
is expected to have a life of 20 years, and a salvage value of $100,000.
Ann ual costs for maintenance, insurance, and other cash expenses will total
$60,000. Annual net cash receipts resulting from this expansion are
predicted to be $115,000. The company’s required rate of return is 12
percent.
Required:
a. Use Excel to calculate the net present value and internal rate of return in a
format similar to the Computer Application spreadsheet shown in the chapter.
b. Should the company purchase the warehouse? Explain.
Net Present Value Analysis with Taxes. Quality Chocolate, Inc., would
like to purchase a new machine for $200,000. The machine will have a life
of 4 years with no salvage value, and is expected to generate annual cash
revenue of $90,000. Annual cash expenses, excluding depreciation, will
total $10,000. The company uses the straig ht - line depreciation method, has
a tax rate of 30 percent, and requires a 14 percent rate of return.
Required:
a. Find the net present value of this investment using the format presented in .
Round to the nearest dollar.
b. Should the company purchase the machin e? Explain.
Problems Saylor URL: http://www.saylor.org/books Saylor.org
531 41. Evaluating Alternative Investments. Washington Brewery has two
independent investment opportunities to purchase brewing equipment so
the company can meet growing customer demand. The first option
(equipment A) requires an initial inves tment of $230,000 for equipment
with an expected life of 5 years and a salvage value of $20,000. The second
option (equipment B) requires an initial investment of $120,000 for
equipment with an expected life of 4 years and a salvage value of $15,000.
The c ompany’s required rate of return is 10 percent. Additional cash flow
information for each investment is provided as follows.
Year 1 Year 2 Year 3 Year 4 Year 5
Equipment A
Utility savings $ 12,000 $ 14,000 $ 15,000 $ 16,000 $ 17,000
Additional revenue 45,000 48,000 50,000 55,000 60,000
Maintenance costs (5,000) (8,000) (10,000) (13,000) (16,000)
Equipment B
Utility savings $ 8,000 $ 9,000 $ 10,000 $ 10,000 -
Additional revenue 35,000 36,000 38,000 42,000 -
Maintenance costs (6,000) (8,000) (9,000) (11,000) -
42. Required:
a. Calculate the net present value for each investment using the format
presented in . (Remember to include the initial investment cash outflow and salvage
value in your calculation.) Round to the nearest dollar.
b. Which, if any, investment is preferable? Explain. Saylor URL: http://www.saylor.org/books Saylor.org
532 Net Present Value, Internal Rate of Return, and Payback Period
Analyses. Sherwin Moore Paint Company would like to further automate its
production process by purchasing production equipment for $660,000. The
equipment is expected to have a useful life of 8 years, and will be sold at
the end of 8 years for $40,000. The equipment requires significant
maintenance work at an annual cost of $75,000. Labor and material cost
savings, shown in the table, are also expected to be significant.
Year 1 $160,000
Year 2 $190,000
Year 3 $200,000
Year 4 $240,000
Year 5 $280,000
Year 6 $220,000
Year 7 $180,000
Year 8 $155,000
The company’s required rate of return is 11 percent. Assume the
company requires all investments to be recovered within five years.
Required:
a. Find the net present value of this investment using the format
presented in . Round to the nearest dollar.
b. Use trial and error to approximate the internal rate of return for this
investment proposal.
c. Determine the payback period for this invest ment using the format shown
in . Saylor URL: http://www.saylor.org/books Saylor.org
533 d. Based on your findings in requirements a , b , and c , should the company
purchase the production equipment? Explain.
Calculating NPV and IRR Using Excel. Sherwin Moore Paint Company
would like to further automate its production process by purchasing
production equipment for $660,000. The equipment is expected to have a
useful life of 8 years, and will be sold at the end of 8 years for $40,000. The
equipment requires sign ificant maintenance work at an annual cost of
$75,000. Labor and material cost savings, shown in the table, are also
expected to be significant.
Year 1 $160,000
Year 2 $190,000
Year 3 $200,000
Year 4 $240,000
Year 5 $280,000
Year 6 $220,000
Year 7 $180,000
Year 8 $155,000
The company’s required rate of return is 11 percent.
Required:
a. Use Excel to calculate the net present value and internal rate of return in a
format similar to the Computer Application spreadsheet shown in the chapter.
b. Should the company purchase the production equipment? Explain.
Net Present Value Analysis, Multiple Investments, and Qualitative
Factors. Oil Production, Inc., would like to drill oil from land the company Saylor URL: http://www.saylor.org/books Saylor.org
534 already owns. The equipment is expected to cost $4,000,000, has a useful
life of 5 years, and will be sold at the end of 5 years for $400,000. Annual
costs for maintenance and other cash expenses will total $550,000. Annual
net cash receipts resulting from the sale of oil are predicted to be
$1,900,000. Working capital of $270,000 is required at the beginning of the
project and will be returned at the end of 5 years. The equipment will
require refurbishing at the end of year 3 at a cost of $300,000. Although the
company’s cost of capital is 15 percent, management established a required
rate of return of 20 percent due to the high risk associated with this project.
Required:
a. Find the net present value of this investment using t he format presented in .
Round to the nearest dollar.
b. Use trial and error to approximate the internal rate of return for this
investment proposal.
c. Should the company accept the proposal? Explain.
d. What qualitative factors might improve management’s view of this
proposal?
Calculating NPV and IRR Using Excel. Oil Production, Inc., would like
to drill oil from land the company already owns. The equipment is expected
to cost $4,000,000, has a useful life of 5 years, and will be sold at the e nd of
5 years for $400,000. Annual costs for maintenance and other cash
expenses will total $550,000. Annual net cash receipts resulting from the
sale of oil are predicted to be $1,900,000. Working capital of $270,000 is
required at the beginning of the pr oject and will be returned at the end of 5
years. The equipment will require refurbishing at the end of year 3 at a cost
of $300,000. Although the company’s cost of capital is 15 percent,
management established a required rate of return of 20 percent due t o the
high risk associated with this project.
Required: Saylor URL: http://www.saylor.org/books Saylor.org
535 a. Use Excel to calculate the net present value and internal rate of return in a
format similar to the Computer Application spreadsheet shown in the chapter.
b. Should the company accept the proposal? Expla in.
Net Present Value, Internal Rate of Return, and Payback Period
Analyses; Ethical Issues. Tower CD Stores would like to open a retail store
in Houston. The initial investment to purchase the building is $420,000, and
an additional $50,000 in working cap ital is required. Since this store will be
operating for many years, the working capital will not be returned in the
near future. Tower expects to remodel the store at the end of 3 years at a
cost of $100,000. Annual net cash receipts from daily operations (cash
receipts minus cash payments) are expected to be as follows.
Year 1 $ 80,000
Year 2 $115,000
Year 3 $118,000
Year 4 $140,000
Year 5 $155,000
Year 6 $167,000
Year 7 $175,000
The company’s required rate of return is 13 percent. Assume
management decided to limit the analysis to 7 years.
Required:
a. Find the net present value of this investment using the format presented in .
Round to the nearest dollar.
b. Use trial and error to approximate the internal rate of return for this
investment proposal. Saylor URL: http://www.saylor.org/books Saylor.org
536 c. Based on your answer to requirements a and b , should Tower open the new
store? Explain.
d. Use the format presented in to calculate the payback period (include
workin g capital in the initial investment). Assuming management requires
all investments to be recovered within three years, should Tower CD Store
open the new store?
e. What is the weakness of using the payback period method to evaluate long -
term investments?
f. Assu me the manager of the company wanted to live in Houston and
intentionally inflated the projected annual cash receipts so that the
proposal would be accepted. The proposal would otherwise have been
rejected. Explain how the company’s use of a postaudit woul d help to
prevent this type of unethical behavior.
Net Present Value with Taxes. Refer to the Tower CD Stores
information presented in the previous problem. Assume the costs
associated with the purchase of the building are depreciated over 20 years
using t he straight - line method, with no salvage value. Costs associated with
the building remodel are depreciated over 10 years with no salvage value,
starting with year 4. The company’s tax rate is 40 percent. Again,
management will limit the analysis to seven y ears.
Required:
a. Find the net present value of this investment using the format presented in .
Round to the nearest dollar.
b. Should Tower open the new store? Explain.
c. How did income taxes affect the decision being made by Tower CD Stores?
One Step Further: Skill - Building Cases
48. Opening New Retail Stores. Refer to Provide two examples of cash outflows and one
example of cash inflows resulting from the decision to open a new store. Saylor URL: http://www.saylor.org/books Saylor.org
537 49. Determining the Cost of Capital by Industry. Refer to the Why do you th ink the cost
of capital in the beverage industry is low relative to the cost of capital in other
industries?
50. The California Lottery and Present Value Concepts. Refer to the Why does the State
of California need only $550,000 to pay a $1,000,000 lottery win ner?
51. Internet Project: Capital Expenditures at Intel. Go to Intel’s Web site
( http://www.intel.com ) and enter “annual report” or “10K report” in the
search feature. Find the most recent annual report or 10K report and
review the Consolidated Statements of Cash Flows portion of the company’s
financial statements. Find the Additions to property, plant and
equipment line item in the Investing Activities section of the st atement, and
answer the following questions. Be sure to submit a printed copy of the
consolidated statements of cash flows with your answers.
a. How much cash did Intel spend on additions to property, plant, and
equipment in the most current year? How does this amount compare with amounts
spent in the previous two years?
b. Describe two capital budgeting decision techniques that were likely used
by Intel to make long - term investment decisions.
Group Activity: Qualitative Factors. Each of the following scenarios is
being considered at three separate companies.
1. A large regional energy company uses coal to produce electricity that is sold
to local power companies. Although government regulations will not require a
cleaner process for at least five years, the compan y is considering spending millions
of dollars on equipment that will reduce pollutants from its production process.
However, the net present value analysis indicates this proposal should be rejected.
2. A producer of mountain bikes known for its expensive, hi gh - quality bikes
would like to introduce a less expensive entry - level line of mountain bikes.
However, the projected internal rate of return for this proposal is lower
than the company’s minimum required rate of return. Saylor URL: http://www.saylor.org/books Saylor.org
538 3. A maker of computer chips with a reputation of staying on the cutting
edge of technology would like to invest in a new production facility. However,
the net present value analysis indicates this proposal should be rejected.
Required:
Your instructor will divide the class into groups of tw o to four
students, and assign one of the three independent scenarios
listed previously to each group. Each group must perform the
requirements listed here:
1. Identify at least two qualitative factors that may lead to accepting
the proposal.
2. Discuss each opt ion, based on the findings of your group, with the
class.
Comprehensive Cases
53. Ethical Issues in Capital Budgeting. Loomis Nursery grows a variety of
plants for wholesale distribution. The company would like to expand its
operations and is considering a mov e to one of two locations. The first
location, Wyatville, is one hour from the ocean and therefore attractive for
employees who like to travel on weekends. The second location, Kenton, is
not as close to the ocean, and much further from desirable vacation
destinations.
The company’s controller, Lisa Lennox, created a net present value analysis
for each location. The Kenton location had a positive net present value, and
the Wyatville location had a negative net present value. Upon providing this
informati on to the chief financial officer of the company, Max Madden, Lisa
was asked to “review the numbers carefully and make sure all the benefits
of moving to Wyatville were included in the analysis.” Lisa knew that Max
preferred vacationing near the ocean and had a strong desire to move Saylor URL: http://www.saylor.org/books Saylor.org
539 operations to Wyatville. However, she was unable to find any errors in her
analysis and could not identify any additional benefits.
Lisa approached Max with this information. Max responded, “There is no
way Kenton should have a higher net present value than Wyatville. Redo
your analysis to show that Wyatville has the highest net present value, and
have it on my desk by the end of the week.”
Required:
a. Is Max Madden’s request ethical? Explain.
b. How should Lisa handle this situation? (It may be helpful to review the
presentation of ethics in .)
Ethical Issues in Capital Budgeting. Toyonda Motor Company
produces a variety of products including motorcycles, all - terrain vehicles,
marine engines, automobiles, light trucks, and heavy - duty trucks. Each
division manager at Toyonda Motor Company is paid a base salary and is
given an annual cash bonus if the division achieves profits of at least 10
percent of the value of assets invested in the division (this is called return
on investment ).
Pe ggy Parkins, manager of the Light Truck Division, is considering investing
in new production equipment. The net present value of the proposal is
positive, and Peggy is convinced the new equipment will provide a
competitive edge in future years. However, be cause of the significant up -
front cost and related depreciation, short - term profits will be negatively
affected by this investment. In fact, the new equipment will reduce return
on investment below the 10 percent threshold for at least 3 years, which
will prevent Peggy from receiving her annual bonuses for at least 3 years.
However, profits are expected to increase significantly after the three - year
period. Peggy is planning to retire in two years and therefore would prefer
to reject the proposal to invest in new production equipment. Saylor URL: http://www.saylor.org/books Saylor.org
540 Required:
a. Describe the ethical conflict facing Peggy Parkins.
b. What type of employee compensation system might prevent this type of
conflict?