# 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?