Chapter 14 Capital Investment Decisions Cornerstones of Managerial

Chapter 14: Capital Investment Decisions Cornerstones of Managerial Accounting, 4 e © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Learning Objectives 1. Explain the meaning of capital investment decisions, and distinguish between independent and mutually exclusive capital investment decisions. 2. Compute the payback period and accounting rate of return for a proposed investment, and explain their roles in capital investment decisions. 3. Use net present value analysis for capital investment decisions involving independent projects. 4. Use the internal rate of return to assess the acceptability of independent projects. 5. Explain the role and value of postaudits. 6. Explain why net present value is better than internal rate of return for capital investment decisions involving mutually exclusive projects. 7. (Appendix 14 A) Explain the relationship between current and future dollars. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 Types of Capital Investment Decisions ► Capital investment decisions are concerned with the process of planning, setting goals and priorities, arranging financing, and using certain criteria to select long-term assets. ► The process of making capital investment decisions often is referred to as capital budgeting. ► Two types of capital budgeting projects will be considered: independent projects and mutually exclusive projects. ►Independent projects are projects that, if accepted or rejected, do not affect the cash flows of other projects. ►Mutually exclusive projects are those projects that, if accepted, preclude the acceptance of all other competing projects. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 Making Capital Investment Decisions ► In general terms, a sound capital investment will earn back its original capital outlay over its life and, at the same time, provide a reasonable return on the original investment. ► After making this assessment, managers must decide on the acceptability of independent projects and compare competing projects on the basis of their economic merits. ► To make a capital investment decision, a manager must ► estimate the quantity and timing of cash flows ► assess the risk of the investment ► consider the impact of the project on the firm’s profits © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Basic Capital Investment Decision Models ►The basic capital investment decision models can be classified into two major categories: ►Nondiscounting models ignore the time value of money. ►Discounting models explicitly consider the time value of money. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Nondiscounting Models: Payback Period ► The payback period is a nondiscounting model that presents the time required for a firm to recover its original investment. ► If the cash flows of a project are an equal amount each period, payback period is computed as follows: ► If the cash flows are unequal, the payback period is computed by adding the annual cash flows until such time as the original investment is recovered. ► If a fraction of a year is needed, it is assumed that cash flows occur evenly within each year. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Cornerstone 14 -1 Calculating Payback © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Using Payback Period to Assess Risk ► One way to use the payback period is to set a maximum payback period for all projects and to reject any project that exceeds this level. ► Some analysts suggest that the payback period can be used as a rough measure of risk, with the notion that the longer it takes for a project to pay for itself, the riskier it is. ► Also, firms with riskier cash flows in general could require a shorter payback period than normal. ► Additionally, firms with liquidity problems would be more interested in projects with quick paybacks. ► Another critical concern is obsolescence. Firms with higher risk of obsolescence such as computer manufacturers would be interested in recovering funds rapidly. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Using the Payback Period to Choose Among Alternatives ► The payback period can be used to choose among competing alternatives. ► Under this approach, the investment with the shortest payback period is preferred over investments with longer payback periods. ► However, this use of the payback period is less defensible because this measure suffers from two major deficiencies: ►It ignores the cash flow performance of the investments beyond the payback period. ►It ignores the time value of money. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Nondiscounting Models: Accounting Rate of Return ►The accounting rate of return (ARR) measures the return on a project in terms of income, as opposed to using a project’s cash flow. ►The accounting rate of return is computed by the following formula: © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Cornerstone 14 -2 Calculating the Accounting Rate of Return © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Limitations of the Accounting Rate of Return ► Unlike the payback period, the ARR does consider a project’s profitability. ► However, the ARR has other potential drawbacks, including the following: ► Ignoring Time Value of Money: Like the payback period, it ignores the time value of money. ► Dependency on Net Income: ARR is dependent upon net income, which is the financial measure most likely to be manipulated by managers. ► Managers’ Incentive: Additionally, because bonuses to managers often are based on accounting income or return on assets, managers may have a personal interest in selecting investments that contribute to net income in the short-run. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 Discounting Models: The Net Present Value Method ► Discounting models use discounted cash flows which are future cash flows expressed in terms of their present value. ► One discounting model is the net present value (NPV), which is the difference between the present value of the cash inflows and outflows associated with a project. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 Net Present Value ► NPV measures the profitability of an investment. ► A positive NPV indicates that the investment increases the firm’s wealth. ► To use the NPV method, a required rate of return must be defined. ► The required rate of return is the minimum acceptable rate of return. ► It also is referred to as the discount rate, hurdle rate, and cost of capital. ► In theory, if future cash flows are known with certainty, then the correct required rate of return is the firm’s cost of capital. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 Net Present Value (continued) ► In practice, managers often choose a discount rate higher than the cost of capital to deal with uncertainty. ► However, if the rate chosen is excessively high, it will bias the selection process toward short-term investments. ► Once the NPV for a project is computed, it can be used to determine whether or not to accept an investment. ► If the NPV is greater than zero the investment is profitable and, therefore, acceptable. ► A positive NPV signals that (1) the initial investment has been recovered, (2) the required rate of return has been recovered, and (3) a return in excess of (1) and (2) has been received. ► If the NPV equals zero, the decision maker will find acceptance or rejection of the investment equal. ► If the NPV is less than zero, the investment should be rejected. In this case, it is earning less than the required rate of return. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 Cornerstone 14 -3 Assessing Cash Flows and Calculating Net Present Value Information: A detailed market study revealed expected annual revenues of $300, 000 for new earphones. Equipment to produce the earphones will cost $320, 000. After five years, the equipment can be sold for $40, 000. In addition to equipment, working capital is expected to increase by $40, 000 because of increases in inventories and receivables. The firm expects to recover the investment in working capital at the end of the project’s life. Annual cash operating expenses are estimated at $180, 000. The required rate of return is 12 percent. Required: Estimate the annual cash flows, and calculate the NPV. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 Cornerstone 14 -3 Assessing Cash Flows and Calculating Net Present Value (continued) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 Cornerstone 14 -3 Assessing Cash Flows and Calculating Net Present Value (continued) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 NPV, Discount Rates, and Cash Flows ► It is common to provide pessimistic and most likely cash flow scenarios to help assess a project’s risk. ► As the discount rate increases, the present value of future cash flows decreases, making it harder for a project to achieve a positive NPV. ► Plotting the NPV as the discount rate varies provides good insight into the risk and economic viability of the proposed project. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4 Internal Rate of Return ► The internal rate of return (IRR), another discounting model, is defined as the interest rate that sets the present value of a project’s cash inflows equal to the present value of the project’s cost. ► It is the interest rate that sets the project’s NPV at zero. ► The following equation can be used to determine a project’s IRR, where t = 1, …, n : ► The right side of this equation is the present value of future cash flows ► The left side is the investment. ► I, CFt, and t are known. ► Thus, the IRR (the interest rate, i, in the equation) can be found using trial and error. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4 Internal Rate of Return (continued) ►Once the IRR for a project is computed, it is compared with the firm’s required rate of return: ►If the IRR is greater than the required rate, the project is deemed acceptable. ►If the IRR is less than the required rate of return, the project is rejected. ►If the IRR is equal to the required rate of return, the firm is indifferent between accepting or rejecting the investment proposal. ►The IRR is the most widely used of the capital investment techniques. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4 Internal Rate of Return: Multiple Period ► If the investment produces a series of uniform cash flows, a single discount factor from the present value table can be used to compute the present value of the annuity. ► If the cash flows are not uniform, then the IRR equation must be used. ► For a multiple-period setting, this equation can be solved by trial and error or by using a business calculator or a spreadsheet program. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4 Cornerstone 14 -4 Calculating Internal Rate of Return With Uniform Cash Flows © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4 You Decide IRR and Uncertainty in Estimates of Cash Savings and Project Life © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4 You Decide IRR and Uncertainty in Estimates of Cash Savings and Project Life (continued) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

5 Postaudit of Capital Projects ► A key element in the capital investment process is a follow-up analysis of a capital project once it is implemented. ► A postaudit compares the actual benefits with the estimated benefits and actual operating costs with estimated operating costs. ► It evaluates the overall outcome of the investment and proposes corrective action if needed. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

5 Postaudit Benefits ►Firms that perform postaudits of capital projects experience a number of benefits, including the following: ►Resource Allocation: By evaluating profitability, postaudits ensure that resources are used wisely. ►Positive Impact on Managers’ Behavior: If managers are held accountable for the results of a capital investment decision, they are more likely to make such decisions in the best interests of the firm. ►Independent Perspective: Postaudit by an independent party ensures more objective results. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

5 Postaudit Limitations ►Postaudits are costly. ►The assumptions driving the original analysis may often be invalidated by changes in the actual operating environment. ►Accountability must be qualified to some extent by the impossibility of foreseeing every possible eventuality. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

6 Mutually Exclusive Projects ►Up to this point, we have focused on independent projects. ►NPV and IRR both yield the same decision for independent projects. ►However, many capital investment decisions deal with mutually exclusive projects. ►For competing projects, the two methods can produce different results. ►Choosing the project with the largest NPV is consistent with maximizing the wealth of shareholders. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

6 Net Present Value Compared with Internal Rate of Return ►NPV differs from IRR in two major ways: ►The NPV method assumes that each cash inflow received is reinvested at the required rate of return, whereas the IRR method assumes that each cash inflow is reinvested at the computed IRR. Reinvesting at the required rate of return is more realistic and produces more reliable results when comparing mutually exclusive projects. ►The NPV method measures profitability in absolute terms, whereas the IRR method measures it in relative terms. NPV measures the amount by which the value of the firm changes. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

6 Net Present Value Compared with Internal Rate of Return (continued) ► When choosing between projects, what counts are the total dollars earned—the absolute profits—not the relative profits. ► Accordingly, NPV, not IRR, should be used for choosing among competing, mutually exclusive projects or competing projects when capital funds are limited. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

6 Net Present Value for Mutually Exclusive Projects ►There are three steps in selecting the best project (with the largest NPV) from several competing projects: ►Step 1: Assess the cash flow pattern for each project. ►Step 2: Compute the NPV for each project. ►Step 3: Identify the project with the greatest NPV. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cornerstone 14 -5 6 Calculating Net Present Value and Internal Rate of Return for Mutually Exclusive Projects © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cornerstone 14 -5 6 Calculating Net Present Value and Internal Rate of Return for Mutually Exclusive Projects (continued) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

6 Special Considerations for the Advanced Manufacturing Environment ► For advanced manufacturing environments, like those using automated systems, capital investment decisions can be more complex because they must take special considerations into account. ► Great care must be exercised to assess the actual cost of an automated system because it is easy to overlook substantial peripheral costs like software, engineering, and training. ► More effort is needed to measure intangible and indirect benefits, like reduced lead time, reliability, and customer satisfaction, in order to assess more accurately the potential value of investments. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

7 Appendix 14 A: Present Value Concepts ► An important feature of money is that it can be invested and can earn interest. ► A dollar today is not the same as a dollar tomorrow. ► This fundamental principle is the backbone of discounting methods. ► Future value is expressed as: F = P(1 + i), where F is the future amount, P is the initial or current outlay, and i is the interest rate. ► The earning of interest on interest is referred to as compounding of interest, expressed as follows for n periods into the future: © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

7 Present Value ► Often, a manager needs to compute not the future value but the amount that must be invested now in order to yield some given future value. ► The amount that must be invested now to produce the future value is known as the present value of the future amount. ► To compute the present value of a future outlay, all we need to do is solve the compounding interest equation for P: ► The process of computing the present value of future cash flows is often referred to as discounting. ► The interest rate used to discount the future cash flow is the discount rate. The expression 1/(1 + i)n in the present value equation is the discount factor. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

7 Annuities ►An annuity is a series of future cash flows. ►If the annuity is uneven, then each future cash flow must be discounted using individual discount rates (the present value for each cash flow is calculated separately and then summed). ► For even cash flows, a single discount rate, which is the sum of each discount rate for each cash flow, can be used. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.