Chapter 16

Capital Expenditure
Decisions

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16-1
Learning Objective 16-1 – Use the net-present-value method
and the internal-rate-of-return method to evaluate an
investment proposal.

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16-2
 Discounted-Cash-Flow Analysis

Decisions involving cash inflows and

outflows beyond the current year are called
capital-budgeting decisions.

Discounted-cash-flow analysis accounts for

the time value of money in such decisions.

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16-3
 Net-Present-Value Method
1.
1. Prepare
Prepare aa table
table showing
showing cashcash flows
flows for
for each
each
year,
year,
2.
2. Calculate
Calculate the
the present
present value
value of
of each
each cash
cash
flow
flow using
using aa discount
discount rate,
rate,
3.
3. Compute
Compute net net present
present value,
value,
4.
4. If
If the
the net
net present
present value
value (NPV)
(NPV) isis zero
zero or
or
positive,
positive, accept
accept the
the investment
investment proposal.
proposal.
Otherwise,
Otherwise, reject
reject it.
it.

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16-4
 Net-Present-Value Method (2/5)
Mattson Co. has been offered a five year contract
to provide component parts for a large
manufacturer.
Co s t and re ve nue info rmatio n
Co s t o f s pe c ial e quipme nt $ 160,000
Wo rking c apital re quire d 100,000
Re lining e quipme nt in 3 ye ars 30,000
S alvag e value o f e quipme nt in 5 ye ars 5,000
Annual c as h re ve nue and c o s ts :
S ale s re ve nue fro m parts 750,000
Co s t o f parts s o ld 400,000
S alarie s , s hipping , e tc . 270,000

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16-5
 Net-Present-Value Method (3/5)

At
 At the
the end
end of
of five
five years,
years, the
the working
working
capital
capital will
will be
be released
released and
and may
may bebe used
used
elsewhere
elsewhere byby Mattson.
Mattson.
Mattson
 Mattson uses
uses aa discount
discount rate
rate of
of 10%.
10%.

Should the contract be accepted?

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16-6
 Net-Present-Value Method (4/5)
Annual net cash inflows from operations

Sales revenue $ 750,000

Cost of parts sold 400,000
Gross margin 350,000
Less out-of-pocket costs 270,000
Annual net cash inflows $ 80,000

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16-7
 Net-Present-Value Method (5/5)
Ca s h 10% P re s e nt
Ye a rs Flo ws Fa c to r Va lue
Inv e s tme nt in e quipme nt No w $ (1 6 0 ,0 0 0 ) 1 .0 0 0 $ (1 6 0 ,0 0 0 )
Wo rking c a pita l ne e de d No w (1 0 0 ,0 0 0 ) 1 .0 0 0 (1 0 0 ,0 0 0 )
Annua l ne t c a s h inflo ws 1 -5 8 0 ,0 0 0 3 .7 9 1 3 0 3 ,2 8 0
Re lining o f e quipme nt 3 (3 0 ,0 0 0 ) 0 .7 5 1 (2 2 ,5 3 0 )
S a lv a g e v a lue o f e quip. 5 5 ,0 0 0 0 .6 2 1 3 ,1 0 5
Wo rking c a pita l re le a s e d 5 1 0 0 ,0 0 0 0 .6 2 1 6 2 ,1 0 0
Ne t pre s e nt v a lue $ 8 5 ,9 5 5

Mattson
Mattson should
should accept
accept the
the contract
contract because
because the
the
present
present value
value of
of the
the cash
cash inflows
inflows exceeds
exceeds the
the present
present
value
value of
of the
the cash
cash outflows
outflows by
by $85,955.
$85,955. The
The project
project
has
has aa positive
positive net
net present
present value.
value.
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16-8
 Internal-Rate-of-Return Method
The
 The internal
internal rate
rate of
of return
return is
is the
the true
true
economic
economic return
return earned
earned byby the
the asset
asset over
over its
its
life.
life.
The
 The internal
internal rate
rate of
of return
return is
is computed
computed by by
finding
finding the
the discount
discount rate
rate that
that will
will cause
cause the
the
net
net present
present value
value ofof aa project
project to
to be
be zero.
zero.

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16-9
 Internal-Rate-of-Return Method (2/5)

Black
 Black Co.
Co. can
can purchase
purchase aa new
new machine
machine at
at aa
cost
cost of
of $104,320
$104,320 that
that will
will save
save $20,000
$20,000 per
per
year
year in
in cash
cash operating
operating costs.
costs.
The
 The machine
machine has
has aa 10-year
10-year life.
life.

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16-10
 Internal-Rate-of-Return Method (3/5)
Future cash flows are the same every year in
this example, so we can calculate the
internal rate of return as follows:
Investment required
Net annual cash flows
= Present value factor

$104,320 = 5.216
$20,000

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16-11
 Internal-Rate-of-Return Method (4/5)
The
The present
present value
value factor
factor (5.216)
(5.216) isis located
located on
on
Table
Table IV
IV in
in Appendix
Appendix A. A. Scan
Scan the
the 10-period
10-period
row
row and
and locate
locate the
the value
value 5.216.
5.216. Look
Look atat the
the
top
top of
of the
the column
column and and you
you find
find aa rate
rate of
of 14%,
14%,
which
which is is the
the internal
internal rate
rate of
of return.
return.

$104,320
= 5.216
$20,000

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16-12
 Internal-Rate-of-Return Method (5/5)
Here’s the proof . . .
14% Pres e nt
Ye ar Amo unt Fac to r Value
Inves tme nt require d Now $ (104,320) 1.000 $ (104,320)
Annual c os t s aving s 1-10 20,000 5.216 104,320
Ne t pres e nt value $ -

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16-13
Learning Objective 16-2 – Compare the net-present-value
and internal-rate-of-return methods, and state the
assumptions underlying each method.

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16-14
 Comparing the NPV and IRR Methods
Net
Net Present
Present Value
Value Internal Rate of
 The
The cost
cost of
of capital
capital is
is Return
used
used as
as the
the actual
actual  The cost of capital is
discount
discount rate.
rate. compared to the
internal rate of return
 Any
Any project
project with
with aa on a project.
negative
negative net
net present
present  To be acceptable, a
value
value is
is rejected.
rejected. project’s rate of return
must be greater than the
cost of capital.
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16-15
 Comparing the NPV and IRR Methods (2/2)

The
The net-present-value
net-present-value method
method hashas the
the
following
following advantages
advantages over
over the
the internal-
internal-
rate-of-return
rate-of-return method:
method:

Easier
Easier to
to use.
use.

Easier
Easier to
to adjust
adjust for
for risk
risk..

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16-16
 Assumptions Underlying
Discounted-Cash-Flow Analysis

All cash flows are treated as though they occur at

year end.

Assumes a perfect capital market.

Cash flows are treated as if they are known

with certainty.

Cash inflows are immediately reinvested at the

required rate of return.

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16-17
 Choosing the Hurdle Rate

The discount rate generally is associated with

the company’s cost of capital.
The cost of capital involves a blending of the
costs of all sources of investment funds, both
debt and equity.

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16-18
Learning Objective 16-3 – Use both the total-cost
approach and the incremental-cost approach to evaluate
an investment proposal.

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16-19
 Comparing Two Investment Projects

To compare competing investment projects, we

can use the following net present value
approaches:

• Total-Cost Approach
• Incremental-Cost Approach

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16-20
 Total-Cost Approach
Each system would last five years.
12 percent hurdle rate for the analysis.
MAINFRAME PC _
Salvage value old system $ 25,000 $ 25,000
Cost of new system (400,000) (300,000)
Cost of new software ( 40,000) ( 75,000)
Update new system ( 40,000) ( 60,000)
Salvage value new system 50,000 30,000
================================================
Operating costs over 5-year life:
Personnel (300,000) (220,000)
Maintenance ( 25,000) ( 10,000)
Other costs ( 10,000) ( 5,000)
Datalink services ( 20,000) ( 20,000)
Revenue from time-share 20,000 -
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16-21
 Total-Cost Approach (2/3)
MAINFRAME ($) Time 0 Time 1 Time 2 Time 3 Time 4 Time 5
Acquisition cost computer (400,000)
Acquisition cost software ( 40,000)
System update ( 40,000)
Salvage value 50,000
Operating costs (335,000) (335,000) (335,000) (335,000) (335,000)
Time sharing revenue 20,000 20,000 20,000 20,000 20,000
Total cash flow 440,000 (315,000) (315,000) (355,000) (315,000) (265,000)
× Discount factor × 1.000 × .893 × .797 × .712 × .636 × .567
Present value (440,000) (281,295) (251,055) (252,760) (200,340) (150,255)
SUM OF PRESENT VALUES = $(1,575,705)
PERSONAL COMPUTER ($)
Acquisition cost computer (300,000)
Acquisition cost software ( 75,000)
System update ( 60,000)
Salvage value 50,000
Operating costs (235,000) (235,000) (235,000) (235,000) (235,000)
Time sharing revenue -0- -0- -0- -0- -0- _
Total cash flow 375,000 (235,000) (235,000) (295,000) (235,000) (205,000)
× Discount factor × 1.000 × .893 × .797 × .712 × .636 × .567
Present value (375,000) (209,855) (187,295) (210,040) (149,460) (116,235)
SUM OF PRESENT VALUES = $(1,247,885)
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 Total-Cost Approach (3/3)
Net cost of purchasing Mainframe system $(1,575,705)
Net cost of purchasing Personal Computer system $(1,247,885)
Net Present Value of costs $
( 327,820)

Mountainview should purchase the personal

computer system for a cost savings of
$327,820.
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16-23
 Incremental-Cost Approach

INCREMENTAL ($)
Time 0 Time 1 Time 2 Time 3 Time 4 Time 5
Acquisition cost computer (100,000)
Acquisition cost software 35,000
System update 20,000
Salvage value 20,000
Operating costs (100,000) (100,000) (100,000) (100,000) (100,000)
Time sharing revenue 20,000 20,000 20,000 20,000 20,000
Total cash flow ( 65,000) ( 80,000) ( 80,000) ( 80,000) ( 80,000) ( 60,000)
× Discount factor × 1.000 × .893 × .797 × .712 × .636 × .567
Present value ( 65,000) ( 71,440) ( 63,760) ( 42,720) ( 50,880) ( 34,020)

SUM OF PRESENT VALUES = $(327,820)

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16-24
 Total-Incremental Cost Comparison
Total Cost:
Net cost of purchasing Mainframe system $(1,575,705)
Net cost of purchasing Personal Computer system $(1,247,885)
Net Present Value of costs $ (327,820)
Incremental Cost:
Net Present Value of costs $ (327,820)

Different methods, Same results!!

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16-25
 Managerial Accountant’s Role
Managerial accountants are often asked to predict
cash flows related to operating cost savings,
additional working capital requirements, and
incremental costs and revenues.
When cash flow projections are very uncertain,
the accountant may . . .
1. increase the hurdle rate,
2. use sensitivity analysis.

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16-26
 Postaudit of Investment Projects

A postaudit is a follow-up after the project has

been approved to see whether or not expected
results are actually realized.

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16-27
Learning Objective 16-4 – Determine the after-tax cash
flows in an investment analysis.

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16-28
 Income Taxes and Capital Budgeting
Cash flows from an investment proposal affect the
company’s profit and its income tax liability.

Income = Revenue − Expenses + Gains − Losses

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16-29
 After-Tax Cash Flows

• Suppose High Country’s management is

considering the purchase of an additional
delivery truck.
• High Country will consider the after-tax
cash flows from the incremental sales
revenue and expenses in order to assist in
their decision making.

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16-30
 After-Tax Cash Flows (2/3)
Incremental sales revenue, net of cost of goods sold $ 50,000  
(cash inflow)
Incremental income tax (cash outflow), $50,000 ×  (15,000)
30%
After-tax cash flow (net inflow after taxes) $ 35,000  

A quick method for computing the after-tax cash inflow from incremental
sales is:

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16-31
 After-Tax Cash Flows (3/3)

Incremental expense (cash outflow) $(30,000)

Reduction in income tax (reduced cash       
outflow), $30,000 × 30% 9,000  
After-tax cash flow (net outflow after $(21,000)
taxes)
A quick method for computing the after-tax cash inflow from incremental
expenses is:

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16-32
 Non-Cash Expenses
• Not all expenses represent cash outflows. The most
common example of a noncash expense is depreciation
expense.

• The annual depreciation expense provides a reduction in

income-tax expense equal to the firm’s tax rate times the
depreciation deduction. This is called a depreciation tax
shield.

• In a discounted-cash-flow analysis, we will discount the

related cash flows which occurs over a period of years,
to find their present value.

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16-33
Learning Objective 16-5 – Use the Modified Accelerated
Cost Recovery System to determine an asset’s depreciation
schedule for tax purposes.

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16-34
 Modified Accelerated Cost Recovery
System (MACRS)
• Under prior Tax Reform Acts most depreciable assets have
been depreciated under the Modified Accelerated Cost
Recovery System, or MACRS.

• Tax Cuts and Jobs Act (TCJA) came into effect on January
1, 2018, and additional changes were made in how
companies calculate depreciation for tax purposes.

• In particular, under the TCJA, many assets could be

depreciated much more quickly than they could before the
TCJA.

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16-35
 Modified Accelerated Cost Recovery
System (MACRS) (2/3)

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16-36
 Modified Accelerated Cost Recovery
System (MACRS) (3/3)

• Depreciation Methods
• Half-Year Convention
• No Salvage Values
• Optional Straight-Line
Depreciation
• Income-Tax Complexities

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16-37
Learning Objective 16-6 – Evaluate an investment proposal
using a discounted-cash-flow analysis, giving full
consideration to income-tax issues.

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16-38
 Gains and Losses

The tax effects of gains and losses on

disposal of assets can be an important
feature of an investment decision.

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16-39
 Investment in Working Capital

Some investment proposals require

additional outlays for working capital, such
as increases in cash, accounts receivable,
and inventory.

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16-40
 Investment in Working Capital (2/3)

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16-41
 Investment in Working Capital (3/3)

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16-42
Learning Objective 16-7 – Discuss the difficulty of ranking
investment proposals, and use the profitability index.

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16-43
 Ranking Investment Projects
We can invest in either of these projects.
Use a 10% discount rate to determine
the net present value of the cash flows.
Pro je c t A Pro je c t B
Imme diate c as h o utlay $ 100,000 $ 100,000
Cas h inflo ws :
Ye ar 1 $ 50,000 $ 30,000
Ye ar 2 40,000 40,000
Ye ar 3 30,000 50,000
To tal inflo ws $ 120,000 $ 120,000

The total cash flows are the same, but the pattern of the flows is
different.
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16-44
 Ranking Investment Projects (2/3)

Let’s calculate the present value of the cash

flows associated with Project A.
Project A PV Factor PV
Immediate cash outlay $(100,000) 1.000 $(100,000)
Cash inflows:
Year 1 $ 50,000 0.909 45,450
Year 2 40,000 0.826 33,040
Year 3 30,000 0.751 22,530
Net present value $ 1,020

This
This project
project has
has aa positive
positive net
net present
present value
value which
which means
means
the
the project’s
project’s return
return is
is greater
greater than
than the
the discount
discount rate.
rate.
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16-45
 Ranking Investment Projects (3/3)
Here is the net present value of the cash
flows associated with Project B.
Project B PV Factor PV
Immediate cash outlay $(100,000) 1.000 $(100,000)
Cash inflows:
Year 1 $ 30,000 0.909 27,270
Year 2 40,000 0.826 33,040
Year 3 50,000 0.751 37,550
Net present value $ (2,140)

Project
Project BB has
has aa negative
negative net
net present
present value
value which
which means
means
the
the project’s
project’s return
return is
is less
less than
than the
the discount
discount rate.
rate.
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16-46
Learning Objective 16-8 – Use the payback method and
accounting-rate-of-return method to evaluate capital
investment projects.

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16-47
 Alternative Methods for
Making Investment Decisions
Payback Method
Payback Initial investment
=
period Annual after-tax cash inflow

A
A company
company cancan purchase
purchase aa machine
machine for
for $20,000
$20,000 that
that
will
will provide
provide annual
annual cash
cash inflows
inflows of
of $4,000
$4,000 for
for 77 years.
years.

Payback $20,000
= = 5 years
period $4,000
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16-48
 Payback: Pro and Con
1. 1. Provides a tool for
1. Fails
Fails to
to consider
consider roughly screening
the
the time
time value
value of
of investments.
money.
money. 2. For some firms, it
2.
2. Does
Does not
not consider
consider may be essential
aa project’s
project’s cash
cash that an investment
flows
flows beyond
beyond the
the recoup its initial
payback
payback period.
period. cash outflows as
quickly as
possible.
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16-49
 Accounting-Rate-of-Return Method

Discounted-cash-flow method focuses on cash


flows and the time value of money.
Accounting-rate-of-return method focuses on the

incremental accounting income that results from
a project.

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16-50
 Accounting-Rate-of-Return Method (2/4)

The following formula is used to calculate the

accounting rate of return:

Average Average
Incremental − incremental expenses,
Accounting revenues including depreciation &
rate of = income taxes
return
Initial investment

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16-51
 Accounting-Rate-of-Return Method (3/4)

Meyers
Meyers Company
Company wants
wants to to install
install an
an espresso
espresso bar
bar
in
in its
its restaurant.
restaurant.
The
The espresso
espresso bar:
bar:
Cost
Cost $140,000
$140,000 and
and has
has aa 10-year
10-year life.
life.
Will
 Will generate
generate incremental
incremental revenues
revenues ofof
$100,000
$100,000 and
and incremental
incremental expenses
expenses ofof $80,000
$80,000
including
including depreciation.
depreciation.
What
What is
is the
the accounting
accounting rate rate of
of return
return on
on
the
the investment
investment project?
project?
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16-52
 Accounting-Rate-of-Return Method (4/4)
Accounting $100,000 − $80,000
= = 14.3%
rate of return $140,000

The
The accounting-rate-of-return
accounting-rate-of-return method method is
is not
not recommended
recommended
for
for aa variety
variety ofof reasons,
reasons, the
the most
most important
important ofof which
which
is
is that
that itit ignores
ignores the
the time
time value
value ofof money.
money.

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16-53
Learning Objective 16-9 (Appendix B) – Explain the impact
of inflation on a capital-budgeting analysis.

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16-54
 Inflation Effects

Nominal Dollars
Real dollars

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16-55
 Inflation Effects (2/2)

Two Capital-Budgeting Approaches under

Inflation

A correct capital-budgeting analysis may be done using

either of the following approaches.

1. Use cash flows measured in nominal dollars and a nominal interest

rate to determine the nominal discount rate.

2. Use cash flows measured in real dollars and a real interest rate to
determine the real discount rate.

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 End Chapter 16

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
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