Strategic Investment Decisions: Measuring, Monitoring, and Motivating Performance

Cost Management
Measuring, Monitoring, and Motivating Performance
Chapter 12 Strategic Investment Decisions
Prepared by Gail Kaciuba Midwestern State University

Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e
John Wiley & Sons, 2005
Slide # 1
Chapter 12: Strategic Investment Decisions
Learning objectives
Q1: How are strategic investment decisions made? Q2: What cash flows are relevant for strategic investment decisions? Q3: How is net present value (NPV) analysis performed and interpreted? Q4: What are the uncertainties and limitations of NPV analysis? Q5: What alternative methods (IRR, payback, and accrual accounting rate of return) are used for long-term decision making? Q6: What additional issues should be considered for strategic investment decisions? Q7: How do income taxes affect strategic investment decision cash flows? Q8: How are the real and nominal methods used to address inflation in NPV analysis (Appendix 12A)
Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e Slide # 2
Q1: Process for Making Strategic Investment Decisions
The process used to compare and analyze long-term investment projects is called capital budgeting. The capital budgeting process includes the following stages:
Identify decision alternatives. Identify relevant cash flows. Apply the appropriate quantitative techniques. Perform sensitivity analysis. Identify and analyze qualitative factors. Consider quantitative and qualitative factors and make a decision.
Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e Slide # 3
Q1: Capital Budgeting Quantitative Techniques
Methods that consider the time value of money: Net present value (NPV) method Internal rate of return (IRR) method
Methods that do not consider the time value of money: Payback method Accounting rate of return method
John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e Slide # 4
Q2: Relevant Cash Flows in Capital Budgeting
Relevant cash flows occur in the future and are different across the alternatives. Examples of relevant cash outflows include: Initial investment outlay Future operating costs Project closing and cleanup costs Examples of relevant cash inflows include: Future revenues Decreased operating costs Salvage value of assets at projects end
Q3: Net Present Value (NPV) Analysis
The NPV of a project is the sum of the projects discounted cash flows:
NPV =
n t=0
Expected cash flow , where 1 r

t t
t = year of the projects life in which cash flow occurs n = life of the project r = discount, or hurdle rate If a projects NPV > 0, it is acceptable
Q3: NPV Analysis and Project Ranking
NPV analysis is often used to screen projects as to whether they are acceptable.
After screening, acceptable projects may be ranked according to their profitability index.
Profitability index = Present value of benefits Present value of costs
The profitability index allows for rankings of projects of various sizes.

Q3: NPV Example

Joseph Leasing is considering an investment in a new apartment building. The Lindie Lane building will cost $450,000 and the net annual cash inflows are expected to be $45,000 for 7 years. At the end of the 7th year, Joseph expects to be able to sell Lindie Lane building for $400,000. Joseph demands a minimum required rate of return of 8% on all investments. Assume all cash inflows occur at the end of each year. Compute the NPV of the Lindie Lane building. Is it an acceptable investment?
PV of cash inflows: Annuity of cash inflows: $45,000 x PV annuity factor of 5.206 $234,270 Sale of building: $400,000 x PV of $1 factor of 0.583 233,200 467,470 PV of cash outflows: Initial investment 450,000 NPV $17,470
John Wiley & Sons, 2005 Chapter 12: Strategic Investment Decisions Eldenburg & Wolcotts Cost Management, 1e
Yes, the NPV > 0, so the investment is acceptable
Slide # 8
Q3: NPV Example

Joseph Leasing is also looking at the purchase of a lot with a double-wide trailer on it. The cost is $65,000 and the expected net cash inflows are $6,800 per year for 10 years. At the end of the 10th year, Joseph expects to be able to sell the lot and trailer for $45,000. Compute the NPV of the trailer investment. Is it an acceptable investment?
PV of cash inflows: Annuity of cash inflows: $6,800 x PV annuity factor of 6.710 Sale of lot and trailer: $45,000 x PV of $1 factor of 0.463 PV of cash outflows: Initial investment NPV
$45,628 20,835 66,463 65,000 $1,463

Yes, the NPV > 0, so the investment is acceptable
Slide # 9
Q3: NPV Example

Compare the two investments for Joseph using the profitability index, and describe to him what the index means. Which investment (or both) should he make?
Profitability index Lindie Lane building: PV of cash inflows PV of cash outflows Trailer: PV of cash inflows PV of cash outflows 467,470 = 450,000 66,463 = 65,000 1.0388
1.0225
The Lindie Lane yields a slightly greater PV for each invested dollar than does the trailer.
If Joseph has sufficient capital, he should invest in both unless he has alternatives that have even greater profitability indices.
Q4: Limitations of NPV Analysis
The uncertainty about future cash flows increases the further the cash flow is in the future, but NPV analysis uses only one discount rate for all future periods.
Individuals providing information about the future cash flows are likely to have a vested interest in the projects acceptance.
Slide # 11
Q5: Internal Rate of Return (IRR) Method
The IRR method computes the discount rate required to set the NPV to zero.
For projects with equal annual cash inflows where the only cash outlay is the initial investment, the IRR can be determined by computing the PV of an annuity factor and solving for the interest rate.
Initial investment = PV of an annuity factor Annual cash inflow
Then the discount rate is found by locating the column for the PV factor, given n.
Q5: IRR Example

Graham Enterprises is considering the purchase of a new machine. The cost is $100,000 and the machine is expected to generate cost savings of $17,700 each year for 10 years. The machine is not expected to have any salvage value at the end of its life. Assume the cost savings are realized at the end of the year. Graham requires a 10% rate of return on all new investments. Compute the IRR for the proposed machine. Should Graham purchase the machine? Locate the 5.65 factor in the present $100,000 = 5.650 value of an annuity table, using n = $17,700 10 years and note that it is found in the 12% column, so the IRR = 12%.
Since the machines IRR exceeds Grahams minimum rate of return, the machine is an acceptable investment, but of course should still be compared to other, potentially better, investments.
Slide # 13
Q5: Payback Method
The payback method computes the number of years before the initial investment is recovered. If cash inflows are the same each year and the project has only one initial outlay, the payback period is computed as:
Payback period in years =
Initial investment Annual cash inflow
For projects where annual cash inflows are not equal, the payback period is computed by merely counting the years required before the initial investment is recovered.
Q5: Payback Method
The payback method is widely used because of its simplicity. However, the payback method is flawed because:
It ignores the time value of money. It ignores cash flows that occur after the payback period.
If used at all, the payback method should be used in conjunction with the NPV or IRR methods to help assess project risk.
Q5: Payback Method Example

Graham Enterprises is considering the purchase of a new machine. The cost is $100,000 and the machine is expected to generate cost savings of $17,700 each year for 10 years. The machine is not expected to have any salvage value at the end of its life. Compute the payback period for the proposed machine.
$100,000 = 5.650 years $17,700
Notice that the payback period is the same as the PV factor computed in the IRR example.
Slide # 16
Q5: Payback Method Example

Cophil, Inc. is considering the purchase of a new machine. There are two alternatives, and the cash flow information is given below. Compute the payback period for each and comment on your findings.
Time Cash Flow period Machine A Machine B The payback period for 0 ($100,000) ($100,000) Machine B is 2 years. The 1 $10,000 $50,000 payback period for Machine A 2 $20,000 $50,000 is 3.5 years ($60,000 covered after 3 years, and $40,000 is 3 $30,000 of year 4s cash inflow). 4 $80,000 5 $80,000 The payback method shows Machine B to be 6 $80,000 preferable to Machine A, but ignores the large cash inflows of Machine A that occur after the payback period.
Slide # 17
Q5: Accrual Accounting Rate of Return Method
The accrual accounting rate of return computes the projects rate of return using operating income in place of cash flows.
Accrual accounting rate of return
= Operating income Annual cash inflow
This method is widely used because the financial accounting information is readily available, but is is flawed because it ignores the time value of money.
Q5: Accrual Accounting Rate of Return Method Example

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

Effect on annual operating income Accrual accounting rate of return
20,000
$12,000
$12,000 $100,000
= 12%
Slide # 19
Q6: Additional Considerations in Strategic Investment Decisions
Qualitative issues that may arise in capital budgeting include:

the effects of the decision on the companys reputation, the effects on the quality of the companys products and services, the effects on the companys community, and the effects on employees.
After a capital budgeting decision is made, a post-investment audit should be performed to assess the decision process.
Q7: Income Tax Considerations
All cash flows should first be converted to an after-tax amount. The tax savings that result from the depreciation deduction is called the depreciation tax shield.
Slide # 21
Q7: Capital Budgeting and Income Tax Considerations (NPV) Example

Colby Products is considering the purchase of a new machine. The cost is $180,000 and it is expected to last 6 years and have no salvage value. The machine is expected to generate cost savings of $50,000 per year. Colbys tax rate is 30% and its discount rate is 10%. For simplification, suppose that Colby uses straight-line depreciation for both books and taxes. Compute the IRR of this machine. Cash inflows after taxes [$50,000 x (1 30%)] Tax savings from depreciation [$30,000 x 30%] Net after-tax annual cash inflows $35,000 9,000 $44,000
NPV = $44,000 x PV factor of an annuity - $180,000 = $44,000 x 4.355 - $180,000 = $11,620
Slide # 22
Q7: Capital Budgeting and Income Tax Considerations (IRR) Example

Colby Products is considering the purchase of a new machine. The cost is $180,000 and it is expected to last 6 years and have no salvage value. The machine is expected to generate cost savings of $50,000 per year. Colbys tax rate is 30% and its discount rate is 10%. For simplification, suppose that Colby uses straight-line depreciation for both books and taxes. Compute the IRR of this machine. Cash inflows after taxes [$50,000 x (1 30%)] Tax savings from depreciation [$30,000 x 30%] Net after-tax annual cash inflows $180,000 $44,000 $35,000 9,000 $44,000
= PV of an annuity factor = 4.091
Locate the 4.091 factor in the present value of an annuity table, using n = 6 years and note that it is found between the 12% & 13% columns, so the IRR is just over 12%.
Q7: Capital Budgeting and Income Tax Considerations (Payback) Example

Colby Products is considering the purchase of a new machine. The cost is $180,000 and it is expected to last 6 years and have no salvage value. The machine is expected to generate cost savings of $50,000 per year. Colbys tax rate is 30% and its discount rate is 10%. For simplification, suppose that Colby uses straight-line depreciation for both books and taxes. Compute the payback period of this machine. Cash inflows after taxes [$50,000 x (1 30%)] Tax savings from depreciation [$30,000 x 30%] Net after-tax annual cash inflows $35,000 9,000 $44,000
$180,000 $44,000
= Payback period = 4.91 years.
Slide # 24
Q7: Capital Budgeting and Income Tax Considerations (Accrual Accounting ROR) Example
Colby Products is considering the purchase of a new machine. The cost is $180,000 and it is expected to last 6 years and have no salvage value. The machine is expected to generate cost savings of $50,000 per year. Colbys tax rate is 30% and its discount rate is 10%. For simplification, suppose that Colby uses straight-line depreciation for both books and taxes. Compute the accrual accounting rate of return of this machine. Cash inflows after taxes [$50,000 x (1 30%)] Tax savings from depreciation [$30,000 x 30%] Net after-tax annual increase in operating income $44,000 $180,000 $35,000 9,000 $44,000
= 24.44% accrual accounting ROR
Slide # 25
Q8: Inflation and NPV Analysis
When the purchasing power of the dollar declines over time, it is known as inflation. The real rate of interest does not consider changes in the purchasing power of a dollar.
The nominal rate of interest is the rate that investors demand when inflation is taken into consideration in their decisions.
Q8: Inflation and NPV Analysis
The risk-free rate is the rate of interest that is paid on long-term government bonds. The risk premium is the additional rate of return investors demand to compensate them for taking risk. The risk premium increases for riskier investments.
The real rate of interest is the nominal rate plus the risk premium demanded for that investment.
Q8: Nominal and Real Methods of NPV Analysis
The real and nominal rates of interest are related as follows:

Nominal rate of = interest
(1 + real rate) x (1 + inflation rate) -1
Nominal future cash flows are real cash flows inflated to future dollars:
Nominal cash flow = Real cash flow x (1 + i)t, where i = rate of inflation, and t = the number of time periods in the future the cash flow occurs
Q8: Nominal and Real Methods of NPV Analysis
In the real method of NPV analysis, future cash flows are state in real dollars (without considering changes in the purchasing power of the dollar) and a real rate of interest is used as the discount rate.
In the nominal method of NPV analysis, future cash flows and the terminal project value must be inflated to future dollars and a nominal rate of interest is used as the discount rate.
Q8: Real Method of NPV Analysis
The depreciation tax shield is calculated in 3 steps:

1.Calculate the annual depreciation deduction for tax purposes, 2.Convert each years depreciation deduction from year zero dollars to real dollars by dividing by (1 + inflation rate)t, 3.Multiply the real value of the depreciation deduction times the tax rate.
Calculate the NPV for the incremental cash flows, including the tax savings from depreciation, using the real rate of interest.
Q8: Real Method of NPV Analysis Example

Stiles, Inc. is considering the purchase of a new machine. The cost is $400,000 and it is expected to last 6 years and have a salvage value of $80,000. Stiles tax rate is 30%, the risk-free rate is 3%, the expected inflation rate is 2%, and Stiles believes that a risk premium of 5% for this machine is appropriate. The machine qualifies as 5-year MACRS property for tax purposes, which means that the depreciation deduction is taken over 6 years at 20%, 32%, 19.2%, 11.52%, 11.52%, and 5.76% of asset cost, respectively. Compute the depreciation tax shield in real dollars for this machine. *this is the nominal depreciation over (1.02)t
MACRS rate Depreciation deduction (nominal) Depreciation deduction (real)* Tax savings (real)
1 20.00%
2 32.00%
3 19.20% $76,800 $72,370 $21,711
4 4 11.52% 11.52% $46,080 $46,080 $42,571 $42,571 $12,771 $12,771
5 5 11.52% 11.52% $46,080 $46,080 $41,736 $41,736 $12,521 $12,521
6 6 5.76% 5.76% $23,040 $23,040 $20,459 $20,459 $6,138 $6,138

Slide # 31
$80,000 $128,000 $78,431 $123,030 $23,529 $36,909
Q8: Real Method of NPV Analysis Example

Compute the tax on the gain on the sale of the machine, in real dollars.
Asset cost Depreciation taken Tax basis of asset Proceeds from sale of asset Gain on sale Tax rate Taxes on gain $400,000 $400,000 $0 $80,000 $80,000 30% $24,000
Note that the tax will be paid in the same year as the disposal, so the $24,000 is already in real dollars. On the prior slide, depreciation deductions taken in years 2 6 are based on an investment stated in year 1 dollars, so they were not in real dollars and needed to be deflated.
Q8: Nominal Method of NPV Analysis
Incremental cash inflows and the terminal cash flow must be adjusted (inflated) for inflation.
Calculate the gain on asset disposal as the historical cost compared to the nominal depreciation deduction. The nominal and real methods yield the same NPV when the inflation rate is constant over the investments life.
Q8: Nominal Method of NPV Analysis Example

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

Tax savings
20.00% $24,000
$80,000 $128,000
Slide # 34

Compute the tax on the gain on the sale of the machine, in nominal dollars.
Disposal value Inflation factor Inflated disposal value Tax basis of asset Gain on sale Tax rate Taxes on gain
$80,000 1.12616 $90,093 $0 $90,093 30% $27,028
= (1.02)6
$400,000 cost less depreciation taken of $400,000
Slide # 35

Suppose the machine generates cost savings of $60,000 per year for 6 years. Compute the NPV of the machine using the nominal method.
Time period Cash inflows Inflated cash inflows Taxes on cash inflows Taxes on gain Depreciation tax savings $24,000 Net cash inflows PV factor (nominal) PV of annual net cash flow Initial outlay NPV $66,840 0.90777 $60,675 $38,400 $82,097 0.82405 $67,652 $23,040 $67,611 0.74805 $50,576 $13,824 $59,286 0.67905 $40,258 $13,824 0.61643 $37,106 1 $60,000 $61,200 2 $60,000 $62,424 3 $60,000 $63,672 4 $60,000 $64,946 5 $60,000 $66,245 6 $60,000 $67,570 $90,093 $6,912 0.55957 $65,624 $321,892 $400,000 ($78,108) Total $360,000 $386,057 $90,093 $120,000 $453,305
($18,360) ($18,727) ($19,102) ($19,484) ($19,873) ($20,271) ($115,817) ($27,028) ($27,028) $60,195 $117,276
Terminal cash flow, inflated
Slide # 36

Strategic Investment Decisions: Measuring, Monitoring, and Motivating Performance

Uploaded by

Copyright:

Available Formats

Strategic Investment Decisions: Measuring, Monitoring, and Motivating Performance

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Strategic Investment Decisions: Measuring, Monitoring, and Motivating Performance

Uploaded by

Copyright:

Available Formats

Cost Management

Measuring, Monitoring, and Motivating Performance

Chapter 12 Strategic Investment Decisions

Prepared by Gail Kaciuba Midwestern State University

John Wiley & Sons, 2005

Chapter 12: Strategic Investment Decisions

John Wiley & Sons, 2005

Q1: Process for Making Strategic Investment Decisions

John Wiley & Sons, 2005

Q1: Capital Budgeting Quantitative Techniques

Q2: Relevant Cash Flows in Capital Budgeting

Q3: Net Present Value (NPV) Analysis

Expected cash flow , where 1 r

Q3: NPV Analysis and Project Ranking

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

Q3: NPV Example

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

Q3: NPV Example

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

John Wiley & Sons, 2005

Q3: NPV Example

Q4: Limitations of NPV Analysis

John Wiley & Sons, 2005

Q5: Internal Rate of Return (IRR) Method

Q5: IRR Example

John Wiley & Sons, 2005

Q5: Payback Method

Q5: Payback Method

Q5: Payback Method Example

$100,000 = 5.650 years $17,700

John Wiley & Sons, 2005

Q5: Payback Method Example

John Wiley & Sons, 2005

Q5: Accrual Accounting Rate of Return Method

Q5: Accrual Accounting Rate of Return Method Example

Annual cost savings

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

Q6: Additional Considerations in Strategic Investment Decisions

Qualitative issues that may arise in capital budgeting include:

Q7: Income Tax Considerations

John Wiley & Sons, 2005

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

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

John Wiley & Sons, 2005

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

= PV of an annuity factor = 4.091

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

= Payback period = 4.91 years.

John Wiley & Sons, 2005

= 24.44% accrual accounting ROR

John Wiley & Sons, 2005

Q8: Inflation and NPV Analysis

Q8: Inflation and NPV Analysis

Q8: Nominal and Real Methods of NPV Analysis

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

Q8: Nominal and Real Methods of NPV Analysis

Q8: Real Method of NPV Analysis

The depreciation tax shield is calculated in 3 steps:

Q8: Real Method of NPV Analysis Example