Because learning changes everything.

Chapter 16

Capital Expenditure
Decisions

Twelfth Edition

© 2020 McGraw Hill. All rights reserved. Authorized only for instructor use in the classroom.
No reproduction or further distribution permitted without the prior written consent of McGraw Hill.
 Segment 1: NPV to evaluate investment proposals

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 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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 Net-Present-Value Method 1

1. Prepare a table showing cash flows for each year,

2. Calculate the present value of each cash flow using a
discount rate,
3. Compute net present value,
4. If the net present value (NPV) is zero or positive, accept
the investment proposal. Otherwise, reject it.

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 Net-Present-Value Method 2

Mattson Co. has been offered a five year contract to provide

component parts for a large manufacturer.

Cost and revenue information

Cost of special equipment $ 160,000
Working capital required 100,000
Relining equipment in 3 years 30,000
Salvage value of equipment in 5 years 5,000
Annual cash revenue and costs:
Sales revenue from parts 750,000
Cost of parts sold 400,000
Salaries, shipping, etc. 270,000

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 Net-Present-Value Method 3

At the end of five years, the working capital will be released

and may be used elsewhere by Mattson.

Mattson uses a discount rate of 10%.

Should the contract be accepted?

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 Net-Present-Value Method 4

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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 Net-Present-Value Method 5

Cash 10% Present

Years
Flows Factor Value
Investment in equipment Now $ (160,000) 1.000 $ (160,000)
Working capital needed Now (100,000) 1.000 (100,000)
Annual net cash inflows 1 to 5 80,000 3.791 303,280
Relining of equipment 3 (30,000) 0.751 (22,530)
Salvage value of equip. 5 5,000 0.621 3,105
Working capital released 5 100,000 0.621 62,100
Net present value $ 85,955

Mattson should accept the contract because the present

value of the cash inflows exceeds the present value of the
cash outflows by $85,955. The project has a positive net
present value.

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 Exercise 16-24

Jack and Jill’s Place is a nonprofit nursery school run by the

parents of the enrolled children. Since the school is out of
town, it has a well rather than a city water supply. Lately, the
well has become unreliable and the school has had to bring
in bottled drinking water. The school’s governing board is
considering drilling a new well (at the top of the hill,
naturally). The board estimates that a new well would cost
$2,825 and save the school $500 annually for 10 years. The
school’s hurdle rate is 8 percent.

Compute the new well’s net present value. Should the

governing board approve the new well?

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 Exercise 16-24 (continued)

Net present value of new well

Cost of new well (time 0) $(2,825)
Present value of annual savings: ($500 * 6.710 from table) 3,355
Net present value $530

The governing board should approve the new well, because the
project’s net present value is positive.

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 Exercise 16-29

Vancouver Shakespearean Theater’s board of directors is

considering the replacement of the theater’s lighting system.
The old system requires two people to operate it, but the new
system would require only a single operator. The new lighting
system will cost $129,750 and save the theater money
annually for the next eight years.
Suppose the board is uncertain about the cost savings with
the new lighting system. How low could the new lighting
system’s annual savings be and still justify acceptance of the
proposal by the board of directors? Assume the theater’s
hurdle rate is 12 percent.

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 Exercise 16-29 (continued)

Net present value

Acquisition cost $(129,750)
Present value of annual savings: (4.968 * X = 129,750 129,750
X = 129,750 / 4.968  X = $26,117)
Net present value $0

If the new lighting system saves at least $26,117 per year, then it
will yield at least a NPV of zero, or greater. Thus, it should be
accepted if it will save at least this amount.

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 Segment 2: Compare the net-present-value and internal-
rate-of-return methods, and state the assumptions
underlying each method. Total cost & incremental cost
approach

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 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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 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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 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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 Total-Cost Approach 1

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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 Total-Cost Approach 2
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 Blank 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 Blank -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

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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 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 0
Operating costs (100,000) (100,000) (100,000) (100,000) (100,000)
Time sharing revenue Blank 20,000 20,000 20,000 20,000 20,000
Total cash flow (65,000) (80,000) (80,000) (80,000) (80,000) (80,000)
× Discount factor × 1.000 × .893 × .797 × .712 × .636 × .567
Present value (65,000) (71,440) (63,760) (42,720) (50,880) (45,360)

SUM OF PRESENT VALUES = $(339,160)

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 Total-Incremental Cost Comparison

Total Cost:

Net cost of purchasing Mainframe system $(1,575,705)

Net cost of purchasing Personal Computer $(1,247,885)

system
Net Present Value of costs $ (327,820)

Incremental Cost:

Net Present Value of costs $ (327,820)

Different methods, Same results!!

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 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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 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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 Segment 3: Payback method and accounting-rate-of-
return method

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 Alternative Methods for Making Investment Decisions

Payback Method

Initial investment
Payback period 
Annual after -tax cash inflow

A company can purchase a machine for $20,000 that

will provide annual cash inflows of $4,000 for 7 years.

$20,000
Payback period   5 years
$4,000

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 Payback: Pro and Con

1. Fails to consider the time 1. Provides a tool for

value of money. roughly screening
investments.
2. Does not consider a
project’s cash flows 2. For some firms, it may
beyond the payback be essential that an
period. investment recoup its
initial cash outflows as
quickly as possible.

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 Accounting-Rate-of-Return Method 1

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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 Accounting-Rate-of-Return Method 2

The following formula is used to calculate the accounting rate

of return:

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

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 Accounting-Rate-of-Return Method 3

Meyers Company wants to install an espresso bar in its

restaurant.
The espresso bar:
• Cost $140,000 and has a 10-year life.
• Will generate incremental revenues of $100,000 and
incremental expenses of $80,000 including depreciation.

What is the accounting rate of return on the investment

project?

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 Accounting-Rate-of-Return Method 4

$100,000  $80,000
Accounting rate of return   14.3%
 $140, 000

The accounting-rate-of-return method is not

recommended for a variety of reasons, the most important
of which is that it ignores the time value of money.

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 Exercise 16-37
Metro Car Washes, Inc., is reviewing an investment proposal. The initial cost as
well as the estimate of the book value of the investment at the end of each year,
the net after-tax cash flows for each year, and the net income for each year are
presented in the following schedule. The salvage value of the investment at the
end of each year is equal to its book value. There would be no salvage value at
the end of the investment’s life. Management uses a 16% after-tax rate of return
for new investment proposals.
Year Initial Cost and Annual Net After- Annual Net
Book Value Tax Cash Flows Income
0 $105,000

1 70,000 $50,00 $15,000

2 42,000 45,000 17,000

3 21,000 40,000 19,000

4 7,000 35,000 21,000

5 0 30,000 23,000
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 Exercise 16-37 (continued)
Compute the project’s payback period:

2.25 years as shown in below table

Year After-tax Cash Flows

1 $50,000
2 45,000 (subtotal = $95,000)
3 (1st quarter) 10,000 (.25 * $40,000)
Total $105,000
Initial Cost $105,000

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 Exercise 16-37 (continued)
Calculate the accounting rate of return on the investment proposal. Base your
calculation on the initial cost of the investment.

Accounting rate of return = average net income / initial investment

Average net income = $19,000 (calculated from information in problem)

Initial investment = $105,000 (given)

Accounting rate of return = $19,000 / $105,000 = 18.1%

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 Exercise 16-37 (continued)
Compute the proposal’s net present value.

Year After-tax cash Discount Factor Present Value

flow
0 ($105,000) 1.000 ($105,000)

1 $50,00 .862 43,100

2 45,000 .743 33,435

3 40,000 .641 25,640

4 35,000 .552 19,320

5 30,000 .476 14,280

Net present value $30,775

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