McGraw-Hill/Irwin 16-1 Noncash Expenses Not all expenses require cash outflows. The most common...

McGraw-Hill/Irwin

16-16-11

Noncash Expenses

Not all expenses require cash outflows. The Not all expenses require cash outflows. The most common example is depreciation.most common example is depreciation.

Recall that High Country’s proposal involved the Recall that High Country’s proposal involved the purchase of a truck. The truck cost $40,000 and purchase of a truck. The truck cost $40,000 and will be depreciated over four years using straight-will be depreciated over four years using straight-line depreciation. The truck is to be purchased line depreciation. The truck is to be purchased

on June 30, 2001. One-half year depreciation is on June 30, 2001. One-half year depreciation is taken in 2001.taken in 2001.

Not all expenses require cash outflows. The Not all expenses require cash outflows. The most common example is depreciation.most common example is depreciation.

Recall that High Country’s proposal involved the Recall that High Country’s proposal involved the purchase of a truck. The truck cost $40,000 and purchase of a truck. The truck cost $40,000 and will be depreciated over four years using straight-will be depreciated over four years using straight-line depreciation. The truck is to be purchased line depreciation. The truck is to be purchased

on June 30, 2001. One-half year depreciation is on June 30, 2001. One-half year depreciation is taken in 2001.taken in 2001.

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Noncash Expenses

Here is a complete depreciation schedule for Here is a complete depreciation schedule for High Country.High Country.

DepreciationDepreciationTaxTax

ShieldShield

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Net Present Value Analysis

Calculation of the present value of proposal cash flows.Calculation of the present value of proposal cash flows.

The sum of the present values from thisThe sum of the present values from thisproposal is a positive $71,550proposal is a positive $71,550

The sum of the present values from thisThe sum of the present values from thisproposal is a positive $71,550proposal is a positive $71,550

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Modified Accelerated Cost Recovery System (MACRS)

Tax depreciation is usually computed using Tax depreciation is usually computed using MACRS. Here are the depreciation rate for 3, MACRS. Here are the depreciation rate for 3,

5, and 7-year class life assets.5, and 7-year class life assets.

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A company is considering the purchase of a A company is considering the purchase of a machine that will increase after-tax cash flows machine that will increase after-tax cash flows

by $20,000 over the next five years. The by $20,000 over the next five years. The machine is depreciated using MACRS and machine is depreciated using MACRS and the company uses a 10% discount rate to the company uses a 10% discount rate to

compute all present values. The machine will compute all present values. The machine will cost $100,000 and the company is subject to cost $100,000 and the company is subject to

a 28% tax rate.a 28% tax rate.

Let’s calculate the net present value of the Let’s calculate the net present value of the proposal.proposal.

A company is considering the purchase of a A company is considering the purchase of a machine that will increase after-tax cash flows machine that will increase after-tax cash flows

by $20,000 over the next five years. The by $20,000 over the next five years. The machine is depreciated using MACRS and machine is depreciated using MACRS and the company uses a 10% discount rate to the company uses a 10% discount rate to

compute all present values. The machine will compute all present values. The machine will cost $100,000 and the company is subject to cost $100,000 and the company is subject to

a 28% tax rate.a 28% tax rate.

Let’s calculate the net present value of the Let’s calculate the net present value of the proposal.proposal.

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Calculation of the present value of the Calculation of the present value of the depreciation tax shield.depreciation tax shield.

$5,600 × (1.10)^-1$5,600 × (1.10)^-1

$20,000 × 28%$20,000 × 28%

$100,000 × 20%$100,000 × 20%

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Calculation of the present value proposal cash Calculation of the present value proposal cash flows.flows.

$20,000 × (1.10)^-1$20,000 × (1.10)^-1

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Net present value of the proposal.Net present value of the proposal.

The presentThe presentvalue of thevalue of the

proposal is lessproposal is lessthan the costthan the cost

of the equipmentof the equipment($100,000). The($100,000). Theproposal has aproposal has a

negativenegative net netpresent value.present value.

The presentThe presentvalue of thevalue of the

proposal is lessproposal is lessthan the costthan the cost

of the equipmentof the equipment($100,000). The($100,000). Theproposal has aproposal has a

negativenegative net netpresent value.present value.

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Investment in Working Capital

Some investment proposals require Some investment proposals require additional outlays for working capital such additional outlays for working capital such as increases in cash, accounts receivable, as increases in cash, accounts receivable,

and inventory.and inventory.

Some investment proposals require Some investment proposals require additional outlays for working capital such additional outlays for working capital such as increases in cash, accounts receivable, as increases in cash, accounts receivable,

and inventory.and inventory.

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Extended Illustration

Let take a close look at a present value Let take a close look at a present value analysis for an investment decision facing analysis for an investment decision facing

James Company.James Company.

Let take a close look at a present value Let take a close look at a present value analysis for an investment decision facing analysis for an investment decision facing

James Company.James Company.

JamesCompany

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James Company has been offered a five-year contract James Company has been offered a five-year contract to provide component parts for a large manufacturer.to provide component parts for a large manufacturer.

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At the end of five years the working capital At the end of five years the working capital will be released and may be used will be released and may be used elsewhere by James.elsewhere by James.

James Company uses a discount rate of James Company uses a discount rate of 10%.10%.

James uses straight-line depreciation.James uses straight-line depreciation.All items are taxed at 30%.All items are taxed at 30%.

Should the contract be accepted?Should the contract be accepted?

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Annual Annual accounting income accounting income from operationsfrom operations

RememberRememberdepreciation isdepreciation isa non-casha non-cashexpense thatexpense thatprovides aprovides atax shield.tax shield.

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Annual Annual cash inflows cash inflows from operationsfrom operations

RememberRememberdepreciation isdepreciation isa non-casha non-cashexpense thatexpense thatprovides aprovides atax shield.tax shield.

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The relining is considered normal maintenance The relining is considered normal maintenance and will reduce income in year 3. Because the and will reduce income in year 3. Because the cost is tax deductible, income will be lower by cost is tax deductible, income will be lower by

$21,000 ($30,000 × 1- tax rate).$21,000 ($30,000 × 1- tax rate).

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Because the salvage value of the equipment will equal Because the salvage value of the equipment will equal the book value (cost less accumulated depreciation), the book value (cost less accumulated depreciation),

there will be no taxable gain or loss.there will be no taxable gain or loss.

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Present value of $1 factor for 3 years at 10%.


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We should accept the contract because the presentWe should accept the contract because the presentvalue of the cash inflows exceeds the present valuevalue of the cash inflows exceeds the present valueof the cash outflows by of the cash outflows by $92,836$92,836. The project has a . The project has a

positivepositive net present value.net present value.

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Extended IllustrationGeneral decision rule . . .General decision rule . . .

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Ranking Investment Projects

We can invest in either of these projects. We can invest in either of these projects. Use a 10% discount rate to determine the Use a 10% discount rate to determine the

net present value of the cash flows.net present value of the cash flows.



Project A Project BImmediate cash outlay 100,000$ 100,000$ Cash inflows: Year 1 50,000$ 30,000$ Year 2 40,000 40,000 Year 3 30,000 50,000 Total inflows 120,000$ 120,000$


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The total cash flows are the same,The total cash flows are the same,but the pattern of the flows isbut the pattern of the flows is

different.different.

The total cash flows are the same,The total cash flows are the same,but the pattern of the flows isbut the pattern of the flows is

different.different.

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Let’s calculate the present value of the cash Let’s calculate the present value of the cash flows associated with flows associated with Project AProject A..

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(1.10)-1 = 0.909 rounded(1.10)-1 = 0.909 rounded

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(1.10)-2 = 0.826 rounded(1.10)-2 = 0.826 rounded

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This project has a positive net present value which means This project has a positive net present value which means the project’s return is the project’s return is greater than greater than the discount rate.the discount rate.

This project has a positive net present value which means This project has a positive net present value which means the project’s return is the project’s return is greater than greater than the discount rate.the discount rate.

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Here is the net present value of the cash Here is the net present value of the cash flows associated with flows associated with Project BProject 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 B has a negative net present value which means Project B has a negative net present value which means the project’s return is the project’s return is less than less than the discount rate.the discount rate.

Project B has a negative net present value which means Project B has a negative net present value which means the project’s return is the project’s return is less than less than the discount rate.the discount rate.

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Internal Rate of Return (IRR)

The interest rate that equates the present The interest rate that equates the present value of inflows and outflows from an value of inflows and outflows from an

investment project.investment project.

The interest rate that equates the present The interest rate that equates the present value of inflows and outflows from an value of inflows and outflows from an

investment project.investment project.

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When the cash flows from a project are When the cash flows from a project are constant, the constant, the present value of an annuitypresent value of an annuity

factor can be used to approximate the rate of factor can be used to approximate the rate of return.return.

A project cost $90,119, and will yield net cash A project cost $90,119, and will yield net cash inflows of $25,000 at the end of each of the inflows of $25,000 at the end of each of the

next five years.next five years.

When the cash flows from a project are When the cash flows from a project are constant, the constant, the present value of an annuitypresent value of an annuity

factor can be used to approximate the rate of factor can be used to approximate the rate of return.return.

A project cost $90,119, and will yield net cash A project cost $90,119, and will yield net cash inflows of $25,000 at the end of each of the inflows of $25,000 at the end of each of the

next five years.next five years.

Let’s determine the IRR for this project!Let’s determine the IRR for this project!

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PV factor = PV factor = Required InvestmentRequired Investment Annual net cash flowAnnual net cash flow

$90,119$90,119 $25,000$25,000

3.605 rounded3.605 rounded

The present value of an annuity factor of 3.605,The present value of an annuity factor of 3.605,is an internal rate of return of is an internal rate of return of 12%12%..

The present value of an annuity factor of 3.605,The present value of an annuity factor of 3.605,is an internal rate of return of is an internal rate of return of 12%12%..

PV factor = PV factor =

PV factor = PV factor =

McGraw-Hill/Irwin

16-16-3232Alternative Methods for Making

Investment Decisions

Payback MethodPayback Method

PaybackPaybackperiodperiod

Initial investment Initial investment Annual after-tax cash inflowAnnual after-tax cash inflow

==

PaybackPaybackperiodperiod ==

$20,000 $20,000 $4,000$4,000 == 5 years5 years

A company can purchase a machine for $20,000 thatA company can purchase a machine for $20,000 thatwill provide annual cash inflows of $4,000 for 7 years.will provide annual cash inflows of $4,000 for 7 years.A company can purchase a machine for $20,000 thatA company can purchase a machine for $20,000 thatwill provide annual cash inflows of $4,000 for 7 years.will provide annual cash inflows of $4,000 for 7 years.

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Payback: Pro and Con

Fails to consider Fails to consider the time value of the time value of money.money.

Does not consider Does not consider a project’s cash a project’s cash flows beyond the flows beyond the payback period.payback period.

Fails to consider Fails to consider the time value of the time value of money.money.

Does not consider Does not consider a project’s cash a project’s cash flows beyond the flows beyond the payback period.payback period.

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Payback: Pro and Con

Provides a tool for Provides a tool for roughly screening roughly screening investments.investments.

For some firms, it For some firms, it may be essential may be essential that an investment that an investment recoup its initial recoup its initial cash outflows as cash outflows as quickly as possible.quickly as possible.

Provides a tool for Provides a tool for roughly screening roughly screening investments.investments.

For some firms, it For some firms, it may be essential may be essential that an investment that an investment recoup its initial recoup its initial cash outflows as cash outflows as quickly as possible.quickly as possible.

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Accounting-Rate-of-Return Method

Discounted-cash-flow method focuses on Discounted-cash-flow method focuses on cash flows cash flows and the time value of money.and the time value of money.

Accounting-rate-of-return method focuses on Accounting-rate-of-return method focuses on the the incremental accounting income incremental accounting income that that

results from a project.results from a project.

Discounted-cash-flow method focuses on Discounted-cash-flow method focuses on cash flows cash flows and the time value of money.and the time value of money.

Accounting-rate-of-return method focuses on Accounting-rate-of-return method focuses on the the incremental accounting income incremental accounting income that that

results from a project.results from a project.

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The following formula is used to calculate The following formula is used to calculate the accounting rate of return:the accounting rate of return:

AccountingAccountingrate ofrate ofreturnreturn

==

Average Average Average Average incremental incremental expenses,incremental incremental expenses, revenues including depreciationrevenues including depreciation

--

Initial investmentInitial investment

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Meyers Company wants to install an espresso bar in Meyers Company wants to install an espresso bar in its restaurant.its restaurant.

The espresso bar:The espresso bar: Cost $140,000 and has a 10-year life.Cost $140,000 and has a 10-year life. Will generate incremental revenues of $100,000 and Will generate incremental revenues of $100,000 and

incremental expenses of $80,000 including incremental expenses of $80,000 including depreciation.depreciation.

What is the accounting rate of return on the What is the accounting rate of return on the investment project?investment project?

Meyers Company wants to install an espresso bar in Meyers Company wants to install an espresso bar in its restaurant.its restaurant.

The espresso bar:The espresso bar: Cost $140,000 and has a 10-year life.Cost $140,000 and has a 10-year life. Will generate incremental revenues of $100,000 and Will generate incremental revenues of $100,000 and

incremental expenses of $80,000 including incremental expenses of $80,000 including depreciation.depreciation.

What is the accounting rate of return on the What is the accounting rate of return on the investment project?investment project?

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The accounting rate of return method is not recommendedThe accounting rate of return method is not recommendedfor a variety of reasons, the most important of which for a variety of reasons, the most important of which

is that it ignores the time value of money.is that it ignores the time value of money.

The accounting rate of return method is not recommendedThe accounting rate of return method is not recommendedfor a variety of reasons, the most important of which for a variety of reasons, the most important of which

is that it ignores the time value of money.is that it ignores the time value of money.

AccountingAccountingrate of returnrate of return

$100,000 - $80,000 $100,000 - $80,000 $140,000$140,000 = 14.3%= 14.3%==

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Capital Budgeting Practices

Percent of managers who believe each technique is important.

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16-16-4040Estimating Cash Flows:

The Role of Activity-Based Costing

ABC systems generally improve the ability of ABC systems generally improve the ability of an analyst to estimate the cash flows an analyst to estimate the cash flows associated with a proposed project.associated with a proposed project.

ABC systems generally improve the ability of ABC systems generally improve the ability of an analyst to estimate the cash flows an analyst to estimate the cash flows associated with a proposed project.associated with a proposed project.

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16-16-4141Justification of Investments in

Advanced Manufacturing Systems

HurdleHurdlerates arerates aretoo hightoo high

HurdleHurdlerates arerates aretoo hightoo high

TimeTimehorizonshorizonsare tooare tooshortshort

TimeTimehorizonshorizonsare tooare tooshortshort

BiasBiastowardstowards

incrementalincrementalprojectsprojects

BiasBiastowardstowards

incrementalincrementalprojectsprojects

GreaterGreatercash flowcash flow

uncertaintyuncertainty

GreaterGreatercash flowcash flow

uncertaintyuncertainty

BenefitsBenefitsdifficult todifficult toquantifyquantify

BenefitsBenefitsdifficult todifficult toquantifyquantify

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End of Chapter 16End of Chapter 16

McGraw-Hill/Irwin 16-1 Noncash Expenses Not all expenses require cash outflows. The most common...

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