Cost Management Measuring, Monitoring, and Motivating Performance

© John Wiley & Sons, 2011Chapter 12: Strategic Investment Decisions

Eldenburg & Wolcott’s Cost Management, 2e Slide # 1

Cost ManagementMeasuring, Monitoring, and Motivating Performance

Chapter 12Strategic Investment Decisions



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 business risks and limitations affect 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)



Q1: Process for Making StrategicInvestment Decisions

• The process used to compare and analyze long-term investment projects is called capital budgeting.

• Strategic investment decisions typically involve a large up front investment

• Time value of money must be considered since the project life is greater than 1 year

• Examples of strategic investment decisions?

Identify & Envision- Investment opportunities

- Quantitative & qualitative information

Explore- Quantitative Analysis

techniques- Sensitivity Analysis- Qualitative analysis

Prioritize- Strategies

- Values, core competencies- Restrictions







• 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.



Q1: Capital Budgeting Quantitative Techniques

• Methods that do not consider the time value of money:• Payback method• Accounting rate of return method

• Methods that consider the time value of money:• Net present value (NPV) method• Internal rate of return (IRR) method



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 project’s end



Q2: Relevant Cash Flows in Capital Budgeting



Q3: Net Present Value (NPV) Analysis

• The NPV of a project is the sum of the project’s discounted cash flows:

n

tt

t=0

Expected cash flowNPV = 1 r

, where

• t = year of the project’s life in which cashflow occurs

• n = life of the project• r = discount, or hurdle rate• If a project’s 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 benefitsPresent value of costs

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



Q3: NPV ExampleJoseph 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 invest-ments. 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 $234,270Sale of building:

$400,000 x PV of $1 factor of 0.583 233,200467,470

PV of cash outflows:Initial investment 450,000

NPV $17,470

Yes,the NPV > 0,

so the investment is acceptable



Q3: NPV ExampleJoseph 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?

Yes, the NPV > 0, so the invest-

ment is acceptable

PV of cash inflows:Annuity of cash inflows:

$6,800 x PV annuity factor of 6.710 $45,628Sale of lot and trailer:

$45,000 x PV of $1 factor of 0.463 20,83566,463

PV of cash outflows:Initial investment 65,000

NPV $1,463



Q3: NPV ExampleCompare the two investments for Joseph using the profitability index, and describe to him what the index means. Which investment (or both) should he make?

The Lindie Lane yields

a slightly greater PV

for each invested

dollar than does the

trailer.

Profitability index

Lindie Lane building:PV of cash inflows 467,470PV of cash outflows 450,000

Trailer:PV of cash inflows 66,463PV of cash outflows 65,000

= 1.0388

= 1.0225

If Joseph has sufficient capital, he should invest in both unless he has alternatives that have even greater profitability indices.



Q4: Business Risk

• Almost all cash flows in strategic investment decisions have some uncertainty

• Discount rates incorporate inflation, interest rates, and riskiness of the project

• Risk of uncertainty in cash flows and discount rates increase:• As the project timeframe increases• When new technology, products, or markets

are involved



Q4: Sensitivity Analysis & Bias

• Sensitivity analysis • Helps managers identify how their NPV results

would change as input variables change• Important tool for managing business risk and

uncertainty

• Individuals providing information about the future cash flows are likely to have a vested interest in the project’s acceptance.



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.

PV of an annuity factor=Initial investment

Annual cash inflow

• Then the discount rate is found by locating the column for the PV factor, given n.



Q5: IRR ExampleGraham 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?

Since the machine’s IRR exceeds Graham’s minimum rate of return, the machine is an acceptable investment, but of course

should still be compared to other, potentially better, investments.

5.650=$100,000 $17,700

Locate the 5.65 factor in the present value of an annuity table, using n = 10 years and note that it is found in the 12% column, so the IRR = 12%.



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 investmentAnnual 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 ExampleGraham 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.

Notice that the payback period is the same as the PV factor computed in the IRR example.

5.650 years=$100,000$17,700



Q5: Payback Method ExampleCophil, 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.

The payback method shows Machine B to be preferable to Machine A, but ignores the

large cash inflows of Machine A that occur after the payback period.

The payback period for Machine B is 2 years. The

payback period for Machine A is 3.5 years ($60,000 covered after 3 years, and $40,000 is

½ of year 4’s cash inflow).

Machine A Machine B0 ($100,000) ($100,000)1 $10,000 $50,0002 $20,000 $50,0003 $30,0004 $80,0005 $80,0006 $80,000

Cash FlowTime period



Q5: Accrual Accounting Rate of Return Method

• The accrual accounting rate of return computes the project’s rate of return using operating income in place of cash flows.

• 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.

Accrual accounting rate

of return

Operating income Initial Investment=



Q5: Accrual Accounting Rate of ReturnMethod 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) 20,000

Effect on annual operating income $12,000

Accrual accounting rate

of return$12,000

$100,000= = 12%



Q6: Additional Considerations in Strategic Investment Decisions

• Qualitative issues that may arise in capital budgeting include:• the effects of the decision on the company’s

reputation,• the effects on the quality of the company’s

products and services,• the effects on the company’s 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.



Q7: Capital Budgeting and IncomeTax 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. Colby’s 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%)] $35,000

Tax savings from depreciation [$30,000 x 30%] 9,000

Net after-tax annual cash inflows $44,000

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

= $44,000 x 4.355 - $180,000 = $11,620



Q7: Capital Budgeting and IncomeTax 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. Colby’s 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.




PV of an annuity factor = 4.091=$180,000

$44,000

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 IncomeTax 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. Colby’s 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.




= Payback period = 4.91 years.$180,000$44,000



Q7: Capital Budgeting and Income Tax Considerations (Accrual Accounting ROR)

ExampleColby 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. Colby’s 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.



Net after-tax annual increase in operating income $44,000

24.44% accrual accounting ROR=$44,000

$180,000



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 future cash flows are real cash flows inflated to future dollars:

Nominal rate of interest

= (1 + real rate) x (1 + inflation rate) - 1

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 year’s 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 ExampleStiles, 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.

1 2 3 4 5 6MACRS rate 20.00% 32.00% 19.20% 11.52% 11.52% 5.76%

Depreciation deduction (nominal) $80,000 $128,000 $76,800 $46,080 $46,080 $23,040

Depreciation deduction (real)* $78,431 $123,030 $72,370 $42,571 $41,736 $20,459Tax savings (real) $23,529 $36,909 $21,711 $12,771 $12,521 $6,138

1 2 3 4 5 6MACRS rate 20.00% 32.00% 19.20% 11.52% 11.52% 5.76%

Depreciation deduction (nominal) $80,000 $128,000 $76,800 $46,080 $46,080 $23,040

Depreciation deduction (real)* $78,431 $123,030 $72,370 $42,571 $41,736 $20,459Tax savings (real) $23,529 $36,909 $21,711 $12,771 $12,521 $6,138

*this is the nominal depreciation over (1.02)t



Q8: Real Method of NPV Analysis ExampleCompute the tax on the gain on the sale of the machine, in real dollars.

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.

Asset cost $400,000Depreciation taken $400,000Tax basis of asset $0Proceeds from sale of asset $80,000Gain on sale $80,000Tax rate 30%Taxes on gain $24,000

Asset cost $400,000Depreciation taken $400,000Tax basis of asset $0Proceeds from sale of asset $80,000Gain on sale $80,000Tax rate 30%Taxes on gain $24,000



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 investment’s life.



Q8: Nominal Method of NPV Analysis ExampleStiles, 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 3 4 5 6MACRS rate 20.00% 32.00% 19.20% 11.52% 11.52% 5.76%Depreciation deduction $80,000 $128,000 $76,800 $46,080 $46,080 $23,040Tax savings $24,000 $38,400 $23,040 $13,824 $13,824 $6,912

1 2 3 4 5 6MACRS rate 20.00% 32.00% 19.20% 11.52% 11.52% 5.76%Depreciation deduction $80,000 $128,000 $76,800 $46,080 $46,080 $23,040Tax savings $24,000 $38,400 $23,040 $13,824 $13,824 $6,912



Q8: Nominal Method of NPV Analysis ExampleCompute the tax on the gain on the sale of the machine, in nominal dollars.

= (1.02)6

$400,000 cost less depreciation taken

of $400,000

Disposal value $80,000Inflation factor 1.12616Inflated disposal value $90,093Tax basis of asset $0Gain on sale $90,093Tax rate 30%Taxes on gain $27,028

Disposal value $80,000Inflation factor 1.12616Inflated disposal value $90,093Tax basis of asset $0Gain on sale $90,093Tax rate 30%Taxes on gain $27,028



Q8: Nominal Method of NPV Analysis ExampleSuppose 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 1 2 3 4 5 6 TotalCash inflows $60,000 $60,000 $60,000 $60,000 $60,000 $60,000 $360,000Inflated cash inflows $61,200 $62,424 $63,672 $64,946 $66,245 $67,570 $386,057Taxes on cash inflows ($18,360) ($18,727) ($19,102) ($19,484) ($19,873) ($20,271) ($115,817)Terminal cash flow, inflated $90,093 $90,093Taxes on gain ($27,028) ($27,028)Depreciation tax savings $24,000 $38,400 $23,040 $13,824 $13,824 $6,912 $120,000Net cash inflows $66,840 $82,097 $67,611 $59,286 $60,195 $117,276 $453,305PV factor (nominal) 0.90777 0.82405 0.74805 0.67905 0.61643 0.55957PV of annual net cash flow $60,675 $67,652 $50,576 $40,258 $37,106 $65,624 $321,892Initial outlay $400,000NPV ($78,108)

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

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