4chap18 - University of Waikatocms.mngt.waikato.ac.nz/webdocs/personal/evos/... · - Capital...

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18 CAPITAL INVESTMENT(Contributed by Deryl Northcott)

IntroductionCapital Investment DefinedWho is Involved in Making CI Decisions?Why Are Capital Investment Decisions Important?Types of Capital InvestmentsThe Capital Investment ProcessWhat Information is Relevant to a CI Decision?Financial Analysis of Capital Investment ProjectsAccounting Concepts

- Payback Period- Accounting Rate of Return

Economics and Finance Concepts- The Net Present Value Method- A Variation on NPV - Profitability Index- Internal Rate of Return- Discounted Payback Period- The Winner - NPV

Issues in Using NPV Correctly- The Timing of Cashflows- Taxation- Depreciation- Taxation Investment Incentives- Taxation Effects - Summary- Inflation- Capital Rationing

Using NPV - SummaryUsing NPV - An Extended ExamplePeople Are Important Too!Summary

IntroductionIt is an unfortunate requirement that to make money, an organisation usually has tospend money - the trick is always in spending it wisely. Making decisions aboutwhat is and isn’t worth spending money on is never easy, especially where the

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368 Financial Management and Decision Making

expenditure is large and the returns risky, as is generally the case with capitalinvestment.

Capital Investment DefinedCapital investment (CI) can be seen as a sub-set of capital budgeting. Capitalbudgeting refers to both the selection of long-term investments, and planning fortheir financing. The Fisher Separation Theorem states that, in theory at least, theinvestment decision is separate from the financial decision. There are specialcircumstances when the investment and financial decisions are inter-related.However, deciding which projects should be undertaken is sufficiently problematicto warrant consideration on its own, and so forms the focus of this chapter.

Capital investment (CI) can be defined as follows:

Capital investment entails the making, communication andacceptance of decisions about investment in long-term, risky capitalassets.

These decisions take place within the organisational context and impact upon thestrategic and operating position of the organisation, and also upon those people whoconstitute the organisation. Therefore, we would expect CI decisions to take intoaccount the strategic and behavioural implications of the proposed investment, aswell as some rigorous examination of its financial effects.

Who is Involved in Making CI Decisions?There is no one answer to this question. Evidence from practice suggests that avariety of people may participate in CI decisions (Bower, 1970; Mukherjee &Henderson, 1987), even though much of the prescriptive literature suggest that thesedecisions are the domain of the accountant. It is common in practice to see any orall of the following personnel contributing:

- accountants / financial managers- operational managers- line staff (who work with the capital assets)- production personnel- engineers- specialist capital investment officers / committees- general managers and boards of directors (who are often responsible for the

final decision to commit to large items of expenditure).

It is therefore rare for CI decisions to be made behind the closed doors of theaccountant’s office. Although accountants have a role in providing financialanalyses and advice, specialist technical expertise is often required to assesspotential investments.

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Chapter 18: Capital Investment 369

Why Are Capital Investment Decisions Important?Capital investment decisions are significant at two levels: for the future operabilityof the organisation making the investment, and for the economy of a nation as awhole. Capital investment directs significant resources towards particular areas ofeconomic activity. So collectively, CI decisions made by individual organisationsimpact upon the future economic position of a nation.

At an organisational level, the commitment of resources to long-term capital assetshas implications for many aspects of operations. Capital investment may concernthe purchase or modification of plant and machinery, so the cost, range, quality,innovation and leadership of products are all affected by CI decisions.

Types of Capital InvestmentsCapital investment projects can take many forms. Generally, they involve:

1. Replacement of existing assets,2. Expansion of existing operations,3. Strategic expenditure to develop new types of production technologies or

product lines, perhaps re-positioning the organisation in the market place, orresponding to some change in the operating environment, or

4. Non-financially motivated expenditures, e.g. safety, environmental orlegislatively required expenditures.

Depending on what the purpose of a CI is, the criteria for approving the project maydiffer. For example, a risky, innovative project which launches the organisationinto a new area of operations will generally be expected to show a good financialreturn. In comparison, a plant alteration required to meet health or safetyregulations may not be expected to achieve any financial return - it is a necessity,and the focus will be on minimising the cost of achieving the legal requirements.

The Capital Investment ProcessIt is important to recognise that there are several ‘phases’ involved in making CIdecisions. The nature and relationship of these phases is shown in Exhibit 18.1.

Exhibit 18.1 A Capital Investment Model

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Strategic Planning

Formal CI Systems

Feedback

Organisational personnel

Source: Northcott, 1992

Indentification ofpotential

investments

Projectdefinition and

screening

Analysis andacceptance Implementation Monitoring and

post-audit

First, potential CI projects must be identified. This requires both innovation ingenerating investment ideas, and judgement in being able to recognise a good ideawhen it appears! Once the initial idea has been identified, the project needs to bedefined and detailed. Here, it is important to consider all the implications of theproject, for example: How much will it cost? What are its financial and strategicadvantages? How will it affect the organisation’s operations? At this stage, it isusually possible to ‘screen out’ those CI ideas which are clearly infeasible, or whichmay not be as good as was first thought.

Once CI ideas have been formulated and screened, the promising projects continueon to the ‘analysis and acceptance’ stage. Here, rigorous financial analyses are usedto assess the financial implications of a CI project (later in this chapter we will lookat the kinds of financial analysis which can be used). Normally, if a project meetsthe requirements of financial analysis, it will be accepted, and then implemented.Once the project is up and running, it may be monitored so that a ‘post audit’ can beconducted, looking at how successful the investment has been.

Exhibit 18.1 shows that this decision process has links to the strategic planningfunction in an organisation, and to the personnel who make CI decisions, implementthe projects and work with the capital assets. Finally, it is important to recognisethat this decision making process takes place within the organisational environment,and so is subject to the objectives, traditions and culture of the organisation.

All of this looks simple. However, practice rarely reflects tidy, structured ‘models’.The phases of this process may, in practice, be interactive and iterative and mayoccur out of order or not at all! However, this model presents a useful starting pointfor considering the facets of CI decision making. Each of the phases is important,and a successful programme of CI decision making should include elements of them

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all.

What Information is Relevant to a CI Decision?The short answer to this question is: anything that changes as a result of a CIdecision will be relevant to assessing the viability of that investment. That is, the CIdecision maker must identify relationships between the decision made, and the costsand benefits which accrue from it either immediately or in the future.

Some typical examples of relevant information include:

- the purchase and installation cost of the capital asset,- changes in revenues or costs,- required increases in working capital items (e.g. inventory).

Getting this information is often more difficult than it would first appear. Forexample, the purchase price of a fixed asset is often the only explicit component ofthe initial outlay cost. Other less obvious costs might include installation, legalcosts, re-training of employees, redundancy payments associated with thediscontinuation of present employees and production set-up costs. Capitalinvestment decision makers must be careful that they have considered all the effectsof implementing a CI project.A number of irrelevant factors are often incorrectly included in the analysis ofproposed CIs. Examples include:

- sunk costs (costs already incurred which cannot now be changed, no matterwhat decision is made),

- future costs and revenues which would have accrued regardless of thecurrent CI decision,

- allocations of fixed costs (where the total cost to the organisation will notchange, even though the way it is allocated for reporting purposes may), and

- financing costs (already taken into account in the required rate of returnimposed on a CI proposal).

Again, asking the simple question: "Will these costs or revenues change as a resultof the decision made?" is usually enough to reveal their relevance (or irrelevance)to the decision. Remember though - it can be difficult to predict what might happenif the CI is not undertaken, so working out the changes caused by a project may notbe easy!

Once the information relevant to a CI decision is identified, financial viability is animportant factor in deciding whether or not to accept proposed investments in manyorganisations. However, there are many more organisations for which profit resultsand wealth generation are not of primary importance, but are merely means to anend. Such organisations include central and local Government bodies and not-for-profit organisations such as clubs, social services and charities. For theseorganisations, the financial viability of a CI may not be a relevant criterion inestablishing its desirability. Investment decisions may be based on criteria whichare difficult to quantify, thus making CI decision making an especially challenging

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task in these organisations.

Although making money is not the objective of many organisations, in someinstances financial analyses can be a helpful input to their CI decisions. Forexample, financial considerations may be relevant where more than one alternativeway of achieving a goal is identified and a choice must be made about which optionto pursue. Where financial analysis has utility, CI decision makers in all types oforganisations need to be aware of the range of decision support techniques availablefor considering financial aspects of investments.

In the next part of this chapter, this range of financial analysis techniques ispresented after looking at the different theoretical perspectives of the alternativeapproaches.

Financial Analysis of Capital Investment ProjectsThere are two main views of financial performance measurement which form thetheoretical underpinnings of CI analysis techniques: accounting concepts andeconomics or finance concepts.

Notions of stewardship and accountability, together with accounting concepts andconventions, have given financial accounting a particular ‘view of the world’. Froman accounting perspective, long-term financial success is measured by profitability,while short-term success places greater emphasis on liquidity.

These concerns of liquidity and profitability have formed the basis of two CIanalysis techniques: ‘payback period’ and ‘accounting rate of return’. Theseaccounting-based methods are popular in practice, especially among CI decisionmakers in small and medium sized firms, and are often referred to as ‘traditional’methods.

Economics and finance theory have introduced notions of financial successconcerned with the maximisation of shareholder wealth and the consideration ofrisk. As CI decision making is concerned with effective resource allocation, itfollows that successful CI projects are those which add to the value of the firm, thusincreasing shareholder wealth. Following from this, a CI is acceptable if itsexpected cash returns exceed its expected cash costs, so liquidity (the timing ofthese cashflows) and profitability (determined for the financial reporting of thesecashflows) become less important.

The combination of assumed wealth maximisation objectives and riskconsiderations has led to the development of CI analysis techniques quite differentfrom the ‘traditional’ accounting-based methods. These techniques are the ‘netpresent value’, ‘profitability index’, ‘internal rate of return’ and ‘discountedpayback period’ approaches.

How each of the alternative analysis techniques is used, and the strengths andweaknesses of each approach will now be discussed.

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Accounting ConceptsPaybackPeriod

Payback period (PP) is concerned with liquidity. It is a short-term oriented methodwhich asks, "How soon will the CI project pay itself back?" The faster a CI projectcan recoup its initial cost, the better. Payback period focuses on the cashflows froma CI project, and the speed at which they are received, rather than on any measureof profitability or overall return.

Decision makers using the PP criterion must decide on an acceptable PP timehorizon as a yardstick for assessing CI proposals. The greater the liquidity needs ofthe investor, the shorter may be the acceptable PP time period. The selection of aPP ‘cut-off point’ is therefore arbitrary.

Example Calculating Payback Period

A firm is considering investing in a new computer system. The cost of purchasingand installing the system is $6,000. The expected cost savings associated with thecomputer system will improve as staff become more familiar with using it. Thepattern of expected cash benefits is:

Year Cashflow($)

Cumulative Cashflow ($)

12345678

500800

1,0001,2001,5002,0002,0002,000

5001,3002,3003,5005,0007,0009,000

11,000

From the cumulative cashflows, we can see that the computer system’s paybackperiod is between five and six years. If we assume that cashflows accrue evenlythroughout the year, then the payback period is 5.5 years. Should the firm purchasethe computer system? The answer depends on the PP criterion they use. If the firmhas established a cut-off point of four years, then they would not purchase thecomputer system. If, however, their cut-off was six years, then the computer systemis acceptable.

The PP analysis method has two major deficiencies. First, it ignores any cashflowswhich occur after the project’s payback period. The benefits accruing from thecomputer system in the previous example in years seven and eight could have been

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enormous, yet the PP calculation would have taken no account of them. Thisdeficiency reflects the short-term orientation of the PP technique. Therefore, theuse of PP as a decision making tool penalises those projects with inherently longlives and promotes projects which produce rapid returns, even though those returnsmay be modest and short-lived.

The second major deficiency of the PP technique is that it ignores the time value ofmoney. A modified version of the PP analysis method, called ‘Discounted PaybackPeriod’ (DPP) has been proposed as a means of overcoming this problem, and willbe discussed later in this chapter.

Despite its deficiencies, payback period is often used in practice. PP analysis maybe useful as a first screening device where an organisation is concerned withliquidity. However, PP should not be used as the sole basis for CI decisions, if theintention is to maximise shareholder wealth.

AccountingRate ofReturn

The second of the accounting-based CI analysis methods is the accounting rate ofreturn (AROR). This method compares a CI project’s ‘profitability’ to the capitalemployed in the investment. One of the difficulties of this method is that there areseveral ways of representing ‘profit’ and ‘capital employed’. Alternative profitmeasures can include or omit financing expenses, depreciation and tax. ‘Capitalemployed’ can be either initial capital (i.e. the historic cost of the organisation’sassets) or average capital employed.

However, the most common definition of AROR uses the ‘earnings before interestand tax’ (EBIT) profit figure (which includes the effects of depreciation), and theaverage capital employed. The ‘average capital employed’ concept requires that weknow how much is invested in an asset at the beginning and end of its useful life.This investment comprises both the value of the asset itself, and the value of anyworking capital which is held in association with this asset (often this workingcapital component is constant over the asset’s life). The concept of ‘capitalemployed’ is illustrated in Exhibit 18.2.

Exhibit 18.2 The Capital Employed over the Life of an Investment

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wc + pp

wc + sv

wc

$ invested

year nTime

Where:

wc = working capital employedsv = salvage valuepp = purchase pricen = the life of the investment

Using this approach, the formula for AROR is given below:

ARORaverage annual accounting profit

average capital employed

i.e ( annual EBITS) n years

(initial outlay residual value) 2

=

÷+ ÷

Σ

Where initial outlay = pp + wcand residual value = sv + wc

Example Calculation of AROR

An asset costs $12,000 to purchase, and has an expected life of five years with asalvage value of $2,000. Additional inventories costing $1,000 are required at thetime the asset is commissioned, but can be liquidated for $1,000 at the end of theasset’s life. It is estimated that the asset will increase annual revenues by $5,000,although it will create a straight-line annual depreciation expense of $2,000.

What is the asset’s AROR?

The annual pre-tax profit generated by this asset is ($5,000 - $2,000) = $3,000 for

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each of its five years of life. So:

Average capital employed:= (Initial capital + terminal capital) ) 2= [$13,000 + ($2,000 + $1,000)] ) 2= ($13,000 + $3.000) ) 2= $8,000

AROR:= $3,000 ) $8,000= 0.375 or 37.5%

Like the payback period method, AROR is not without substantial flaws. Thismethod uses accounting profit, rather than cashflows, as a measure of return on aninvestment. Inconsistencies in the derivation of profit figures (perhaps due tochanging accounting policies) can produce widely differing AROR results. Also,accounting profits suffer from ‘distortions’ such as depreciation expenses and gainsand losses on the sale of fixed assets. Although these items feature in thedetermination of ‘profit’, they do not result in the actual payment or receipt of cashby the organisation. And, since they are not actual cashflows, they have no impacton the wealth of the investors.

The second major flaw of the AROR method is shared with the PP method - it doesnot take account of the time value of money. The return on a CI is deemed to be itsaverage accounting profits, even though these profits occur in different time periodsand may change from year to year .

However, AROR is frequently used in practice as a CI decision support technique.It may be that some CI decision makers prefer to analyse investments using a profit-based measure. Often such an approach is consistent with the profit performancemeasures to which managers are themselves subjected. Whatever the reason for itsuse, the AROR approach is inappropriate for those organisations seeking tomaximise shareholder wealth.

So, it can be seen that the two main ‘traditional’ analysis methods are not ideal.Although both are used in practice, they have serious shortcomings, and can lead toincorrect CI decisions. These techniques have largely fallen from favour in thenormative CI literature, and have been replaced with the ‘sophisticated’ techniqueswhich find their roots in economic theory.

Economics and Finance ConceptsThe NetPresentValueMethod

The net present value (NPV) analysis method discounts all future cashflows from aCI back to their present value, and compares them with the present value ‘cost’ ofentering into the investment. Hence, the ‘net’ present value is the differencebetween the present values of the investment’s inflows and outflows.

The decision criterion used in conjunction with the NPV method is the same for all

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investments and all organisations: if the NPV is positive (i.e. greater than zero),then the investment should be accepted. Conversely, if the NPV is negative theinvestment should be rejected. A positive NPV indicates that an addition to thewealth of the investors is expected. Theoretically, a decision maker would beindifferent about a CI with a NPV of exactly zero. However, intuitively, a zeroincrease in wealth is usually insufficient reward for the effort of pursuing theinvestment, and so a zero NPV project would rarely be attractive.

In order to use the NPV analysis method, there are several inputs which must bedetermined. Broadly the required information includes:

- the CI’s required initial outlay,- the relevant future cash flows associated with the CI,- the anticipated life of the CI, and- the appropriate discount rate to be used.

As noted earlier, determining the initial outlay and future cashflows associated witha CI is rarely straight-forward. Similarly, uncertain effects such as wear and tear,obsolescence and changes in the activities of the organisation can render asset lifeestimates incorrect. Perhaps the most problematic input is the determination of anappropriate risk-adjusted discount rate - the choice of discount rate is crucial to theoutcome of the NPV analysis.

Example Calculating Net Present Value (NPV)Vehicle Purchase Proposal

Porter Co. is considering purchasing a delivery vehicle at a cost of $16,000. Anemployee will be trained to obtain a Heavy Transport Licence at a cost of $100. Vehicle running costs are estimated at $3,000 p.a., but Porter Co.will save $7,000p.a. in contract delivery charges. The vehicle will have a useful life of six years, tobe sold for $3,000 at the end of year six. Porter Co. requires a 12% rate of returnon this type of investment (tax and depreciation are ignored until later in thischapter).

Detailing the relevant cashflows using a ‘time-line’:

Cashflows($00s)

Time 0(now)

Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6

Purchase priceHTL trainingRunning costsSavings on delivery costs

-160-1 -30

+70

-30

+70

-30

+70

-30

+70

-30

+70

-30

+70

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Sale of vehicle +30Total annual cashflows -161 +40 +40 +40 +40 +40 +70

All initial outlay costs are said to occur in ‘time 0’ - i.e. now. Note that runningcosts and savings on delivery contract charges are annuities continuing for the lifeof the investment. Note also the implicit assumption that cashflows occur at the endof each year. For example, the first year’s running costs are assumed to occur inone year’s time, and will be discounted by one year to obtain their present value. This assumption facilitates simple illustrations, and in practice, where it is difficultto ascertain the exact timing of cashflows, such simplifying assumptions may beused.

Finding the vehicle’s NPV:

NPV = -$16,100 + (PV of an annuity of $4,000 for 6 yrs @ 12%) + (PV of a sum of $3,000 received in 6 years’ time, at 12%)

= -$16,100 + ($4,000 x 4.1114) + ($3,000 x 0.5066)= -$16,100 + $16,446 + $1,520= + $1,866

So, the vehicle purchase opportunity has a positive NPV, and should be accepted.

A Variationon NPV -ProfitabilityIndex

The Profitability Index (PI) measure uses exactly the same discounted cashflowinformation as the NPV method. However, instead of finding the differencebetween initial outlay and the present value of future cashflows, the PI approachfinds the ratio of these two values. A generalised formula for PI is:

Σ PVs of future cash flowsPI = Initial Outlay

For example, if we calculated the PI of the delivery vehicle proposal in the previousexample, it would be:

$17,966PI = $16,100

= 1.116

A PI of greater than 1 indicates an acceptable project, while a project with a PI lessthan 1 should be rejected. The PI approach will always produce the same accept orreject decision as the NPV approach, as it is simply a re-ordering of the sameinformation. However, PI has advantages over NPV where a firm is subject tocapital rationing, as will be noted later.

Internal Rateof Return

Internal rate of return (IRR) is another major CI analysis method derived from thetheoretical perspective of economics. The IRR approach focuses on finding thediscount rate at which the NPV of a project would be zero. That is, the ‘IRR’ is the

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rate of return earned by the project itself, and equates the present value of futurecashflows to the initial outlay. Simple examples illustrate this approach.

Example IRR Calculations

1. Simple returns:You invest $1,000, and at the end of the year you receive an interest cheque for$120. The IRR of this investment is easily found:

IRR =

=

$120$1,00012%

2. Compound returns:You invest $1000 in Municorp. shares. After holding these shares for fouryears, you sell them and receive $1,810.60. The IRR of this investment can befound by solving the following equation:

FV PV IRR

IRR

IRR

($1, . ) ($1,000) ( )

$1, . $1,000 ( )

. ( )

810 60 1

810 60 1

18106 1

4

4

4

= × +÷ = +

= +

At this point there are two choices: you can consult a table of compound interestfactors to find the four year rate which has a factor of 1.8106 (16%), or you cansolve the equation algebraically:

1.8106 (1 IRR)(1 IRR) 1.16

IRR 16%

4 = ++ =

=

In practice, finding the IRR of a project involves complex calculations. Now thatcomputers are widely available, IRRs can be automatically computed for a series ofcashflows. However, it aids our understanding of how IRR works to consider a‘trial and error’ approach to finding the IRR of a CI project. Let us reconsider thedelivery vehicle purchase example. We can restate the problem in terms of theIRR. To find the IRR, we set the NPV at zero and solve for the discount rate, thatis:

0 = -$16,100 + (PV of an annuity of $4,000 for 6 yrs @ IRR%) + (PV of a sum of $3,000 received in 6 years’ time, at IRR%)

Without the help of a computer, there is no quick way to solve this equation. Thesimplest manual approach is to repeatedly guess at the IRR until answers areobtained which are close to the required zero. Once we have obtained a discountrate which produces a slightly positive NPV, and a discount rate which produces a

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slightly negative NPV, then we can use linear interpolation between the two pointsto find an estimate of the IRR which will give an NPV of zero.

Example Finding a Project’s IRR by Interpolation(Based on example of vehicle purchase proposal)

The IRR of the vehicle purchase opportunity is the discount rate at which the NPVequals zero, i.e.:

0 = -$16,100 + (PV of an annuity of $4,000 for 6 yrs @ IRR%) + (PV of a sum of $3,000 received in 6 years’ time, at IRR%)

The NPV of this project has already been calculated at 12% as +$1,866. Since thisresult is positive, raising the discount rate will reduce the NPV. Re-calculating theNPV using a 16% discount rate:

NPV = -$16,100 + (PV of an annuity of $4,000 for 6 yrs @ 16%) + (PV of a sum of $3,000 received in 6 years’ time, at 16%)

= -$16,100 + ($4,000 x 3.6847) + ($3,000 x 0.4014)= -$16,100 + $14,739 + $1,204= -$157

With one positive NPV result and one negative NPV result, linear interpolation isused to estimate the IRR. This can be represented graphically:

NPV

+$1866

-$15712%

16%Discount rate

The IRR (NPV = 0)

Interpolation is based on the trigonometric relationship that:

(i) the distances between the two observed NPVs and the zero NPV point

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(i.e. $1866 and $157), and(ii) the distances between the two trial discount rates and the IRR

have the same ratio.

Interpolating between the 12% and 16% results we find that:

IRR = 12% + 1866

1866 - (-157) (16% - 12%)

= 12% + (0.922 4%)= 15.69%

×

×

The IRR of 15.69% is much closer to 16% than to 12%, and this was obvious fromthe NPV results. The 12% calculation produced an answer that deviated by $1866from the desired zero point, while the 16% answer was only $157 off target.

It should be noted that linear interpolation provides only an estimate of IRR.‘Linear’ interpolation assumes that the relationship between the two data points isthat of a straight line. This is rarely true. So, the closer are the two discount ratesused, the more accurate will be the answer, as a straight line will better approximatethe relationship over a shorter distance.

It can be seen that the IRR method, while using the same cashflow information asthe NPV method, presents a percentage return on the investment, rather thanmeasuring the investment’s net contribution to wealth. Research evidence suggeststhat many practitioners favour the percentage expression of IRR (Pike, 1982).However, it is thought that this preference is due to the mistaken belief that usingIRR removes the need to determine a discount rate. Of course, when consideringthe acceptability of a CI project, its IRR must be compared to some pre-determinedrequired rate of return. So, even using IRR, the need to work out an appropriatediscount rate is not escaped!

There are also some weaknesses associated with IRR, arising both from itsmathematical formulation, and from the model’s inherent assumptions. The IRRequation requires that a polynomial root (or solution) can be found which makes theNPV equal to zero. However, there are cases where a series of cashflows has noroot, or multiple roots, as demonstrated in the following examples:

Example Cashflows with No IRR Solution

Time 0 Yr 1 Yr 2

Cashflow +$1000 -$3000 $2500

Because of the opposite signs of the cashflows in Yr 1 and Yr 2, there is nodiscount rate which will produce a zero NPV for this series of cashflows.

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Example Cashflows with Multiple IRR Solutions

Time 0 Yr 1 Yr 2

Cashflow -$4000 +$25000 -$25000

This set of cashflows has IRR solutions at 25% and 400%, and would produce apositive NPV at any discount rate between these two values.

In such cases, the use of IRR as a decision-support tool is problematic. Which IRRis the correct one? A necessary (but not sufficient) condition for multiple IRRsolutions is that there is more than one change in the sign of the cashflows. Typically, we see an initial cash outflow followed by a series of inflows over the lifeof the CI. However, where there are further changes in the sign of the cashflows,the multiple solution problem can occur. The possibility of multiple IRRs makesthis method less attractive as a CI analysis tool.

The second main problem with the IRR approach is that it can produce rankings ofCI projects which conflict with those obtained using NPV. This becomes aproblem where a firm must select between mutually exclusive CI projects, asillustrated in the following example.

Example Conflicting Project Rankings Using IRR and NPV

Ratima Co. owns a factory. The company is considering investing in modificationsto that factory, and must choose between two options with the following cashflows:

(i) spend $40,000 now and receive $58,000 in 3 years’ time, or(ii) spend $40,000 now and receive $46,000 in 1 year’s time.

This factory modification is a one-off expenditure for Ratima Co. and no furtherinvestment opportunities are expected for at least four years. Ratima Co. has arequired rate of return of 10%.

Calculating the NPV and IRR of these two options we get:

Project NPV(@10%) IRR(i) + $3,576 13.19%(ii) + $1,818 15.00%

Therefore, using the NPV rule we would accept option (i) as it has the greater NPV.However, using the IRR rule (where both options exceed the RRR), we would beinclined to select option (ii) as it has the greater IRR.

The different rankings result from the differing assumptions of the NPV and IRRapproaches, in this case best referred to as ‘opportunity cost’ assumptions. IfProject (i) is foregone, the investor forfeits a return (for three years) of 13.19%. If

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Project (ii) is forgone, the investor forfeits a return (for one year) of 15%. Whilethe IRR of project (ii) appears more appealing, the NPV shows that on aninvestment of $40,000, a 15% return for one year is worth less than a 13.19% returnfor three years.

It is not appropriate to use the IRR approach for ranking mutually exclusiveprojects. Clearly project (i) should be accepted, as it will make the largercontribution to the wealth of the investor. Reliance on the IRR rankings wouldlead to an incorrect decision in this instance.

The re-investment assumption of the IRR model causes problems where cashflowsaccrue over the life of an investment. The IRR model assumes that all cashflowsproduced by a CI can be re-invested at the IRR. This is often unrealistic. If aproject has an IRR of 20%, but market rates for investment are only 14%, then wecannot expect to re-invest cashflows arising from the CI at the 20% rate. So, theIRR method has overstated the return which will realistically be generated by theCI. Using NPV no such assumption is required, as it is possible to vary discountrates to reflect changing investment possibilities over the life of the project. Hereagain, NPV is preferred over the IRR method.

DiscountedPaybackPeriod

When the payback period (PP) method was considered earlier, it was noted that avariation called the discounted payback period (DPP) improved this approach. TheDPP approach has all the perceived advantages of PP - it is easy to understand andcompute, and it allows the investor to focus on liquidity where this is appropriate.But, unlike PP, DPP takes into account the time value of money. Therefore, theDPP approach is a useful step towards the theoretically superior method of NPV,particularly for smaller business managers who find the PP approach attractive.

The DPP method discounts each year’s net cash flow by the appropriate discountrate and determines the number of years it takes for these discounted cashflows torecoup the CI’s initial outlay. Because DPP recognises the time value of money, itproduces a longer payback period than does the non-discounted PP approach, andtakes into account more of the CI’s cashflows.

Another advantage of DPP over the traditional PP method is that it has a clear‘accept or reject’ criterion. Using DPP, a project is acceptable if it pays back withinits lifetime. An example illustrates the difference between the PP and DPPapproaches.

Example Payback Period v. Discounted Payback Period

An investment, with an initial outlay of $20,000, produces net cash inflows of$7,000 p.a. for six years.

Year Net Cashflow Present Value Cumulative Present Value($) (@15%) ($)

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0 -20,000 -20,000 -20,0001 +7,000 +6,087 -13,9132 +7,000 +5,293 -8,6203 +7,000 +4,603 -4,0174 +7,000 +4,002 -155 +7,000 +3,480 +3,4656 +7,000 +3,026 +6,491

Would this investment be accepted?

Using the PP method:The PP is just under three years ($20,000 ÷ $7,000). Acceptance depends onthe chosen cut-off time: if cut-off is two years, would reject, if three years wouldaccept.

Using the DPP method:The discounted payback period is just over four years. The investment wouldbe accepted, as it pays back within its six year lifetime.

Discounted payback period still does share one limitation with PP - cashflowswhich occur after the payback period are ignored. However, since the DPP isalways longer than the PP, the DPP method ignores fewer of these cashflows. DPPalso conveys a sense of liquidity measurement which is not achieved using the NPVmethod. Since PP is often the only CI analysis undertaken in smaller businesses,switching to DPP is a step in the right direction for many CI decision makers.

The Winner-NPV

Financial analysis techniques do not provide all the answers in CI decision making. Organisations may have objectives which cannot be reflected in quantitativefinancial analyses. However, where it is relevant to consider the financialperformance of a CI, there are several reasons why NPV provides the best meansfor doing so.

Payback period is a useful first screening device, and AROR has some strength infacilitating comparison of CI outcomes with profit performance measures. But,only the discounted cashflow methods focus, as the name suggests, on cash (thesource of wealth) and the time value of money (the value of that cash).

NPV has none of the computational problems of IRR, and a combination of NPVand PI can tell us both the value of the CI, and the significance of that returnrelative to the size of the investment (which is useful when limited funds areavailable for investment). The NPV also allows for additivity of CI values, whereasIRRs cannot be added to achieve a sense of the total return to the organisation.

So, IRR can work, (but sometimes doesn’t and is complex), DPP is a step in theright direction, and NPV is best! Since NPV is preferred, there are some issues thatmust be addressed to ensure that it is used correctly.

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Issues in Using NPV CorrectlyThe Timingof Cashflows

A key aspect of using NPV is the recognition of the different timing of cashflowsfrom a CI project. In practice, cashflows may occur at any time throughout theyear, but for simplicity we assume that all cashflows occur at the end of the year.For example, if considering a CI investment on 1 January 1993, and the firstrunning cost is to be incurred in July 1993, we would assume that this running costcashflow occurs on 31 December 1993, and discount it by one year to find itspresent value. Such assumptions will, of course, slightly distort NPV results. Formajor projects where the amount of the cash flow is significant it is, of course,important to discount the cash flows by the exact number of days required.However, it should be recognised that NPV can only ever be a decision supporttool. It can never provide an exact answer, as many of the cashflows are themselvesuncertain and must be estimated. The effect of simplifying assumptions aboutcashflows usually has limited impact on the analysis.

Taxation Up until now the effects of taxation have been ignored, for simplicity. However, inreality, tax has a significant impact on the cashflows of CIs. Where cashflows froma CI change the amount of tax payable, then this is itself a real cashflow effect.There are a number of ways in which these tax effects occur:

- when revenues (or reduced costs) from a CI increase profit,- when costs (or reduced revenues) of a CI decrease profit,- when a gain or loss is made on the sale of a fixed asset,- when a CI is depreciated or written down, and- when special taxation relief is provided as an investment incentive.

Tax Effects on Costs and RevenuesThe first of these taxation effects is perhaps the most obvious. It is unrealistic toconsider only pre-tax cash revenues from a CI, as revenues which change reportedprofits also change tax liabilities, and produce taxation cashflows. It is importantalso to consider the timing of these tax cashflows. Most businesses pay tax one yearafter the end of each financial year. So for example, a cost or revenue which occursin three years’ time will normally produce a taxation effect in four years’ time,assuming (for simplicity) that all cashflows occur at the end of the year.

Example Tax Effect on CI Costs and Revenues

Hall Co. is considering purchasing a new packaging machine. The machine willcost $52,000, plus installation costs will be $4,000. A $2,000 increase in inventorywill be required, which can be liquidated for $2,000 at the end of the machine’s 5year life. The machine is expected to cost $26,000 per year to run, but will reducepackaging costs by an estimated $60,000 per year. It will have a zero salvage valuein five years’ time. Hall Co.is subject to a 35% tax rate.

Calculating tax cashflows:

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Only the increased costs and revenues appear in the income statement, affectingprofit and therefore tax. Both the asset price and installation cost are capitalised tothe asset account, and the increased inventory is a current asset rather than anexpense.

The relevant cashflows are:

Cashflows Time 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6($000s)

Purchase price -52Installation -4Inventory -2 +2Running Costs -26 -26 -26 -26 -26Cost Savings +60 +60 +60 +60 +60Increased tax* -11.9 -11.9 -11.9 -11.9 -11.9

TOTALS -58 +34 +22.1 +22.1 +22.1 +24.1 -11.9

* the tax effect is calculated as: (increase in profit) x (tax rate) = ($60,000 - $26,000) x 0.35 = $11,900

and as profit has increased, so will the tax liability, producing a cash outflow,assumed to occur one year after the costs and revenues themselves.

Gains or Losses on Asset SalesIf a CI project involves the sale of a currently held asset, further taxation effects canoccur. If the selling price differs from the asset’s net book value then a gain or losson sale occurs. Although not actual cashflows in themselves, gains will increaseprofit thus increasing tax, and losses will decrease profit and reduce tax payable.Again, it is normally assumed that such tax effects produce cashflows one year afterthe sale of the asset, when the tax liability is payable.

Example Tax Effects from the Sale of an Asset

Angle Co. is considering replacing an old forklift purchased six years ago for$50,000 with an estimated useful life of ten years. It has been depreciated on astraight-line basis to a salvage value of $10,000. Angle Co. has a 35% tax rate.

Calculating the net book value of the forklift:

Book value Original Purchase Price accumulated depreciation

$50,000 6$50,000 $10,000

10$26,000

= −

= − × −

=

- .


Selling price scenarios:(i) The old forklift is sold for $30,000 (cash received now):

Gain on sale = ($30,000 - $26,000)= $4,000

⇒ Tax payable = $4,000 x 0.35= $1,400 (payable in 1 year’s time)

(ii) The old forklift is sold for $15,000 (cash received now):

Loss on sale = ($26,000 - $15,000) = $11,000⇒ Tax break received = $11,000 x 0.35 = $3,850 (received in 1 year’s time)

When the sale of an existing asset forms part of a CI proposal, both the cashreceived for the asset (i.e. its selling price) and the taxation implications of any gainor loss on sale must be taken into account in analysing the cashflows.

Depreciation Although the purchase price of a CI is incurred at the outset of the investment,financial accounting practice is to spread this initial cost over the life of an asset viadepreciation. When conducting NPV analysis, depreciation itself is meaningless.The initial cash outlay occurs when the asset is purchased in ‘time 0’, and theaccounting treatment of the asset does not change that. However, as an asset isdepreciated over its life, that depreciation is recognised as an expense in the incomestatement each year, thus reducing profit. And as we know, a reduction in profit,though looking bad from an accounting point of view, is good from a cashflowperspective as it means less tax!

Different countries have different ways of allowing asset depreciation for taxationpurposes. Some countries (like the UK) use ‘writing down allowances’ which areestablished at a fixed rate. Other countries (including New Zealand) prescribeallowable depreciation rates which a business can use to expense different assets inthe income statement. The following example shows an illustration of howdepreciation allowances affect taxation cashflows.

Example Depreciation and Taxation Cashflows

An asset is purchased by Taylor Co. for $100,000, and has a useful life of fouryears. It is subject to a depreciation allowance of 25% on its diminishing value.Taylor Co. is subject to a 35% tax rate.

Depreciation allowances:Tax effect (cash inflow)

1st year $100,000 x 0.25 = $25,000 $25,000 x 0.35 = $8,7502nd year $75,000 x 0.25 = $18,750 $18,750 x 0.35 = $6,5633rd year $56,250 x 0.25 = $14,063 $14,063 x 0.35 = $4,922

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4th year $42,187 x 0.25 = $10,547 $10,547 x 0.35 = $3,691

The taxation cashflows resulting from the depreciation allowances would normallyoccur one year after the depreciation expense is recognised. So, if the firstdepreciation allowance occurs at the end of the first year of the asset’s life, thetiming of the taxation cashflows would be as follows:

Time 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5

Cashflows:Initial outlay -$100,000

Depn tax effects - +$8,750 +$6,563 +$4,922 +$3,691

It is important to remember that if a CI project replaces an existing asset, then onlythe change in depreciation is relevant to the NPV analysis. For example, if anexisting asset depreciated at $3,000 per year, is to be replaced with a new assethaving annual depreciation of $5,000, then only the increase in depreciation of$2,000 per year is relevant to calculating taxation effects.

The taxation cashflows resulting from depreciation allowances can have asignificant impact on the NPV of a CI project. Therefore, it is important to identifyany changes in depreciation allowances so that the amount and timing of taxpayments can be correctly incorporated into the NPV analysis.

TaxationInvestmentIncentives

Sometimes Governments make special taxation provisions to encourage investmentin particular types of capital assets. In these cases, depreciation allowances may beaccelerated, or there may be special ‘one-off’ tax credits in the year of the asset’spurchase. It is in the interests of the CI decision maker to be aware of suchincentives, as they could impact on the viability of a CI project.

TaxationEffects -Summary

Taxation affects the NPV of a CI by changing its cashflows. This occurs becausereal cash effects of a CI (e.g. revenues and costs) and the accounting treatment ofCI effects (e.g. gains and losses on asset sale and depreciation) all impact onreported profit and therefore change tax liabilities. A CI proposal cannot becorrectly analysed without taking these taxation issues into account.

Inflation Inflation affects the value of cashflows by eroding their purchasing power. Investorswant to be compensated for this reduced purchasing power of future cashflows, soinflation is built into the discount rate used in NPV analyses.

A rate of return which includes an inflation component is a nominal rate. The realrate of return removes the inflation component. It is important to distinguishbetween real and nominal rates of return when discounting cashflows for NPVanalysis. Both the rate and the cashflows used must be consistent. Therefore, if a

- .


nominal rate of return is used as the discount rate, then it should be recognised thatinflation will increase the nominal size of the cashflows over the life of the CI.Alternatively, if cashflows are assumed to stay constant over the life of the asset,then a real rate of return should be used. It is a common mistake to use inconsistentcombinations of rates of return and cashflows, resulting in incorrect NPV analyses. If done properly, both approaches will provide the same result.

CapitalRationing

It has been assumed up to this point that a firm will have sufficient funds availableto invest in any available project which has a positive NPV. However, due toexternally imposed restrictions, (e.g. hard capital rationing) or internally imposedbudgets (e.g. soft capital rationing) there may be only limited funds available to thefirm for investment. Where this is the case, a choice must be made betweenpositive NPV projects.

Here, the profitability index (PI) is more useful than NPV. While NPV shows thevalue of an investment, PI expresses that value as a proportion of the initial outlayfunds required. Therefore, where funds are scarce, a higher PI project would bepreferred as it returns more per scarce dollar than a project with a lower PI.

A more sophisticated approach to selecting CI projects under conditions of singleor multi period capital rationing is the use of Linear Programming (LP). Linearprogramming is a (usually) computerised mathematical technique. It calculates‘optimal’ solutions where an objective (e.g. maximising NPV) is pursued underconstrained conditions (e.g. capital rationing), and can in its more sophisticatedforms, cope with probabilistic outcomes, multiple objectives and multipleconstraints. Linear programming is also useful where minimum liquidity andprofitability constraints must be met by a CI investment programme.

Using NPV - Summary‘Real world’ complications make the financial analysis of CI projects difficult.However, once the impact of these factors is assessed the NPV analysis method(together with PI) can accommodate the effects of tax, depreciation and inflationand lead to correct decision making where mutually exclusive projects exist. Aswith most financial decision making, the hard part is predicting what the futureholds, but no CI analysis method alone can address this problem!

A comprehensive example to draw together the issues discussed, and to illustratehow to conduct an NPV analysis on a CI proposal, may now be helpful.

Using NPV - An Extended ExampleIn this example, there are two machines: an existing machine, and a new machinewhich could be purchased as a replacement. In approaching the information, it ishelpful to consider a CI project as having three types of cashflows:

1. Initial outlay (occurring in Year 0 - now)

- .


2. Annual incremental cashflows (occurring over the life of the investment), and3. Terminal cashflows (occurring at the end of the investment’s life).

Constructing a time-line of the cashflows from an examination of the informationabout the CI proposal assists in discounting these cashflows in order to find theproject’s NPV. The construction of a time-line makes the analysis easier to follow.

Information on the CI proposal to replace an existing machine:

Old machine New machinePurchase price $200,000 $320,000Expected useful life 8 years 5 yearsCurrent age 3 years not applicableExpected salvage value $ 0 $20,000Depreciation straight-line straight-linePre-tax annual revenue generated $80,000 $180,000Pre-tax annual running costs $20,000 $20,000Inventory required $15,000 $25,000Current resale value $100,000 not applicable

Note that inventory can be sold at the end of the assets’ lives for its current value.

Tax rate 30%Discount rate 10% (real, ie no inflation considered)Timing of tax payments 1 year after the current operating yearCost of rent for the machine site $27,000 p.a.

Identifying the relevant cashflows:

1. Initial outlay (Year 0):Purchase of new machine ($320,000)Required increase in inventories (10,000)Sale of old machine* 100,000INITIAL OUTLAY (cash outflow) ($230,000)

*Tax effect from sale of old machine:Current book value = Historic cost - accumulated depreciation

= $200,000 - [ 3 x (200,000 - 0)/8 ]= $200,000 - $75,000= $125,000

Loss on sale = Book value - selling price= $125,000 - $100,000= $25,000

Tax break = loss on sale x tax rate= $25,000 x 0.30

= $7,500 (cash inflow one year after sale of machine)

- .


2. Annual incremental cashflows:

Pre-tax increase in profit = (increase in revenues - increase inrunning cost)

= ($100,000 - 0)= $100,000 (cash inflow in years 1 to 5)

Tax on increased profits = increase in profits x tax rate= $100,000 x 0.30= $30,000 (cash outflow in years 2 to 6)

Depreciation tax shield = (new depreciation - old depreciation)x tax rate

= [ (320,000 - 20,000)/5 - (200,000 - 0)/8 ] x 0.30

= ($60,000 - $25,000) x 0.30= $10,500 (cash inflow in years 2 to 6)

Note that the cost of rent for the machine site is not included - it is irrelevant asit will not change if the new machine is purchased.

3. Terminal cashflows (Year 5):

Sale of new asset $20,000Liquidation of increased inventory $10,000TERMINAL CASHFLOW (cash inflow) $30,000

Time-line of cashflows (in $000):

Year 0 1 2 3 4 5 6

Initial outlay -230Tax: sale of old machine +7.5Increased profits +100 +100 +100 +100 +100Tax: increased profits -30 -30 -30 -30 -30Depn. tax shield +10.5 +10.5 +10.5 +10.5 +10.5Terminal cashflow +30

TOTALS -230 +107.5 +80.5 +80.5 +80.5 +110.5 -19.5

($)Discounted @ 10% -230000 +97727 +66529 +60481 +54983 +68612 -11007

(Σ) NPV = +$107,325

The opportunity to replace the old machine with a new machine has a substantial,positive NPV. This financial analysis result can now be used as part of theinformation (together with considerations such as strategy, market factors,technology etc.) to arrive at an investment decision.

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People Are Important Too!It is often forgotten that CI decision making is a human activity rather than anobjective, mechanical procedure. There are people behind the ‘process’. Capitalinvestment theory has tended to reflect an image of economically rational, profitmaximising decision makers with perfect knowledge and few emotions. Suchpeople can correctly use and interpret the sophisticated CI techniques proposed inthe literature, and will never make a bad decision simply because they are having abad day! A hopeful, but somewhat unrealistic scenario. Behavioural factors, bothat an individual and organisational level, impact on decision making practice. Thesefactors must be considered so that a complete, rich picture of CI decision makingcan be achieved.

For example, it is usually assumed that the results of NPV analyses are used as aneconomic input into CI decisions, reflecting projects’ financial viability.Alternatively, a positive NPV result may be seen as a political bargaining tool.Divisional managers who want to secure organisational resources (and politicalinfluence) for their own division might point to a positive NPV project as anexample of the lucrative investment opportunities available to that division. Then,not only are the analysis results assisting an economic decision, they are also beingused as ammunition in a resource bargaining situation which may produce apolitical advantage for the division manager. In such cases, there may be atemptation to make the NPV results look good, as a lack of attractive investmentopportunities would reflect poorly on a division’s future success. Which objectivethen takes precedence? This becomes a function of the organisational climate andof the individual decision maker’s preferences, and there may be no one rightanswer.

The main implication of this is that CI decision making practice cannot beunderstood without considering the organisational and political contexts withinwhich it occurs. CI decisions influence, and are influenced by, other aspects oforganisational activity. For example, there can be conflicts between ‘rational’ CIdecisions and performance evaluation systems. It is difficult in practice to ensurethat CI decision makers will aim to maximize shareholder’s wealth, unless they aresomehow motivated to do so. Therefore, performance evaluation systems need toreward behaviour which promotes the economic goals of the organisation. Thismeans that performance evaluation of CI decision makers should take a long-termorientation, and should focus on the criteria by which CI decisions are made (e.g.NPV) rather than accounting performance measures. Also, people should be heldresponsible for only those outcomes over which they have control. This can bedifficult where CI project implementation is removed from the initial decisionmakers, or where decisions are made by groups of people rather than individuals.

It is also important that the CI decision making activity be integrated with theorganisation’s strategic planning. Capital investment decisions are long-term,dictating major resource allocations which will affect the future direction andactivities of the organisation. Like other strategic decisions, CI decisions must beresponsive to the firm’s technology, goals and environment. These factors are oftenuncertain and difficult to incorporate within quantitative decision models. So, it is

- .


misleading (and potentially counter-productive) to focus only on the quantitativefinancial tools used in CI analysis. The strategic success of CI decision makingrequires a much broader focus.

When we look back at the model of the CI decision making process presentedearlier, it is clear that such a model can only be a simplistic representation ofpractice. The model has no iterative loops, no intervention of external or politicalfactors in the process, and no recognition of the un-programmed ‘chaos’ whichoften characterises decision making practice. This model does, however, provide astarting point for considering the factors which contribute to effective CI decisionmaking.

SummaryIn the overall scheme of the CI decision making activity, the information provider isboth master and servant. Servant, because information must be provided which isuseful to those people who are charged with making the CI decision. Master,because the information presented, and the way in which it is presented, cansignificantly shape the final decision! In the end, it is people who will take actionbased on the numbers. Both people and process are important, as both determinesuccess or failure in the CI decision making activity.

Glossary ofKey Terms

Discount Rate/Required Rate of ReturnThe rate that is applied to future cash flows to restate them in year zero dollars.

Discounted Cash Flow (DCF)An approach to capital investment decision making that expresses future cash flowsin current dollar values. The two most common forms of DCF are Internal Rate ofReturn and Net Present Value.

Internal Rate of Return (IRR)The discount rate that adjusts the sum of all cash flows associated with the analysisto zero.

Net Present Value (NPV)A method of evaluating future cash flows by adjusting the future dollars to year zerodollars via a discount rate.

Payback PeriodThe period required for future cash inflows to equal the initial cash investment.

Present ValueThe value in year zero dollars of a future cash flow.

Tax EffectThe reduction of revenue and expense items due to the tax rate, frequently used torefer to the effect of non cash items such as depreciation on the annual cash flows.

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References Bower, J.L., Managing the Resource Allocation Process: A study of CorporatePlanning and Investment, Richard D. Irwin Inc., Homewood, Illinois, 1970.

Fisher, I., The Theory of Interest, Macmillan, New York, 1930.

Haka, S.F., ‘Capital Budgeting Techniques and Firm Specific Contingencies: ACorrelational Analysis’, Accounting, Organizations and Society, Vol. 12(1), 1987,pp. 31-48.

Horngren, C.T. & Foster, G., Cost Accounting: A Managerial Emphasis, 6thEdition, Prentice-Hall Inc., Englewood Cliffs, New Jersey, 1987.

March, J.G. & Olsen, J.P., Ambiguity and Choice in Organizations, Bergen,Universitetsforlaget, 1976.

Mukherjee, T.K. & Henderson, G.V., ‘The Capital Budgeting Process: Theory andpractice’, Interfaces, Vol. 17 (2), March-April, 1987, pp. 78-90.

Northcott, D., Capital Investment Decision Making, Academic Press Ltd, London,1992.

Pike, R.H., Capital Budgeting in the 1980s: A Major Survey of the InvestmentPractices in Large Companies, The Chartered Institute of Management Accountants (CIMA), U.K., 1982.

SelectedReadings

Klammer, T.P. & Walker, M.C., ‘The continuing increase in the use ofsophisticated capital budgeting techniques’, California Management Review, 1984,pp. 135-148.

Patterson, C.S., ‘Investment decision criteria used by listed New Zealandcompanies’, Accounting and Finance, Vol. 29 (2), November, 1989, pp. 73-89.

Pike, R.H. & Wolfe, M.B., Capital Budgeting for the 1990s: A Review of CapitalInvestment Trends in Larger Companies, The Chartered Institute of ManagementAccountants (Occasional Paper Series), London, 1988.

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Questions

18.1Firm X is replacing an old machine. The new machine costs $120,000, will incur $500 installationcosts and will operate in a workshop which currently costs $1,500 per annum to rent. The old machinehas an original purchase price of $80,000 and a current book value of $40,000. However, Firm X cansell it for $65,000. The firm’s tax rate is 50% and tax is payable in the year that profits are reported.

Required:Assuming that Wooltrue Company has a tax rate of 50%, and that tax is payable in the year profits arereported, what is the ‘initial outlay’ involved in the purchase of the new machine?

18.2Wooltrue Company operates a knitting machine which cost $70,000 and has accumulated depreciationof $45,000. The company intends to replace this machine with a modern version costing $120,000plus $200 installation charge. With the new machine, wool inventories will have to be increased by$4,000, but an immediate overhaul planned for the old machine (at $2,500) will no longer be required.The old machine can instead be sold for $30,000.

Required:Assuming that Wooltrue Company has a tax rate of 50%, what is the ‘initial outlay’ involved in thepurchase of the new machine?

18.3Company Y intends to replace an old plant item. The old asset has an original purchase price of$1,700, with accumulated depreciation of $1,100, but can only be sold for $400. If the replacementplant item has a purchase price of $1,900, what is the total initial outlay in replacing the machine?(Company Y is taxed at 50%, payable in the year profits are reported.)

18.4A company purchases a new asset for $21,000 plus $250 installation costs. The expected useful life ofthis asset is five years, with a $2,000 maintenance programme in year three. It is estimated that theasset can be sold for $5,000 at the end of year five.

Expected after tax cash savings from use of the asset are $5,000 per annum for the five years. Theasset is to be depreciated at 20% straight line, and the company’s tax rate is 50%. Assume that tax ispayable in the same year that profits are reported.

Required:a. Construct a ‘time line’ of the cash flows associated with the purchase and operation of the new

machine.b. From your time line, what is the net present value of purchasing this asset, given a required rate of

return of 15%? Should the asset be purchased?

- .


18.5Define ‘payback period’.

18.6Using the payback period decision criterion, which of the following would be accepted, given apayback cutoff of four years?

Project Amount Invested Cash flows$ Yr 1 Yr 2 Yr 3 Yr 4 Yr 5

A 10,000 3,000 4,000 3,000 2,000 -B 17,000 1,000 1,000 2,000 5,000 35,000C 3,000 2,000 2,000 - - -

18.7Name two limitations of payback period as an investment decision criterion.

18.8Name two positive features of payback period as an investment decision criterion.

18.9Describe the accounting rate of return (AROR) technique.

18.10Calculate the AROR of project B:

Initial cost $10,000Expected salvage value $2,500 after 5 yearsCash flows per annum $3,000 for 5 yearsPre-tax accounting profits p.a. $2,800 for 5 yearsCompany taxation rate 48%

18.11Firm X uses AROR as an investment decision criterion, with a minimum acceptable rate of 25%. If aproposed investment has an initial outlay of $15,000, expected life of six years and salvage value of$400, what must be the TOTAL net profit before tax earned over the life of the asset to meet theAROR selection criterion? (The tax rate is 50%).

18.12What are the main disadvantages of Accounting Rate of Return as an investment decision criterion?

18.13

- .


Define ‘net present value’.

18.14Using a net present value (NPV) decision criterion, would you accept an investment project with anegative, positive or zero NPV?

18.15Calculate the NPV of the following investment, given a required rate of return of 22%:

Initial outlay $18,000Inflow year 1 $7,000Inflow year 2 $8,000Inflow year 3 $14,000Outflow year 4 $1,400

Would you advise the firm to accept this investment opportunity?

18.16A firm is considering the purchase of a new word processor system, at a cost of $4,000 plus $600installation costs. It is estimated that such a system will produce administrative cost savings of $600per annum (after tax and other effects taken into account) with an expected useful life of eight years.In addition, existing typewriters with a nil book value can be sold for $300. Depreciation on the newword processor system is allowable at a rate of 12.5% per annum straight line with an expected nilsalvage value. The firm’s tax rate is 50%. Assume that tax is payable in the same year that profits arereported.

Required:a. Using a six year maximum payback period criterion, would you advise the firm to purchase the

new system?b. Given a 20% AROR as a sole investment requirement, should the firm purchase the system?c. What is the NPV of this investment given a 20% required rate of return? Should it be accepted on

the basis of its NPV?

18.17What is the definition of ‘Internal Rate of Return’?

18.18a. Would you expect net present value, internal rate of return and profitability index to produce the

same ‘accept/reject’ decision in evaluating a potential investment project?b. Would you expect the three methods to produce the same rankings for acceptable projects?

18.19a. Calculate the IRR for a project having the following cash flows:

Initial outlay $7,860

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Inflow in year one $3,200Inflow in year two $4,600Terminal flow year four $1,500

b. If the firm had a required rate of return of 15%, would such a project be accepted (assuming thefirm had no other investment opportunities)?

18.20Consider two mutually exclusive investment opportunities, in a firm whose required rate of return is15%.

Project A:Initial outlay $21,696Cashflow yr 1 $12,000Cashflow yr 2 $10,000Cashflow yr 3 $8,000

Project B:Initial outlay $10,000Receive cashflow of 2,000 for the next 60 years

Required:a. What are the IRRs of projects A and B?b. What are the NPVs of projects A and B?c. What can you say about the project you would prefer to accept, given that both cannot be

accepted?

18.21What is a ‘sunk cost’? How should sunk costs be treated in the analysis of CI projects?

18.22Outline the main differences between the ‘accounting’ perspective on CI analysis, and the ‘economics’type approach. Comment on the relevance of these two perspectives for CI decision making.

18.23The managers of O’Flannigan Co. have traditionally used payback period and accounting rate ofreturn criteria for assessing CI projects. They consider a project to be acceptable if it pays backwithin four years, and has an AROR of at least 18%. The following information relates to a CIopportunity currently under consideration. O’Flannigan Co. is subject to a 30% taxation rate. Assume that tax is payable in the same year that profits are reported.

Year Net pre-tax cashflow Depreciation expenseproduced

0 -$20,000 nil1 +$10,000 $3,000

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2 +$8,000 $3,0003 +$7,000 $3,0004 +$3,000 $3,0005 +$2,000 $3,000

The project will have a salvage value of $1,000 at the end of year 5.

a. Calculate the project’s payback period.b. Calculate the project’s accounting rate of return.c. Would this project be acceptable to O’Flannigan Co?d. You suggest to the manager of O’Flannigan Co. that the discounted payback period method would

produce an improved analysis. On the basis of this criterion, (using a 14% required rate of return)would you recommend that the CI project be undertaken? Show your calculations.

18.24Yeo Fragrance Co. is considering signing a contract with an advertising agency to promote one of itsproducts, Scented Body Lotion. The advertising agency requires immediate payment of $6,000, plusan annual payment of $2,000 at the end of each of the next three years. The advertising agencypredicts that the Scented Body Lotion campaign will increase sales of this product by 3000 units perannum for the next three years (while the campaign continues). Also, long-term effects fromimproved consumer awareness are expected to produce increased sales of 2000 units per annum forthe following two years. Each unit of Scented Body Lotion sold contributes a positive cashflow of$1.50, and it is assumed that these cashflows accrue at the end of each year of sales. Yeo FragranceCo. has a 14% required rate of return for its cosmetic products, and is subject to a 30% taxation ratepayable one year after each financial period.

a. Calculate for the advertising campaign:b. Its payback periodc. Its discounted payback periodd. Its net present value, ande. Its profitability index.f. Would you recommend signing the advertising contract? Why or why not?g. What other uncertain factors might you wish to investigate before making such an investment

decision?

18.25The Arawa Meat Co. is required by new hygiene regulations to install stainless steel flooring in itsprocessing area. It is considering three options, all of which have an expected useful life of ten yearsin meeting required hygiene standards:

Option 1: Low grade flooring: Initial cost = $15,000Annual maintenance costs = $3,000Annual cleaning costs = $4,000

Option 2: Medium grade flooring: Initial cost = $18,000Annual maintenance costs = $2,000Annual cleaning costs = $2,000

Option 3: High grade flooring: Initial cost = $24,000

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Annual maintenance costs = $1,000Annual cleaning costs = $2,000

Using an NPV analysis with a 15% discount rate, which option would you recommend to the ArawaMeat Co? (Ignore taxation and depreciation.)

18.26Miller Industries Ltd. bought a lathe for $8,000 five years ago. The lathe has been subject to an annualdepreciation allowance of 25% on its diminishing value. If the lathe is now to be sold for $3,000 andthe company’s tax rate is 33%, what cashflows will be associated with the asset sale?

18.27Belcher Co. owns a disused machine which was purchased ten years ago for $45,000 and has a currentwritten-down value of $8,000. There are two options available for this machine:

1. it can be sold to a scrap merchant for $3,000 payable immediately, or2. it can be modified at an immediate cost of $14,000.

If the machine is modified, it is expected to become productive immediately and will generate a pre-tax cashflow of +$6,000 per annum for the next four years. The cost of modifying the machine wouldbe capitalised and added on to its current written-down value. Depreciation allowances of 25%(straight line) would then apply for the remaining four years of the modified machine’s life, at the endof which the machine would have zero resale value.

Belcher Co. is subject to a 35% taxation rate payable one year after each financial year, and uses arequired rate of return of 12%.

Required:a. Identify the relevant cashflows for each of the alternative machine options.b. Calculate the NPV of each option.c. What course of action would you recommend?

18.28You overhear a senior manager say to her management accountant:

"You’ll just have to take those numbers away and do them again. The boss really wantsto go ahead with this project, and he’s not going to appreciate me presenting him with afinancial analysis which indicates a no-go decision!"

Discuss the way(s) in which accounting information is being used in this situation.

18.29Suggest ways in which a performance evaluation system can incorporate the objectives of CI decisionmaking. Discuss approaches to, and problems of, measuring:a. The ‘effectiveness’ of CI decisions.b. The contribution of individual decision makers to these decisions.

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18.30Discuss the role of effective post audit.

18.31What do you think might be the practical difficulties of incorporating a strategic focus within CIdecision making?

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