Title of chapter 1

Capital Budgeting DecisionsChapter 13Copyright The McGraw-Hill Companies, Inc 2011Copyright The McGraw-Hill Companies, Inc 201113-#Chapter 13: Capital Budgeting Decisions.

The term capital budgeting is used to describe how managers plan significant cash outlays on projects that have long-term implications, such as the purchase of new equipment and the introduction of new products. This chapter describes several tools that can be used by managers to help make these types of investment decisions.

13-1Typical Capital Budgeting DecisionsPlant expansionEquipment selectionEquipment replacementLease or buyCost reductionCopyright The McGraw-Hill Companies, Inc 2011#Copyright The McGraw-Hill Companies, Inc 201113-#Capital budgeting analysis can be used for any decision that involves an outlay now in order to obtain some future return. Typical capital budgeting decisions include:Cost reduction decisions. Should new equipment be purchased to reduce costs?Expansion decisions. Should a new plant or warehouse be purchased to increase capacity and sales?Equipment selection decisions. Which of several available machines should be purchased? Lease or buy decisions. Should new equipment be leased or purchased?Equipment replacement decisions. Should old equipment be replaced now or later?

13-2Typical Capital Budgeting DecisionsCapital budgeting tends to fall into two broad categories . . .

Screening decisions. Does a proposed project meet some preset standard of acceptance?

Preference decisions. Selecting from among several competing courses of action. Copyright The McGraw-Hill Companies, Inc 201113-#There are two main types of capital budgeting decisions: Screening decisions relate to whether a proposed project passes a preset hurdle. For example, a company may have a policy of accepting projects only if they promise a return of 20% on the investment.

Preference decisions relate to selecting among several competing courses of action. For example, a company may be considering several different machines to replace an existing machine on the assembly line. In this chapter, we initially discuss ways of making screening decisions. Preference decisions are discussed toward the end of the chapter.

13-3Time Value of MoneyA dollar today is worth more than a dollar a year from now. Therefore, projects that promise earlier returns are preferable to those that promise later returns. The capital budgeting techniques that best recognize the time value of money are those that involve discounted cash flows.Copyright The McGraw-Hill Companies, Inc 201113-#The time value of money concept recognizes that a dollar today is worth more than a dollar a year from now. Therefore, projects that promise earlier returns are preferable to those that promise later returns.

13-4The Net Present Value MethodTo determine net present value we . . .Calculate the present value of cash inflows,Calculate the present value of cash outflows,Subtract the present value of the outflows from the present value of the inflows.Copyright The McGraw-Hill Companies, Inc 201113-#The net present value method compares the present value of a projects cash inflows with the present value of its cash outflows. The difference between these two streams of cash flows is called the net present value.

13-5

The Net Present Value MethodCopyright The McGraw-Hill Companies, Inc 201113-#The net present value is interpreted as follows:If the net present value is positive, then the project is acceptable.If the net present value is zero, then the project is acceptable.If the net present value is negative, then the project is not acceptable.

13-6The Net Present Value MethodNet present value analysis emphasizes cash flows and not accounting net income.The reason is that accounting net income is based on accruals that ignore the timing of cash flows into and out of an organization.

Copyright The McGraw-Hill Companies, Inc 2011#Copyright The McGraw-Hill Companies, Inc 201113-#Net present value analysis (as well as the internal rate of return, which will be discussed shortly) emphasizes cash flows and not accounting net income. The reason is that accounting net income is based on accruals that ignore the timing of cash flows into and out of an organization.

13-7Recovery of the Original InvestmentDepreciation is not deducted in computing the present value of a project because . . .It is not a current cash outflow.

Discounted cash flow methods automatically provide for a return of the original investment.Copyright The McGraw-Hill Companies, Inc 201113-#The net present value method excludes depreciation for two reasons:First, depreciation is not a current cash outflow.Second, discounted cash flow methods automatically provide for a return of the original investment, thereby making a deduction for depreciation unnecessary. 13-8Recovery of the Original InvestmentCarver Hospital is considering the purchase of an attachment for its X-ray machine.

No investments are to be made unless they have an annual return of at least 10%.

Will we be allowed to invest in the attachment?

Copyright The McGraw-Hill Companies, Inc 201113-#Assume the facts as shown with respect to Carver Hospital. Will we be allowed to invest in the attachment?

13-9

Present valueof an annuityof $1 tableRecovery of the Original InvestmentCopyright The McGraw-Hill Companies, Inc 2011#Copyright The McGraw-Hill Companies, Inc 201113-#The net present value of the investment is zero.

13-10Two Simplifying AssumptionsTwo simplifying assumptions are usually made in net present value analysis:All cash flows other than the initial investment occur at the end of periods.All cash flows generated by an investment project are immediately reinvested at a rate of return equal to the discount rate.

Copyright The McGraw-Hill Companies, Inc 2011#Copyright The McGraw-Hill Companies, Inc 201113-#Two simplifying assumptions are usually made in net present value analysis:The first assumption is that all cash flows other than the initial investment occur at the end of periods.The second assumption is that all cash flows generated by an investment project are immediately reinvested at a rate of return equal to the discount rate. 13-11Choosing a Discount RateThe firms cost of capital is usually regarded as the minimum required rate of return.

The cost of capital is the average rate of return the company must pay to its long-term creditors and stockholders for the use of their funds.Copyright The McGraw-Hill Companies, Inc 201113-#A companys cost of capital, which is defined as the average rate of return a company must pay to its long-term creditors and shareholders for the use of their funds, is usually regarded as the minimum required rate of return. When the cost of capital is used as the discount rate, it serves as a screening device in net present value analysis.

13-12Lester Company has been offered a five year contract to provide component parts for a large manufacturer.

The Net Present Value MethodAt the end of five years the working capital will be released and may be used elsewhere by Lester. Lester Company uses a discount rate of 10%.Should the contract be accepted?Copyright The McGraw-Hill Companies, Inc 201113-#Assume the information as shown with respect to Lester Company.

13-13Annual net cash inflow from operations

The Net Present Value Method

Copyright The McGraw-Hill Companies, Inc 201113-#The annual net cash inflow from operations of $80,000 is computed as shown.

13-14

Accept the contract because the project has a positive net present value.The Net Present Value MethodCopyright The McGraw-Hill Companies, Inc 2011#Copyright The McGraw-Hill Companies, Inc 201113-#The net present value of the investment opportunity is $85,955. Since the net present value is positive, it suggests making the investment. 13-15Internal Rate of Return MethodThe internal rate of return is the rate of return promised by an investment project over its useful life. It is computed by finding the discount rate that will cause the net present value of a project to be zero.

It works very well if a projects cash flows are identical every year. If the annual cash flows are not identical, a trial and error process must be used to find the internal rate of return.Copyright The McGraw-Hill Companies, Inc 201113-#The internal rate of return is the rate promised by an investment project over its useful life. It is sometimes referred to as the yield on a project.The internal rate of return is the discount rate that will result in a net present value of zero. The internal rate of return works very well if a projects cash flows are identical every year. If the cash flows are not identical every year, a trial-and-error process can be used to find the internal rate of return. 13-16Internal Rate of Return MethodGeneral decision rule . . .

When using the internal rate of return, the cost of capital acts as a hurdle rate that a project must clear for acceptance.Copyright The McGraw-Hill Companies, Inc 2011#Copyright The McGraw-Hill Companies, Inc 201113-#If the internal rate of return is equal to or greater than the minimum required rate of return, then the project is acceptable. If it is less than the required rate of return, then the project is rejected.When using internal rate of return, the cost of capital acts as a hurdle rate that a project must clear for acceptance. 13-17Internal Rate of Return MethodDecker Company can purchase a new machine at a cost of $104,320 that will save $20,000 per year in cash operating costs. The machine has a 10-year life.

Copyright The McGraw-Hill Companies, Inc 201113-#Assume the facts as shown with respect to the Decker Company.

13-18Internal Rate of Return MethodFuture cash flows are the same every year in this example, so we can calculate the internal rate of return as follows: Investment required Annual net cash flowsPV factor for theinternal rate of return= $104, 320 $20,000= 5.216Copyright The McGraw-Hill Companies, Inc 201113-#Since the cash flows are the same every year, the equation shown can be used to compute the appropriate present value factor of 5.216. 13-19Internal Rate of Return MethodFind the 10-period row, move across until you find the factor 5.216. Look at the top of the column and you find a rate of 14%.

Using the present value of an annuity of $1 table . . .Copyright The McGraw-Hill Companies, Inc 2011#Copyright The McGraw-Hill Companies, Inc 201113-#Using the present value of an annuity of $1 table, the internal rate of return is equal to 14 percent. 13-20Internal Rate of Return MethodDecker Company can purchase a new machine at a cost of $104,320 that will save $20,000 per year in cash operating costs. The machine has a 10-year life.The internal rate of return on this project is 14%.If the internal rate of return is equal to or greater than the companys required rate of return, the project is acceptable.Copyright The McGraw-Hill Companies, Inc 201113-#If Deckers minimum required rate of return is equal to or greater than 14 percent, then the machine should be purchased. 13-21Comparing the Net Present Value and Internal Rate of Return MethodsNPV is often simpler to use.

Questionable assumption:Internal rate of return method assumes cash inflows are reinvested at the internal rate of return.

Copyright The McGraw-Hill Companies, Inc 201113-#If the internal rate of return is high, this assumption may be unrealistic. It is more realistic to assume that the cash flows can be reinvested at the discount rate, which is the underlying assumption of the net present value method.13-22Expanding the Net Present Value MethodTo compare competing investment projects we can use the following net present value approaches:Total-costIncremental cost

Copyright The McGraw-Hill Companies, Inc 201113-#We will now expand the net present value method to include two alternatives and the concept of relevant costs. The net present value method can be used to compare competing investment projects in two ways the total cost approach and the incremental cost approach.

13-23The Total-Cost ApproachWhite Company has two alternatives:(1) remodel an old car wash or, (2) remove it and install a new one.The company uses a discount rate of 10%.

Copyright The McGraw-Hill Companies, Inc 201113-#Assume that White Company has two alternatives remodel an old car wash or remove the old car wash and replace it with a new one. The company uses a discount rate of 10 percent.

The annual net cash inflows are $60,000 for the new car wash and $45,000 for the old car wash.

13-24The Total-Cost ApproachIf White installs a new washer . . .

Lets look at the present valueof this alternative.

Copyright The McGraw-Hill Companies, Inc 201113-#In addition, assume that the information as shown relates to the installation of a new washer. 13-25The Total-Cost ApproachIf we install the new washer, the investment will yield a positive net present value of $83,202.

Copyright The McGraw-Hill Companies, Inc 2011#Copyright The McGraw-Hill Companies, Inc 201113-#The net present value of installing a new washer is $83,202.

13-26The Total-Cost ApproachIf White remodels the existing washer . . .

Lets look at the present valueof this second alternative.Copyright The McGraw-Hill Companies, Inc 201113-#If White chooses to remodel the existing washer, the remodeling costs would be $175,000 and the cost to replace the brushes at the end of six years would be $80,000. 13-27The Total-Cost ApproachIf we remodel the existing washer, we will produce a positive net present value of $56,405.

Copyright The McGraw-Hill Companies, Inc 2011#Copyright The McGraw-Hill Companies, Inc 201113-#The net present value of remodeling the old washer is $56,405. 13-28The Total-Cost ApproachBoth projects yield a positive net present value.

However, investing in the new washer will produce a higher net present value than remodeling the old washer.Copyright The McGraw-Hill Companies, Inc 2011#Copyright The McGraw-Hill Companies, Inc 201113-#While both projects yield a positive net present value, the net present value of the new washer alternative is $26,797 higher than the remodeling alternative. 13-29The Incremental-Cost Approach Under the incremental-cost approach, only those cash flows that differ between the two alternatives are considered.

Lets look at an analysis of the White Company decision using the incremental-cost approach.Copyright The McGraw-Hill Companies, Inc 201113-#Under the incremental cost approach, only those cash flows that differ between the remodeling and replacing alternatives are considered.

13-30The Incremental-Cost Approach

We get the same answer under either thetotal-cost or incremental-cost approach.Copyright The McGraw-Hill Companies, Inc 2011#Copyright The McGraw-Hill Companies, Inc 201113-#The differential cash flows between the alternatives are as shown. Notice, the net present value of $26,797 is identical to the answer derived from the total cost approach. 13-31Least Cost DecisionsIn decisions where revenues are not directly involved, managers should choose the alternative that has the least total cost from a present value perspective.

Lets look at the Home Furniture Company.

Copyright The McGraw-Hill Companies, Inc 201113-#In decisions where revenues are not directly involved, managers should choose the alternative that has the least total cost from a present value perspective.

13-32Uncertain Cash Flows An ExampleAssume that all of the cash flows related to an investment in a supertanker have been estimated, except for its salvage value in 20 years.Using a discount rate of 12%, management has determined that the net present value of all the cash flows, except the salvage value is a negative $1.04 million.How large would the salvage value need to be to make this investment attractive?Copyright The McGraw-Hill Companies, Inc 2011#Copyright The McGraw-Hill Companies, Inc 201113-#Assume that all of the cash flows related to an investment in a supertanker have been estimated, except for its salvage value in 20 years.

Using a discount rate of 12 percent, management has determined that the net present value of all the cash flows, except the salvage value is a negative $1.04 million.

This negative net present value will be offset by the salvage value of the supertanker.

How large would the salvage value need to be to make this investment attractive?13-33Uncertain Cash Flows An Example

This equation can be used to determine that if the salvage value of the supertanker is at least $10,000,000, the net present value of the investment would be positive and therefore acceptable.Copyright The McGraw-Hill Companies, Inc 2011#Copyright The McGraw-Hill Companies, Inc 201113-#The equation shown can be used to determine that if the salvage value of the supertanker is at least $10 million, the net present value of the investment would be positive and therefore acceptable.While the salvage value is not known with certainty, the $10 million figure offers a useful reference point for making the decision. 13-34Preference Decision The Ranking of Investment ProjectsScreening DecisionsPertain to whether or not some proposed investment is acceptable; these decisions come first.Preference DecisionsAttempt to rank acceptable alternatives from the most to least appealing.

Copyright The McGraw-Hill Companies, Inc 2011#Copyright The McGraw-Hill Companies, Inc 201113-#Recall that when considering investment opportunities, managers must make two types of decisions screening decisions and preference decisions.

Screening decisions, which come first, pertain to whether or not some proposed investment is acceptable.

Preference decisions, which come after screening decisions, attempt to rank acceptable alternatives from the most to least appealing.Preference decisions need to be made because the number of acceptable investment alternatives usually exceeds the amount of available funds. 13-35Internal Rate of Return MethodThe higher the internal rate of return, the more desirable the project.When using the internal rate of return method to rank competing investment projects, the preference rule is:Copyright The McGraw-Hill Companies, Inc 2011#Copyright The McGraw-Hill Companies, Inc 201113-#When using the internal rate of return method to rank competing investment projects, the preference rule is: the higher the internal rate of return, the more desirable the project.

13-36Net Present Value MethodThe net present value of one project cannot be directly compared to the net present value of another project unless the investments are equal.

Copyright The McGraw-Hill Companies, Inc 2011#Copyright The McGraw-Hill Companies, Inc 201113-#The net present value of one project cannot be directly compared to the net present value of another project, unless the investments are equal.

13-37Ranking Investment Projects Project Net present value of the project profitability Investment required index=

The higher the profitability index, themore desirable the project.Copyright The McGraw-Hill Companies, Inc 2011#Copyright The McGraw-Hill Companies, Inc 201113-#In the case of unequal investments, a profitability index can be computed as the net present value of the project divided by the investment required. Notice three things:The profitability indexes for investments A and B are 0.10 and 0.20, respectively.

The higher the profitability index, the more desirable the project. Therefore, investment B is more desirable than investment A.

As in this type of situation, the constrained resource is the limited funds available for investment, the profitability index is similar to the contribution margin per unit of the constrained resource as discussed an earlier chapter.

13-38Other Approaches toCapital Budgeting DecisionsOther methods of making capital budgeting decisions include . . .The Payback Method.Simple Rate of Return.

Copyright The McGraw-Hill Companies, Inc 201113-#This section focuses on two other methods of making capital budgeting decisions the payback method and the simple rate of return. The payback method will be discussed first followed by the simple rate of return method. 13-39The Payback MethodThe payback period is the length of time that it takes for a project to recover its initial cost out of the cash receipts that it generates. When the annual net cash inflow is the same each year, this formula can be used to compute the payback period:

Payback period = Investment required Annual net cash inflowCopyright The McGraw-Hill Companies, Inc 201113-#The payback method focuses on the payback period, which is the length of time that it takes for a project to recoup its initial cost out of the cash receipts that it generates.

When the annual net cash inflow is the same every year, the formula for computing the payback period is the investment required divided by the annual net cash inflow.

13-40The Payback MethodManagement at The Daily Grind wants to install an espresso bar in its restaurant. The espresso bar:

Costs $140,000 and has a 10-year life.Will generate annual net cash inflows of $35,000.

Management requires a payback period of 5 years or less on all investments.

What is the payback period for the espresso bar?Copyright The McGraw-Hill Companies, Inc 201113-#Assume the management of the Daily Grind wants to install an espresso bar in its restaurant.

The cost of the espresso bar is $140,000 at it has a ten-year life.

The bar will generate annual net cash inflows of $35,000.

Management requires a payback period of five years or less.

What is the payback period on the espresso bar? 13-41The Payback MethodPayback period = Investment required Annual net cash inflowPayback period = $140,000 $35,000Payback period = 4.0 yearsAccording to the companys criterion, management would invest in the espresso bar because its payback period is less than 5 years.Copyright The McGraw-Hill Companies, Inc 2011#Copyright The McGraw-Hill Companies, Inc 201113-#The payback period is 4 years. Therefore, management would choose to invest in the bar. 13-42Problems with the Payback Method

Ignores the time valueof money.

Ignores cashflows after the paybackperiod.

Short-comingsof the paybackperiod.Copyright The McGraw-Hill Companies, Inc 2011#Copyright The McGraw-Hill Companies, Inc 201113-#Criticisms of the payback method include the following.

First, a shorter payback period does not always mean that one investment is more desirable than another. This is because the payback method ignores cash flows after the payback period, thus it has no inherent mechanism for highlighting differences in useful life between investments.

Second, the payback method does not consider the time value of money.

13-43Strengths of the Payback Method

Serves as screening tool.

Identifies investments that recoup cash investments quickly.

Identifies products that recoup initial investment quickly.

Strengthsof the paybackperiod.Copyright The McGraw-Hill Companies, Inc 2011#Copyright The McGraw-Hill Companies, Inc 201113-#Strengths of the payback method include the following.

It can serve as a screening tool to help identify which investment proposals are in the ballpark.It can aid companies that are cash poor in identifying investments that will recoup cash investments quickly.It can help companies that compete in industries where products become obsolete rapidly to identify products that will recoup their initial investment quickly. 13-44Payback and Uneven Cash Flows

12345$1,000$0$2,000$1,000$500When the cash flows associated with an investment project change from year to year, the payback formula introduced earlier cannot be used. Instead, the un-recovered investment must be tracked year by year.Copyright The McGraw-Hill Companies, Inc 2011#Copyright The McGraw-Hill Companies, Inc 201113-#When the cash flows associated with an investment project change from year to year, the payback formula introduced earlier cannot be used. Instead, the un-recovered investment must be tracked year by year.13-45Payback and Uneven Cash Flows

12345$1,000$0$2,000$1,000$500For example, if a project requires an initial investment of $4,000 and provides uneven net cash inflows in years 1-5 as shown, the investment would be fully recovered in year 4.Copyright The McGraw-Hill Companies, Inc 2011#Copyright The McGraw-Hill Companies, Inc 201113-#For example, if a project requires an initial investment of $4,000 and provides uneven net cash inflows in years one to five as shown. The investment would be fully recovered in year four.

13-46Simple Rate of Return MethodDoes not focus on cash flows -- rather it focuses on accounting net operating income.The following formula is used to calculate the simple rate of return:Simple rateof return=Annual incremental net operating income Initial investment**Should be reduced by any salvage from the sale of the old equipmentCopyright The McGraw-Hill Companies, Inc 201113-#The simple rate of return method (also known as the accounting rate of return or the unadjusted rate of return) does not focus on cash flows, rather it focuses on accounting net operating income.

The equation for computing the simple rate of return is as shown. 13-47Simple Rate of Return Method Management of The Daily Grind wants to install an espresso bar in its restaurant. The espresso bar:Cost $140,000 and has a 10-year life.Will generate incremental revenues of $100,000 and incremental expenses of $65,000 including depreciation. What is the simple rate of return on the investment project?

Copyright The McGraw-Hill Companies, Inc 201113-#Assume the management of the Daily Grind wants to install an espresso bar in its restaurant.

The cost of the espresso bar is $140,000 and it has a ten-year life.

The espresso bar will generate incremental revenues of $100,000 and incremental expenses of $65,000 including depreciation.

What is the simple rate of return on this project?

13-48Simple Rate of Return MethodSimple rateof return $35,000 $140,000 = 25%=

Copyright The McGraw-Hill Companies, Inc 2011#Copyright The McGraw-Hill Companies, Inc 201113-#The simple rate of return is 25 percent.

13-49Criticism of the Simple Rate of Return

Ignores the time valueof money.

The same project may appear desirable in some years and undesirable in other years.

Short-comingsof the simple rate of return.Copyright The McGraw-Hill Companies, Inc 2011#Copyright The McGraw-Hill Companies, Inc 201113-#Criticisms of the simple rate of return include the following:First, it does not consider the time value of money.

Second, the simple rate of return fluctuates from year to year when used to evaluate projects that do not have constant annual incremental revenues and expenses. The same project may appear desirable in some years and undesirable in others.

13-50Income Taxes in Capital Budgeting DecisionsAppendix 13CCopyright The McGraw-Hill Companies, Inc 2011Copyright The McGraw-Hill Companies, Inc 201113-#Appendix 13C: Income Taxes in Capital Budgeting Decisions13-51Simplifying AssumptionsTaxable income equals net income as computed for financial reports.The tax rate is a flat percentage of taxable income.

Copyright The McGraw-Hill Companies, Inc 2011#Copyright The McGraw-Hill Companies, Inc 201113-#First, lets identify some simplifying assumptions.Taxable income equals net income as computed for financial reports.The tax rate is a flat percentage of taxable income.

13-52Concept of After-tax Cost

An expenditure net of its tax effect is known as after-tax cost.

Here is the equation for determining the after-tax cost of any tax-deductible cash expense:Copyright The McGraw-Hill Companies, Inc 2011#Copyright The McGraw-Hill Companies, Inc 201113-#An expenditure net of its tax effect is known as after-tax cost. The equation for determining the after-tax cost of any tax-deductible cash expense is as shown.

13-53After-tax Cost An ExampleAssume a company with a 30% tax rate is contemplating investing in a training program that will cost $60,000 per year.

We can use this equation to determine that the after-tax cost of the training program is $42,000.

Copyright The McGraw-Hill Companies, Inc 2011#Copyright The McGraw-Hill Companies, Inc 201113-#Part IAssume a company with a 30 percent tax rate is contemplating investing in a training program that will cost $60,000 per year.

Part IIThe aforementioned equation can be used to determine that the after-tax cost of the training program is $42,000.

13-54After-tax Cost An ExampleThe answer can also be determined by calculating the taxable income and income tax for two alternativeswithout the training program and with the training program.The after-tax cost of the training program is the same $42,000.Copyright The McGraw-Hill Companies, Inc 2011#Copyright The McGraw-Hill Companies, Inc 201113-#The answer can also be determined by calculating the taxable income and income tax for two alternatives without the training program and with the training program.

Notice that the after-tax cost of the training program would be the same $42,000. 13-55After-tax Cost An Example

The amount of net cash inflow realized from a taxable cash receipt after income tax effects have been considered is known as the after-tax benefit.Copyright The McGraw-Hill Companies, Inc 2011#Copyright The McGraw-Hill Companies, Inc 201113-#The amount of net cash inflow realized from a taxable cash receipt after income tax effects have been considered is known as the after-tax benefit.The equation for determining the after-tax benefit of any taxable cash receipt is as shown.

13-56Depreciation Tax ShieldWhile depreciation is not a cash flow, it does affect the taxes that must be paid and therefore has an indirect effect on a companys cash flows.

Copyright The McGraw-Hill Companies, Inc 2011#Copyright The McGraw-Hill Companies, Inc 201113-#While depreciation is not a cash flow, it does affect the taxes that must be paid and therefore has an indirect effect on a companys cash flows.

When depreciation deductions shield revenues from taxation, they are generally referred to as a depreciation tax shield. The equation for calculating the tax savings from a depreciation tax shield is as shown.

Remember that when as asset is purchased, a cash outflow occurs. Depreciation is just the allocation of that purchase price over some estimated life. 13-57Depreciation Tax Shield An ExampleAssume a company has annual cash sales and cash operating expenses of $500,000 and $310,000, respectively; a depreciable asset, with no salvage value, on which the annual straight-line depreciation expense is $90,000; and a 30% tax rate.

Copyright The McGraw-Hill Companies, Inc 2011#Copyright The McGraw-Hill Companies, Inc 201113-#Assume that a company has: annual cash sales and cash operating expenses of $500,000 and $310,000, respectively; a depreciable asset, with no salvage value, on which the annual straight-line depreciation expense is $90,000; and a 30 percent tax rate. 13-58Depreciation Tax Shield An ExampleAssume a company has annual cash sales and cash operating expenses of $500,000 and $310,000, respectively; a depreciable asset, with no salvage value, on which the annual straight-line depreciation expense is $90,000; and a 30% tax rate.

The depreciation tax shield is $27,000. Copyright The McGraw-Hill Companies, Inc 2011#Copyright The McGraw-Hill Companies, Inc 201113-#The aforementioned equation can be used to calculate the depreciation tax shield of $27,000. 13-59Depreciation Tax Shield An ExampleThe answer can also be determined by calculating the taxable income and income tax for two alternativeswithout the depreciation deduction and with the depreciation deduction.The depreciation tax shield is the same $27,000.Copyright The McGraw-Hill Companies, Inc 2011#Copyright The McGraw-Hill Companies, Inc 201113-#The answer can also be determined by calculating the taxable income and income tax for two alternatives without the depreciation deduction and with the depreciation deduction.

Notice that the depreciation tax shield would be the same $27,000. 13-60Holland Company An ExampleHolland Company owns the mineral rights to land that has a deposit of ore. The company is deciding whether to purchase equipment and open a mine on the property. The mine would be depleted and closed in 10 years and the equipment would be sold for its salvage value.

More information is provided on the next slide.Copyright The McGraw-Hill Companies, Inc 2011#Copyright The McGraw-Hill Companies, Inc 201113-#Holland Company owns the mineral rights to land that has a deposit of ore. The company is deciding whether to purchase equipment and open a mine on the property. The mine would be depleted and closed in ten years and the equipment would be sold for its salvage value. 13-61Holland Company An ExampleShould Holland open a mine on the property?

Copyright The McGraw-Hill Companies, Inc 2011#Copyright The McGraw-Hill Companies, Inc 201113-#Pertinent financial information is as shown.

Hollands after-tax cost of capital is 12 percent and its tax rate is 30 percent.

Should Holland open a mine on the property?

13-62Holland Company An ExampleStep Three: Translate the relevant cash flows to after-tax cash flows as shown.

Copyright The McGraw-Hill Companies, Inc 2011#Copyright The McGraw-Hill Companies, Inc 201113-#The third step is to translate the relevant cash flows to after-tax cash flows as shown. 13-63

Holland Company An ExampleStep Four: Discount all cash flows to their present value as shown.

Copyright The McGraw-Hill Companies, Inc 2011#Copyright The McGraw-Hill Companies, Inc 201113-#The fourth step is to discount all cash flows to their present value as shown.

Notice that the net present value of the project is $24,744.

13-64End of Chapter 13

Copyright The McGraw-Hill Companies, Inc 2011#Copyright The McGraw-Hill Companies, Inc 201113-#End of Chapter 13.13-65Sheet1If the Net Present Value is . . .Then the Project is . . .Positive . . .Acceptable because it promises a return greater than the required rate of return.Zero . . .Acceptable because it promises a return equal to the required rate of return.Negative . . .Not acceptable because it promises a return less than the required rate of return.

&APage &P

Sheet1Cost$3,170Life4 yearsSalvage valuezeroIncrease in annual cash inflows$1,000

Sheet2

Sheet3

Sheet1ItemYear(s)Amount of Cash Flow10% FactorPresent Value of Cash FlowsInitial investment (outflow)Now(3,170)1.000(3,170)Annual cash inflows1-4$1,0003.170$3,170Net present value$ -0-

Sheet2

Sheet3

Sheet1Present Value of $1Periods10%12%14%10.9090.8930.87721.7361.6901.64732.4872.4022.32243.1703.0372.91453.7913.6053.433

&APage &P

Sheet1Cost and revenue informationCost of special equipment$160,000Working capital required100,000Relining equipment in 3 years30,000Salvage value of equipment in 5 years5,000Annual cash revenue and costs:Sales revenue from parts750,000Cost of parts sold400,000Salaries, shipping, etc.270,000

&APage &P

Sheet1Sales revenue$750,000Cost of parts sold(400,000)Salaries, shipping, etc.(270,000)Annual net cash inflows$80,000

&APage &P

Sheet1YearsCash Flows10% FactorPresent ValueInvestment in equipmentNow$(160,000)1.000$(160,000)Working capital neededNow(100,000)1.000(100,000)Annual net cash inflows1-580,0003.791303,280Relining of equipment3(30,000)0.751(22,530)Salvage value of equip.55,0000.6213,105Working capital released5100,0000.62162,100Net present value$85,955

&APage &P

Sheet1(1)(2)(3)(4)(5)YearInvestment Outstanding during the yearCash InflowRecover of Investment during the year(2) - (3)Unrecovered Investment at the end of the year(1) - (4)13,1701,000$317$6832,48722,4871,000$249$7511,73631,7361,000$173$82790949091,000$91$9090.0Total investment recovered$3,170If the Internal Rate of Return is . . .Then the Project is . . .Equal to or greater than the minimum required rate of return . . .Acceptable.Less than the minimum required rate of return . . .Rejected.

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Sheet1Periods10%12%14%10.9090.8930.87721.7361.6901.647. . .. . .. . .. . .95.7595.3284.946106.1455.6505.216

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Sheet1New Car WashOld Car WashAnnual revenues$90,000$70,000Annual cash operating costs30,00025,000Annual net cash inflows$60,000$45,000

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Cost$300,000Productive life10 yearsSalvage value$7,000Replace brushes atthe end of 6 years$50,000Salvage of old equip.$40,000

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Sheet1Install the New WasherYearCash Flows10% FactorPresent ValueInitial investmentNow$(300,000)1.000$(300,000)Replace brushes6(50,000)0.564(28,200)Annual net cash inflows1-1060,0006.145368,700Salvage of old equipmentNow40,0001.00040,000Salvage of new equipment107,0000.3862,702Net present value$83,202

&APage &P

Sheet1Remodel costs$175,000Replace brushes at the end of 6 years80,000

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Sheet1Remodel the Old WasherYearCash Flows10% FactorPresent ValueInitial investmentNow$(175,000)1.000$(175,000)Replace brushes6(80,000)0.564(45,120)Annual net cash inflows1-1045,0006.145276,525Net present value$56,405

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Sheet1Net Present ValueInvest in new washer$83,202Remodel existing washer56,405In favor of new washer$26,797

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Sheet1YearCash Flows10% FactorPresent ValueIncremental investmentNow$(125,000)1.000$(125,000)Incremental cost of brushes6$30,0000.56416,920Increased net cash inflows1-1015,0006.14592,175Salvage of old equipmentNow40,0001.00040,000Salvage of new equipment107,0000.3862,702Net present value$26,797

&APage &P

Sheet1(1)(2)(3)(4)(5)YearInvestment Outstanding during the yearCash InflowReturn on Investment (1) 10%Recover of Investment during the year(2) - (3)Unrecovered Investment at the end of the year(1) - (4)13,1701,000$317$6832,48722,4871,000$249$7511,73631,7361,000$173$82790949091,000$91$9090.0Total investment recovered$3,170If the Internal Rate of Return is . . .Then the Project is . . .Equal to or greater than the minimum required rate of return . . .Acceptable.Less than the minimum required rate of return . . .Rejected.Net present value to be offset$1,040,000=$10,000,000Present value factor0.104

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Sheet1InvestmentProject AProject BNet present value (a)$1,000$1,000Investment required (b)$10,000$5,000Profitability index (a) (b)0.100.20

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Sheet1After-tax cost(net cash outflow)=(1-Tax rate) Tax-deductible cash expense

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Sheet1After-tax cost(net cash outflow)=(1-Tax rate) Tax-deductible cash expense$42,000=(1 - .30) $60,000

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Sheet1After-tax benefit(net cash inflow)=(1-Tax rate) Taxable cash receipt

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Sheet1Tax savings from the depreciation tax shield=Tax rate Depreciation deduction

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Sheet1Tax savings from the depreciation tax shield=Tax rate Depreciation deduction

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Sheet1Tax savings from the depreciation tax shield=Tax rate Depreciation deduction$27,000=.30 $90,000

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Sheet1Cost of equipment$300,000Working capital needed$75,000Estimated annual cash receipts from ore sales$250,000Estimated annual cash expenses for mining ore$170,000Cost of road repairs needed in 6 years$40,000Salvage value of the equipment in 10 years$100,000After-tax cost of capital12%Tax rate30%

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Sheet1After-tax cost(net cash outflow)=(1-Tax rate) Tax-deductible cash expenseCash receipts from ore sales$250,000Less cash expenses for mining ore170,000Net cash receipts$80,000Holland Company(1)(2)(3)(4)Items and ComputationsYearAmountTax Effect(1) (2)After-Tax Cash FlowsCost of new equipmentNow$(300,000)0$(300,000)Working capital neededNow$(75,000)0$(75,000)Annual net cash receipts1-10$80,0001-.30$56,000Road repairs6$(40,000)1-.30$(28,000)Annual depreciation deductions1-10$30,000.30$9,000Salvage value of equipment10100,0001-.30$70,000Release of working capital1075,0000$75,000Net present value

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Sheet1After-tax cost(net cash outflow)=(1-Tax rate) Tax-deductible cash expenseCash receipts from ore sales$250,000Less cash expenses for mining ore170,000Net cash receipts$80,000Holland Company(1)(2)(3)(4)(5)(6)Items and ComputationsYearAmountTax Effect(1) (2)After-Tax Cash Flows12% FactorPresent ValueCost of new equipmentNow$(300,000)0$(300,000)1.000$(300,000)Working capital neededNow$(75,000)0$(75,000)1.000(75,000)Annual net cash receipts1-10$80,0001-.30$56,0005.650316,400Road repairs6$(40,000)1-.30$(28,000)0.507(14,196)Annual depreciation deductions1-10$30,000.30$9,0005.65050,850Salvage value of equipment10100,0001-.30$70,0000.32222,540Release of working capital1075,0000$75,0000.32224,150Net present value$24,744

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