Chap016 TNx2
Chap016 TNx2
Chap016 TNx2
McGraw-Hill/Irwin
Learning Objective 1
McGraw-Hill/Irwin
Discounted-CashDiscounted-Cash-Flow Analysis
Plant expansion Equipment selection Equipment replacement
Cost reduction
Lease or buy
Net-PresentNet-Present-Value Method
o o o o
Prepare a table showing cash flows for each year, Calculate the present value of each cash flow using a discount rate, Compute net present value, If the net present value (NPV) is positive, accept the investment proposal. Otherwise, reject it.
Net-PresentNet-Present-Value Method
Mattson Co. has been offered a five year contract to provide component parts for a large manufacturer.
Cost and revenue information Cost of special equipment $160,000 Working capital required 100,000 Relining equipment in 3 years 30,000 Salvage value of equipment in 5 years 5,000 Annual cash revenue and costs: Sales revenue from parts 750,000 Cost of parts sold 400,000 Salaries, shipping, etc. 270,000
Net-PresentNet-Present-Value Method
At the end of five years the working capital will be released and may be used elsewhere by Mattson. Mattson uses a discount rate of 10%.
Net-PresentNet-Present-Value Method
Annual net cash inflows from operations
Sales revenue Cost of parts sold Gross margin Less out-of-pocket costs Annual net cash inflows $ 750,000 400,000 350,000 270,000 $ 80,000
Net-PresentNet-Present-Value Method
Investment in equipment Working capital needed Years Now Now Cash Flows $(160,000) (100,000) 10% Factor 1.000 1.000 Present Value $ (160,000) (100,000)
Net-PresentNet-Present-Value Method
Investment in equipment Working capital needed Annual net cash inflows Years Now Now 1-5 Cash Flows $(160,000) (100,000) 80,000 10% Factor 1.000 1.000 3.791 Present Value $ (160,000) (100,000) 303,280
Net-PresentNet-Present-Value Method
Investment in equipment Working capital needed Annual net cash inflows Relining of equipment Years Now Now 1-5 3 Cash Flows $(160,000) (100,000) 80,000 (30,000) 10% Factor 1.000 1.000 3.791 0.751 Present Value $ (160,000) (100,000) 303,280 (22,530)
Net-PresentNet-Present-Value Method
Investment in equipment Working capital needed Annual net cash inflows Relining of equipment Salvage value of equip. Years Now Now 1-5 3 5 Cash Flows $(160,000) (100,000) 80,000 (30,000) 5,000 10% Factor 1.000 1.000 3.791 0.751 0.621 Present Value $ (160,000) (100,000) 303,280 (22,530) 3,105
Net-PresentNet-Present-Value Method
Investment in equipment Working capital needed Annual net cash inflows Relining of equipment Salvage value of equip. Working capital released Net present value Years Now Now 1-5 3 5 5 Cash Flows $(160,000) (100,000) 80,000 (30,000) 5,000 100,000 10% Factor 1.000 1.000 3.791 0.751 0.621 0.621 Present Value $ (160,000) (100,000) 303,280 (22,530) 3,105 62,100 $ 85,955
Mattson should accept the contract because the present value of the cash inflows exceeds the present value of the cash outflows by $85,955. The project has a positive net present value.
Internal-Rate-ofInternal-Rate-of-Return Method
The internal rate of return is the true economic return earned by the asset over its life. The internal rate of return is computed by finding the discount rate that will cause the net present value of a project to be zero.
Internal-Rate-ofInternal-Rate-of-Return Method
Black Co. 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.
Internal-Rate-ofInternal-Rate-of-Return Method
Future cash flows are the same every year in this example, so we can calculate the internal rate of return as follows:
Investment required Net annual cash flows $104, 320 $20,000 = Present value factor
= 5.216
Internal-Rate-ofInternal-Rate-of-Return Method
The present value factor (5.216) is located on the Table IV in the Appendix. Scan the 10period row and locate the value 5.216. Look at the top of the column and you find a rate of 14% which is the internal rate of return.
$104, 320 $20,000
5.216
Internal-Rate-ofInternal-Rate-of-Return Method
Heres the proof . . .
Investment required Annual cost savings Net present value Year Now 1-10 Amount $ (104,320) 20,000 14% Factor 1.000 5.216 Present Value (104,320) 104,320 $ -
Learning Objective 2
McGraw-Hill/Irwin
Depreciable Assets
Both the NPV and IRR methods focus on cash flows, and periodic depreciation charges are not cash flows . . .
Tax Return Form 1120
Learning Objective 3
McGraw-Hill/Irwin
TotalTotal-Cost Approach
Each system would last five years. 12 percent hurdle rate for the analysis.
MAINFRAME PC _ Salvage value old system $ 25,000 $ 25,000 Cost of new system (400,000) (300,000) Cost of new software ( 40,000) ( 75,000) Update new system ( 40,000) ( 60,000) Salvage value new system 50,000 30,000 ================================================ Operating costs over 5-year life: Personnel (300,000) (220,000) Maintenance ( 25,000) ( 10,000) Other costs ( 10,000) ( 5,000) ( 20,000) ( 20,000) Datalink services Revenue from time-share 25,000 -
TotalTotal-Cost Approach
MAINFRAME ($) Acquisition cost computer Acquisition cost software System update Salvage value Operating costs Time sharing revenue Total cash flow X Discount factor Present value PERSONAL COMPUTER ($) Acquisition cost computer Acquisition cost software System update Salvage value Operating costs Time sharing revenue Total cash flow X Discount factor Present value Today (400,000) ( 40,000) Year 1 Year 2 Year 3 Year 4 Year 5 ( 40,000) 50,000 (335,000) (335,000) (335,000) (335,000) (335,000) (335,000) 20,000 20,000 20,000 20,000 20,000 20,000 440,000 (315,000) (315,000) (355,000) (315,000) (265,000) X 1.000 X .893 X .797 X .712 X .636 X .567 (440,000) (281,295) (251,055) (252,760) (200,340) (150,255)
SUM = ($1,575,705)
Today (300,000) ( 75,000) Year 1 Year 2 Year 3 Year 4 Year 5
( 60,000) 50,000 (235,000) (235,000) (235,000) (235,000) (235,000) (235,000) -0-0-0-0-0-0_ 375,000 (235,000) (235,000) (295,000) (235,000) (205,000) X 1.000 X .893 X .797 X .712 X .636 X .567 (375,000) (209,855) (187,295) (210,040) (149,460) (116,235)
SUM = ($1,247,885)
TotalTotal-Cost Approach
($1,575,705)
Mountainview should purchase the personal computer system for a cost savings of $327,820.
IncrementalIncremental-Cost Approach
Irrelevant
MAINFRAME PC _ Differentials Salvage value old system $ 25,000 $ 25,000 0 Cost of new system (400,000) (300,000) (100,000) Cost of new software ( 40,000) ( 75,000) 35,000 Update new system ( 40,000) ( 60,000) 20,000 Salvage value new system 50,000 30,000 20,000 =========================================================== Operating costs over 5-year life: Personnel (300,000) (220,000) ( 80,000) Maintenance ( 25,000) ( 10,000) ( 15,000) Other costs ( 10,000) ( 5,000) ( 5,000) ( 20,000) ( 20,000) 0 Datalink services Revenue from time-share 20,000 20,000
IncrementalIncremental-Cost Approach
INCREMENTAL ($) Acquisition cost computer Acquisition cost software System update Salvage value Operating costs Time sharing revenue Total cash flow X Discount factor Present value Today (100,000) 35,000 Year 1 Year 2 Year 3 Year 4 Year 5
20,000 20,000 (100,000) (100,000) (100,000) (100,000) (100,000) 20,000 20,000 20,000 20,000 20,000 20,000 ( 65,000) ( 80,000) ( 80,000) ( 80,000) ( 80,000) ( 60,000) X 1.000 X .893 X .797 X .712 X .636 X .567 ( 65,000) ( 71,440) ( 63,760) ( 42,720) ( 50,880) ( 34,020)
SUM = ($ 327,820)
Learning Objective 4
McGraw-Hill/Irwin
The tax rate is 40%, so income taxes are $525,000 40% = $ 210,000
Cash Revenues
High Countrys management is considering the purchase of a new truck that will increase cash revenues by $110,000 and increase cash cost of goods sold by $60,000. The company is subject to a tax rate of 40%.
The tax rate is 40%, so income taxes are $50,000 40% = $ 20,000
Net Income 30,000_ A short cut works like this: Increase in income ( 1 - tax rate)
Noncash Expenses
Not all expenses require cash outflows. The most common example is depreciation.
Recall that High Countrys proposal involved the purchase of a truck. The truck cost $40,000 and will be depreciated over four years using straightline depreciation. The truck is to be purchased on June 30, 2007. One-half year depreciation is taken in 2007.
Noncash Expenses
Here is a complete depreciation schedule for High Country.
Year 1 2 3 4 5 Depreciation Expense $ 5,000 10,000 10,000 10,000 5,000 40,000 Tax Reduced Tax Rate Payment _ 40% $ 2,000 40% 4,000 40% 4,000 40% 4,000 40% 2,000 16,000
$ 18,000 $ 36,000 $ 36,000 2,000 4,000 4,000 ( 40,000) 20,000 40,000 40,000 X 1.000 X .893 X .797 X .712 ( 40,000) 17,860 31,880 28,480
$ 36,000 $ 18,000 4,000 2,000 40,000 20,000 X .636 X .567 25,440 11,340
SUM = $ 75,000
The sum of the present values from this proposal is a positive $75,000
Learning Objective 5
McGraw-Hill/Irwin
$5,600 (1.10)^-1
$20,000 28%
$100,000 20%
$20,000 (1.10)^-1
The present value of the proposal is less than the cost of the equipment ($100,000). The proposal has a negative net present value.
Learning Objective 6
McGraw-Hill/Irwin
Extended Illustration
Let take a close look at a present value analysis for an investment decision facing James Company. James Company
Extended Illustration
James Company has been offered a five-year contract to provide component parts for a large manufacturer.
Cost and revenue information Cost of special equipment $160,000 Working capital required 100,000 Relining equipment in 3 years 30,000 Salvage value of equipment in 5 years 5,000 Annual cash revenue and costs: Sales revenue from parts 750,000 Cost of parts sold 400,000 Salaries, advertising and others 200,000
Extended Illustration
At the end of five years the working capital will be released and may be used elsewhere by James. James Company uses a discount rate of 10%. James uses straight-line depreciation. All items in this example are taxed at 30%.
Extended Illustration
Annual accounting income from operations
Sales revenue Cost of parts sold Gross margin Salaries and other Depreciation expense Income before taxes Income taxes Net income $ 750,000 450,000 300,000 200,000 31,000 69,000 20,700 48,300
Extended Illustration
Annual cash inflows from operations
Sales revenue Cost of parts sold Gross margin Salaries and other Depreciation expense Income before taxes Income taxes Net cash flows $ 750,000 450,000 300,000 200,000 100,000 20,700 79,300
Extended Illustration
Years Now Now 1-5 3 5 5 Cash Flows $(160,000) (100,000) 79,300 (21,000) 5,000 100,000
Investment in equipment Working capital needed Annual net cash inflows Relining of equipment Salvage value of equipment Working capital released Net present value
The relining is considered normal maintenance and will reduce income in year 3. Because the cost is tax deductible, income will be lower by $21,000 ($30,000 1- tax rate).
Extended Illustration
Years Now Now 1-5 3 5 5 Cash Flows $(160,000) (100,000) 79,300 (21,000) 5,000 100,000
Investment in equipment Working capital needed Annual net cash inflows Relining of equipment Salvage value of equipment Working capital released Net present value
Because the salvage value of the equipment will equal the book value (cost less accumulated depreciation), there will be no taxable gain or loss.
Extended Illustration
Investment in equipment Working capital needed Annual net cash inflows Years Now Now 1-5 Cash Flows $(160,000) (100,000) 79,300 10% Factor 1.000 1.000 Present Value $(160,000) (100,000) 303,402
Net Cash PV of Cash Year Inflow PV Factor Inflow 1 $ 79,300 0.909 $ 72,084 2 79,300 0.862 68,357 3 79,300 0.751 59,554 4 79,300 0.683 54,162 5 79,300 0.621 49,245 $ 396,500 $ 303,402
Extended Illustration
Investment in equipment Working capital needed Annual net cash inflows Relining of equipment Years Now Now 1-5 3 Cash Flows $(160,000) (100,000) 79,300 (21,000) 10% Factor 1.000 1.000 0.751 Present Value $(160,000) (100,000) 303,402 (15,771)
Extended Illustration
Investment in equipment Working capital needed Annual net cash inflows Relining of equipment Salvage value of equipment Years Now Now 1-5 3 5 Cash Flows $(160,000) (100,000) 79,300 (21,000) 5,000 10% Factor 1.000 1.000 0.751 0.621 Present Value $(160,000) (100,000) 303,402 (15,771) 3,105
Extended Illustration
Investment in equipment Working capital needed Annual net cash inflows Relining of equipment Salvage value of equipment Working capital released Net present value Years Now Now 1-5 3 5 5 Cash Flows $(160,000) (100,000) 79,300 (21,000) 5,000 100,000 10% Factor 1.000 1.000 0.751 0.621 0.621 Present Value $(160,000) (100,000) 303,402 (15,771) 3,105 62,100 $ 92,836
We should accept the contract because the present value of the cash inflows exceeds the present value of the cash outflows by $92,836. The project has a $92,836. positive net present value.
Extended Illustration
General decision rule . . .
If the Net Present Value is . . . Positive . . . Then the Project is . . . Acceptable, since it promises a return greater than the required rate of return. Acceptable, since it promises a return equal to the required rate of return. Not acceptable, since it promises a return less than the required rate of return.
Zero . . .
Negative . . .
Learning Objective 7
McGraw-Hill/Irwin
different.
This project has a positive net present value which means the projects return is greater than the discount rate.
Project B has a negative net present value which means the projects return is less than the discount rate.
Learning Objective 8
McGraw-Hill/Irwin
Payback = period
$20,000 $4,000
= 5 years
Accounting-Rate-ofAccounting-Rate-of-Return Method
Discounted-cash-flow method focuses on cash flows and the time value of money.
Accounting-rate-of-return method focuses on the incremental accounting income that results from a project.
Accounting-Rate-ofAccounting-Rate-of-Return Method
The following formula is used to calculate the accounting rate of return:
Average Average incremental - incremental expenses, revenues including depreciation = Initial investment
Accounting-Rate-ofAccounting-Rate-of-Return Method
Meyers Company wants to install an espresso bar in its restaurant.
The espresso bar:
Cost $140,000 and has a 10-year life. Will generate incremental revenues of $100,000 and incremental expenses of $80,000 including depreciation.
Accounting-Rate-ofAccounting-Rate-of-Return Method
Accounting = rate of return $100,000 - $80,000 $140,000 = 14.3%
The accounting rate of return method is not recommended for a variety of reasons, the most important of which is that it ignores the time value of money.
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Learning Objective 9
McGraw-Hill/Irwin
Learning Objective 10
McGraw-Hill/Irwin
Inflation Effects
Nominal Dollars Real dollars
End of Chapter 16