PLEASE COMPLETE NO LATER THAN 11/04 @8am

Each question(1,2,& 3) must be a minimum of 200 words. Please EXPLAIN answers in FULL detail and make answers knowledgeable based off the attached reading, also INCLUDE outside scholarly sources.

ARE YOU ABLE TO COMPLETE THIS FOR ME? 20.00

Self-Study Review Problem on pg 463

1.Complete the information requested in parts (a) and (b) of the Self-Study Review Problem on pg 463. Then answer the following questions related to capital investment proposals. (1) What is meant by the expression, time value of money? (2) Why should all capital investment proposals include time value of money (present value) calculations of future cash flows that are to be received from the alternative investments?

2. Some non financial factors included in capital investment decisions are more important now than they were 20-25 years ago. Give some examples of the types of non financial factors that managers would consider more important in today's capital investment decisions than they were in the past.

3.What level of management would be involved in making capital investment decisions? Why? Why are these decisions more critical than day-to-day decisions made by individuals and companies?

This discussion must be a minimum of 100 words:

Discuss the principal objections to the use of the cash payback method for evaluating capital investment proposals. In your initial response, please do not use citations to convey your understanding. Based on your reading, please communicate your own understanding of the requirements.

edm10890_ch10_442-483.indd Page 442 7/24/10 3:45 PM user-f497 /Volumes/105/PHS00142/work/indd CHAPTER 10 Planning for Capital Investments LEARNING OBJECTIVES W I L S O N , After you have mastered the material in this chapter you will be able to: 1 2 3 4 5 6 7 8 9 Explain the time value of money concept and applyQto capital investment decisions. it U A Determine and interpret the net present value of an investment opportunity. S Determine and interpret the internal rate of return of an investment opportunity. H Identify cash flows associated with an investment opportunity. E Compare capital investment alternatives. Determine the present value of future cash flows. Determine the payback period for an investment opportunity. 1 9 9 7 B U Determine the unadjusted rate of return for an investment opportunity. Conduct a postaudit of a completed investment. CHAPTER OPENING The president of EZ Rentals (EZ) is considering expanding the company's rental service business to include LCD projectors that can be used with notebook computers. A marketing study forecasts that renting projectors could generate revenue of $200,000 per year. The possibility of increasing revenue is alluring, but EZ's president has a number of unanswered questions. How much do the projectors cost? What is their expected useful life? Will they have a salvage value? Does EZ have the money to buy them? Does EZ have the technical expertise to support the product? How much will training cost? How long will customer demand last? What if EZ buys the projectors and they become technologically obsolete? How quickly will EZ be able to recover the investment? Are there more profitable ways to invest EZ's funds? 442 edm10890_ch10_442-483.indd Page 443 7/24/10 3:45 PM user-f497 /Volumes/105/PHS00142/work/indd Spending large sums of money that will have long-term effects on company profits makes most managers anxious. What if a cell phone manufacturer spends millions of dollars to build a factory in the United States and its competitors locate their manufacturing facilities in countries that provide cheap labor? The manufacturer's cell phones will be overpriced, but it cannot move overseas because it cannot find a buyer for the factory. What if a pharmaceutical company spends millions of dollars to develop a drug which then fails to receive FDA approval? What if a communications company installs underground cable but satellite transmission steals its market? What if a company buys computer equipment that rapidly becomes technologically obsolete? Although these possibilities may be remote, they can be expensive when they do occur. For example, Wachovia Bank's 1997 annual report discloses a $70 million dollar write-off of computer equipment. This chapter discusses some of the analytical techniques companies use to evaluate major investment opportunities. The Curious Accountant W I L S O N , The August 28, 2009, drawing for the Mega millions multi- Q U which were purchased in California and New York, had A an advertised value of $338 million. This amount, howS ever, was based on the assumption that the winners H would take their prize as 26 equal annual payments of E state lottery produced two winning tickets. The tickets, $14,153,384. If the winnings were taken in this manner, the first payment would be made immediately, and the others would be paid annually over the next 25 years. The 1 9 each winner would receive one-half of these amounts. 9 Assume that you work as a personal financial planner and that one of your clients held one of the winning 7 lottery tickets. If you think you could invest your client's winnings and earn an annual return of 7 percent, would you B advise your client to take the lump-sum payment or the annual payments? Why? (The answer is on page 457.) U winner also had the option of taking an immediate, lump-sum payment of $231 million. With two winning tickets, 443 edm10890_ch10_442-483.indd Page 444 444 7/24/10 3:45 PM user-f497 /Volumes/105/PHS00142/work/indd Chapter 10 CAPITAL INVESTMENT DECISIONS LO 1 Explain the time value of money concept and apply it to capital investment decisions. Purchases of long-term operational assets are capital investments. Capital investments differ from stock and bond investments in an important respect. Investments in stocks and bonds can be sold in organized markets such as the New York Stock Exchange. In contrast, investments in capital assets normally can be recovered only by using those assets. Once a company purchases a capital asset, it is committed to that investment for an extended period of time. If the market turns sour, the company is stuck with the consequences. It may also be unable to seize new opportunities because its capital is committed. Business profitability ultimately hinges, to a large extent, on the quality of a few key capital investment decisions. A capital investment decision is essentially a decision to exchange current cash outflows for the expectation of receiving future cash inflows. For EZ Rentals, purchasing LCD projectors, cash outflows today, provides the opportunity to collect $200,000 per year in rental revenue, cash inflows in the future. Assuming the projectors have useful lives of four years and no salvage value, how much should EZ be W willing to pay for the future cash inflows? If you were EZ's president, would you spend $700,000 today to receive $200,000 each year for the next four years? You I would give up $700,000 today for the opportunity to receive $800,000 (4 3 $200,000) L in the future. What if you collect less than $200,000 per year? If revenue is only $160,000 per year, you would lose $60,000 [$700,000 2 (4 3 $160,000)]. Is $700,000 S too much to pay for the opportunity to receive $200,000 per year for four years? If O $700,000 is too much, would you spend $600,000? If not, how about $500,000? There is no one right answer to these questions. However, understanding the time value of N money concept can help you develop a rational response. , Time Value of Money Q The time value of money concept recognizes that the present value of a dollar received U in the future is less than a dollar. For example, you may be willing to pay only $0.90 today for a promise to receive $1.00 one year from today. The further into the future A the receipt is expected to occur, the smaller is its present value. In other words, one S dollar to be received two years from today is worth less than one dollar to be received one year from today. Likewise, one dollar to be received three years from today is less H valuable than one dollar to be received two years from today, and so on. E The present value of cash inflows decreases as the time until expected receipt increases for several reasons. First, you could deposit today's dollar in a savings account to earn interest that increases its total value. If you wait for your money, 1 you lose the opportunity to earn interest. Second, the expectation of receiving a future dollar carries an element of risk. Changed conditions may result in the 9 failure to collect. Finally, inflation diminishes the buying power of the dollar. In 9 other words, the longer you must wait to receive a dollar, the less you will be able to buy with it. 7 When a company invests in capital assets, it sacrifices present dollars in exchange B for the opportunity to receive future dollars. Since trading current dollars for future U dollars is risky, companies expect compensation before they invest in capital assets. The compensation a company expects is called return on investment (ROI). As discussed in Chapter 9, ROI is expressed as a percentage of the investment. For example, the ROI for a $1,000 investment that earns annual income of $100 is 10 percent ($100 4 $1,000 5 10%). Determining the Minimum Rate of Return To establish the minimum expected return on investment before accepting an investment opportunity, most companies consider their cost of capital. To attract capital, companies must provide benefits to their creditors and owners. Creditors expect interest payments; owners expect dividends and increased stock value. Companies that earn lower returns edm10890_ch10_442-483.indd Page 445 7/24/10 3:45 PM user-f497 /Volumes/105/PHS00142/work/indd Planning for Capital Investments than their cost of capital eventually go bankrupt; they cannot continually pay out more than they collect. The cost of capital represents the minimum rate of return on investments. Calculating the cost of capital is a complex exercise which is beyond the scope of this text. It is addressed in finance courses. We discuss how management accountants use the cost of capital to evaluate investment opportunities. Companies describe the cost of capital in a variety of ways: the minimum rate of return, the desired rate of return, the required rate of return, the hurdle rate, the cutoff rate, or the discount rate. These terms are used interchangeably throughout this chapter. CHECK YOURSELF 10.1 Study the following cash inflow streams expected from two different potential investments. W Total I Alternative 1 $2,000 $3,000 $4,000 $9,000 L Alternative 2 4,000 3,000 2,000 9,000 S O Based on visual observation alone, which alternative has the higher present value? Why? N Answer Alternative 2 has the higher present value. The size of the discount increases as the length of the time period increases. In other words, a dollar , received in year 3 has a lower Year 1 Year 2 Year 3 present value than a dollar received in year 1. Since most of the expected cash inflows from Alternative 2 are received earlier than those from Alternative 1, Alternative 2 has a higher present value even though the total expected cash inflows are the same. Q U A S CONVERTING FUTURE CASH INFLOWS TO THEIR EQUIVALENT PRESENT VALUES H E Given a desired rate of return and the amount of a future cash flow, present value can be determined using algebra. To illustrate, refer to the $200,000 EZ expects to earn the first year it leases LCD projectors.1 Assuming EZ desires a 12 percent rate 1 of return, what amount of cash would EZ be willing to invest today (present value 9 outflow) to obtain a $200,000 cash inflow at the end of the year (future value)? The answer follows:2 9 Investment 1 (0.12 3 Investment) 5 Future cash inflow 7 1.12 Investment 5 $200,000 B Investment 5 $200,000 4 1.12 U Investment 5 $178,571 If EZ invests $178,571 cash on January 1 and earns a 12 percent return on the investment, EZ will have $200,000 on December 31. An investor who is able to earn a 12 percent return on investment is indifferent between having $178,571 now or receiving 1 The following computations assume the $200,000 cash inflow is received on the last day of each year. In actual practice the timing of cash inflows is less precise and present value computations are recognized to be approximate, not exact. 2 All computations in this chapter are rounded to the nearest whole dollar. LO 2 Determine the present value of future cash flows. 445 edm10890_ch10_442-483.indd Page 446 446 7/24/10 3:45 PM user-f497 /Volumes/105/PHS00142/work/indd Chapter 10 $200,000 one year from now. The two options are equal, as shown in the following mathematical proof: Investment 1 (0.12 3 Investment) 5 $200,000 $178,571 1 (0.12 3 $178,571) 5 $200,000 $178,571 1 $21,429 5 $200,000 $200,000 5 $200,000 Present Value Table for Single-Amount Cash Inflows The algebra illustrated above is used to convert a one-time future receipt of cash to its present value. One-time receipts of cash are frequently called single-payment, or lump-sum, cash flows. Because EZ desires a 12 percent rate of return, the present value of the first cash inflow is $178,571. We can also determine the present value of a $200,000 single amount (lump sum) at the end of the second, third, and fourth years. Instead of using W cumbersome algebraic computations to convert these future values to their present value equivalents, financial analysts frequently use a table of conversion factors to convert future I values to their present value equivalents. The table of conversion factors used to convert L future values into present values is commonly called a present value table.3 A typical present value table presents columnsS with different return rates and rows with different periods of time, like Table 1 in the Appendix located at the end of this chapter. O To illustrate using the present value table, locate the conversion factor in Table 1 at the intersection of the 12% column and the one-period row. The conversion factor is N 0.892857. Multiplying this factor by the $200,000 expected cash inflow yields $178,571 , ($200,000 3 0.892857). This is the same value determined algebraically in the previous section of this chapter. The conversion factors in the present value tables simplify converting future values to present values. Q The conversion factors for the second, third, and fourth periods are 0.797194, 0.711780, and 0.635518, respectively. These factors are in the 12% column at rows 2, 3, U and 4, respectively. Locate these factors in Table 1 of the Appendix. Multiplying the conversion factors by the futureA inflow for each period produces their present value cash equivalents, shown in Exhibit 10.1. Exhibit 10.1 indicates that investing $607,470 today at S a 12 percent rate of return is equivalent to receiving $200,000 per year for four years. H Because EZ Rentals desires to earn (at least) a 12 percent rate of return, the company E should be willing to pay up to $607,470 to purchase the LCD projectors. Present Value Table for1 Annuities The algebra described previously for converting equal lump-sum cash inflows to present 9 value equivalents can be further simplified by adding the present value table factors 9 7 EXHIBIT 10.1 B Present Value of a $200,000 Cash Inflow to be Received for Four Years U PV 5 FV 3 Present Value Table Factor 5 Period 1 PV Period 2 PV Period 3 PV Period 4 PV Total 5 5 5 5 $200,000 200,000 200,000 200,000 3 3 3 3 0.892857 0.797194 0.711780 0.635518 5 5 5 5 Present Value Equivalent $178,571 159,439 142,356 127,104 $607,470 The present value table is based on the formula [1 4 (1 1 r)n] where r equals the rate of return and n equals the number of periods. 3 edm10890_ch10_442-483.indd Page 447 7/24/10 3:45 PM user-f497 /Volumes/105/PHS00142/work/indd Planning for Capital Investments together before multiplying them by the cash inflows. The total of the present value table factors in Exhibit 10.1 is 3.037349 (0.892857 1 0.797194 1 0.711780 1 0.635518). Multiplying this accumulated conversion factor by the expected annual cash inflow results in the same present value equivalent of $607,470 ($200,000 3 3.037349). As with lump-sum conversion factors, accumulated conversion factors can be calculated and organized in a table with columns for different rates of return and rows for different periods of time. Table 2 in the Appendix is a present value table of accumulated conversion factors. Locate the conversion factor at the intersection of the 12% column and the fourth timeperiod row. The factor at this intersection is 3.037349, confirming that the accumulated conversion factors represent the sum of the single-payment conversion factors. The conversion factors in Table 2 apply to annuities. An annuity is a series of cash flows that meets three criteria: (1) equal payment amounts; (2) equal time intervals between payments; and (3) a constant rate of return. For EZ Rentals, the expected cash inflows from renting LCD projectors are all for equivalent amounts ($200,000); the expected intervals between cash inflows are equal lengths of time (one year); and the rate of return for each inflow is constant at 12 percent. The series of expected W cash inflows from renting the projectors is therefore an annuity. The present value of an annuity table can be used only if all of these conditions are satisfied. I The present value of an annuity table (Table 2) simplifies converting future cash L inflows to their present value equivalents. EZ Rentals can convert the cash inflows as shown in Exhibit 10.1, using four conversion factors, multiplying each conversion S factor by the annual cash inflow (four multiplications), and adding the resulting prodO ucts. In contrast, EZ can recognize that the series of payments is an annuity, which requires multiplying a single conversion factor from Table 2 by the amount of the N annuity payment. Regardless of the conversion method, the result is the same (a pre, sent value of $607,470). Recall that EZ can also make the conversion using algebra. The table values are derived from algebraic formulas. The present value tables reduce the computations needed to convert future values to present values. Q U A Software programs offer an even more efficient means of converting future values into S present value equivalents. These programs are frequently built into handheld financial calculators and computer spreadsheet programs. As an example, we demonstrate the H procedures used in a Microsoft Excel spreadsheet. E An Excel spreadsheet offers a variety of financial functions, one of which converts Software Programs that Calculate Present Values a future value annuity into its present value equivalent. This present value function uses the syntax PV(rate,nper,pmt) in which rate is the desired rate of return, nper is 1 the number of periods, and pmt is the amount of the payment (periodic cash inflow). To convert a future value annuity into its present value equivalent, provide the func9 tion with the appropriate amounts for the rate, number of periods, and amount of the 9 annuity (cash inflows) into a spreadsheet cell. Press the Enter key and the present 7 value equivalent appears in the spreadsheet cell. The power of the spreadsheet to perform computations instantly is extremely useB ful for answering what-if questions. Exhibit 10.2 demonstrates this power by providing U spreadsheet conversions for three different scenarios. The first scenario demonstrates the annuity assumptions for EZ Rentals, providing the present value equivalent ($607,470) of a four-year cash inflow of $200,000 per year at a 12 percent rate of interest. The present value is a negative number. This format indicates that an initial $607,470 cash outflow is required to obtain the four-year series of cash inflows. The present value equivalent in Scenario 2 shows the present value if the annuity assumptions reflect a 14 percent, rather than 12 percent, desired rate of return. The present value equivalent in Scenario 3 shows the present value if the annuity assumptions under Scenario 1 are changed to reflect annual cash inflows of $300,000, rather than $200,000. A wide range of scenarios could be readily considered by changing any or all the variables in the spreadsheet function. In each case, the computer does the calculations, giving the manager more time to analyze the data rather than compute it. 447 edm10890_ch10_442-483.indd Page 448 448 7/24/10 3:45 PM user-f497 /Volumes/105/PHS00142/work/indd Chapter 10 EXHIBIT 10.2 Microsoft Excel Spreadsheet Present Value Function W I L S O N , Although software is widely used in business practice, the diversity of interfaces used by different calculators and spreadsheet programs makes it unsuitable for textbook presentations. This text uses the present value tables in the Appendix in the text Q illustrations and the end-of-chapter exercises and problems. If you use software to U solve these problems, your answers will be the same. All these toolsformulas, conversion tables, softwareare A based on the same mathematical principles and will produce the same results. S Ordinary Annuity Assumption H All the conversion methods described above assume the cash inflows occur at the end E 4 of each accounting period. This distribution pattern is called an ordinary annuity. In practice, cash inflows are likely to be received throughout the period, not just at the end. For example, EZ Rentals is likely to collect cash revenue from renting projectors 1 each month rather than in a single lump-sum receipt at the end of each of the four 9 years. Companies frequently use the ordinary annuity assumption in practice because it simplifies time value of money computations. Because capital investment decisions 9 are necessarily based on uncertain projections about future cash inflows, the lives of investment opportunities, and7the appropriate rates of return, achieving pinpoint accuracy is impossible. Sacrificing precision for simplicity by using the ordinary annuity B assumption is a reasonable trade-off in the decision-making process. U Reinvestment Assumption The present value computations in the previous sections show that investing $607,470 today at a 12 percent rate of return is equivalent to receiving four individual $200,000 payments at the end of four successive years. Exhibit 10.3 illustrates that a cash inflow of $200,000 per year is equivalent to earning a 12 percent rate of return on a $607,470 investment.5 4 When equal cash inflows occur at the beginning of each accounting period, the distribution is called an annuity due. Although some business transactions are structured as annuities due, they are less common than ordinary annuities. This text focuses on the ordinary annuity assumption. 5 Exhibit 10.3 is analogous to an amortization table for a long-term note with equal payments of principal and interest. edm10890_ch10_442-483.indd Page 449 7/24/10 3:45 PM user-f497 /Volumes/105/PHS00142/work/indd Planning for Capital Investments 449 EXHIBIT 10.3 Cash Flow Classifications for EZ's Investment in Projectors Time Period 1 2 3 4 Totals (a) Investment Balance During the Year $607,470 480,366 338,010 178,571 (b) Annual Cash Inflow (c) Return on Investment (a 3 0.12) (d) Recovered Investment (b 2 c) $200,000 200,000 200,000 200,000 $800,000 $ 72,896 57,644 40,561 21,429 $192,530 $127,104 142,356 159,439 178,571 $607,470 (e) Year-End Investment Balance (a 2 d) $480,366 338,010 178,571 0 W It is customary to assume that the desired rate ofI return includes the effects of compounding.6 Saying an investment is \"earning the desired rate of return,\" assumes L the cash inflows generated by the investment are reinvested at the desired rate of S return. In this case, we are assuming that EZ will reinvest the $200,000 annual cash inflows in other investments that will earn a 12 percent O return. N TECHNIQUES FOR ANALYZING CAPITAL , INVESTMENT PROPOSALS Managers can choose from among numerous analyticalQ techniques to help them make capital investment decisions. Each technique has advantages and disadvantages. A U manager may apply more than one technique to a particular proposal to take advantage of more information. Since most companies have computer capabilities that A include a variety of standard capital budgeting programs, applying different techS niques to the same proposal normally requires little extra effort. Limiting analysis to only one tool could produce biased results. Obtaining more than one perspective H offers substantial benefit. E Net Present Value 1 By using the present value conversion techniques described earlier, EZ Rentals' management determined it would be willing to invest $607,470 today (present value) to 9 obtain a four-year, $200,000 future value annuity cash inflow. The $607,470 invest9 ment is not the cost of the LCD projectors; it is the amount EZ is willing to pay for 7 them. The projectors may cost EZ Rentals more or less than their present value. To determine whether EZ should invest in the projectors, management must compare the B present value of the future cash inflows ($607,470) to the cost of the projectors (the U current cash outflow required to purchase them). Subtracting the cost of the investment from the present value of the future cash inflows determines the net present value of the investment opportunity. A positive net present value indicates the investment will yield a rate of return higher than 12 percent. A negative net present value means the return is less than 12 percent. 6 Compounding refers to reinvesting investment proceeds so the total amount of invested capital increases, resulting in even higher returns. For example, assume $100 is invested at a 10 percent compounded annual rate of return. At the end of the first year, the investment yields a $10 return ($100 3 0.10). The $10 return plus any recovered investment is reinvested so that the total amount of invested capital at the beginning of the second year is $110. The return for the second year is $11 ($110 3 0.10). All funds are reinvested so that the return for the third year is $12.10 [($110 1 $11) 3 0.10]. LO 3 Determine and interpret the net present value of an investment opportunity. edm10890_ch10_442-483.indd Page 450 450 7/24/10 3:45 PM user-f497 /Volumes/105/PHS00142/work/indd Chapter 10 To illustrate, assume EZ can purchase the projectors for $582,742. Assuming the desired rate of return is 12 percent, EZ should buy them. The net present value of the investment opportunity is computed as follows. Present value of future cash inflows Cost of investment (required cash outflow) Net present value $607,470 (582,742) $ 24,728 The positive net present value suggests the investment will earn a rate of return in excess of 12 percent (if cash flows are indeed $200,000 each year). Because the projected rate of return is higher than the desired rate of return, this analysis suggests EZ should accept the investment opportunity. Based on the above analysis we are able to establish the following decision rule: Net present value decision rule: If the net present value is equal to or greater than W zero, accept the investment opportunity. I L S CHECK YOURSELF 10.2 O To increase productivity, Wald Corporation is considering the purchase of a new machine that N costs $50,000. Wald expects using the machine to increase annual net cash inflows by $12,500 for each of the next five years. Wald desires a minimum annual rate of return of 10 percent on , the investment. Determine the net present value of the investment opportunity and recommend whether Wald should acquire the machine. Q U Present value of future cash flows 5 Future cash flow 3 Table 2 factor (n 5 5, r 5 10%) A Present value of future cash flows 5 $12,500 3 3.790787 5 $47,385 S Net present value 5 PV of future cash flows 2 Cost of machine Net present value 5 $47,385 2H $50,000 5 ($2,615) E The negative net present value indicates the investment will yield a rate of return Answer below the desired rate of return. Wald should not acquire the new machine. LO 4 Determine and interpret the internal rate of return of an investment opportunity. 1 9 Internal Rate of Return 9 The net present value method indicates EZ's investment in the projectors will provide a return in excess of the desired rate, but it does not provide the actual rate of return to 7 expect from the investment. If EZ's management team wants to know the rate of return B to expect from investing in the projectors, it must use the internal rate of return method. U The internal rate of return is the rate at which the present value of cash inflows equals the cash outflows. It is the rate that will produce a zero net present value. For EZ Rentals, the internal rate of return can be determined as follows. First, compute the present value table factor for a $200,000 annuity that would yield a $582,742 present value cash outflow (cost of investment). Present value table factor 3 $200,000 5 $582,742 Present value table factor 5 $582,742 4 $200,000 Present value table factor 5 2.91371 Second, since the expected annual cash inflows represent a four-year annuity, scan Table 2 in the Appendix at period n 5 4. Try to locate the table factor 2.91371. edm10890_ch10_442-483.indd Page 451 7/24/10 3:45 PM user-f497 /Volumes/105/PHS00142/work/indd Planning for Capital Investments 451 The rate listed at the top of the column in which the factor is located is the internal rate of return. Turn to Table 2 and determine the internal rate of return for EZ Rentals before you read further. The above factor is in the 14 percent column. The difference in the table value (2.913712) and the value computed here (2.91371) is not significant. If EZ invests $582,742 in the projectors and they produce a $200,000 annual cash flow for four years, EZ will earn a 14 percent rate of return on the investment. The internal rate of return may be compared with a desired rate of return to determine whether to accept or reject a particular investment project. Assuming EZ desires to earn a minimum rate of return of 12 percent, the preceding analysis suggests it should accept the investment opportunity because the internal rate of return (14 percent) is higher than the desired rate of return (12 percent). An internal rate of return below the desired rate suggests management should reject a particular proposal. The desired rate of return is sometimes called the cutoff rate or the hurdle rate. To be accepted, an investment proposal must provide an internal rate of return higher than the hurdle rate, cutoff rate, or desired rate of return. These terms are merely alternatives for the cost of capital. Ultimately, to be accepted, an investment must W provide an internal rate of return higher than a company's cost of capital. Based on the above analysis we are able to establish the following decision rule: I Internal rate of return decision rule: If the internal rate of return is equal to or L greater than the desired rate of return, accept the investment opportunity. S O TECHNIQUES FOR MEASURING INVESTMENT N CASH FLOWS , The EZ Rentals example represents a simple capital investment analysis. The investment option involved only one cash outflow and a single annuity inflow. Investment opportunities often involve a greater variety of cash outflows and inflows. The followQ ing section of this chapter discusses different types of cash flows encountered in busiU ness practice. A Cash Inflows S Cash inflows generated from capital investments comeH from four basic sources. As in the case of EZ Rentals, the most common source of cash E inflows is incremental revenue. Incremental revenue refers to the addi- tional cash inflows from operating activities generated by using additional capital assets. For example, a taxi company expects revenues from taxi fares to increase if it purchases additional taxicabs. 1 Similarly, investing in new apartments should increase rent revenue; opening a new store 9 should result in additional sales revenue. 9 A second type of cash inflow results from cost savings. Decreases in 7 cash outflows have the same beneficial effect as increases in cash inflows. Either way, a firm's cash position improves. For example, purchasing an B automated computer system may enable a company to reduce cash outflows for salaries. Similarly, relocating a manufacturing facility closerU its raw materials source can to reduce cash outflows for transportation costs. An investment's salvage value provides a third source of cash inflows. Even when one company has finished using an asset, the asset may still be useful to another company. Many assets are sold after a company no longer wishes to use them. The salvage value represents a one-time cash inflow obtained when a company terminates an investment. Companies can also experience a cash inflow through a reduction in the amount of working capital needed to support an investment. A certain level of working capital is required to support most business investments. For example, a new retail store outlet requires cash, receivables, and inventory to operate. When an investment is terminated, the decrease in the working capital commitment associated with the investment normally results in a cash inflow. LO 5 Identify cash flows associated with an investment opportunity. edm10890_ch10_442-483.indd Page 452 452 7/24/10 3:45 PM user-f497 /Volumes/105/PHS00142/work/indd Chapter 10 Cash Outflows Cash outflows fall into three primary categories. One category consists of outflows for the initial investment. Managers must be alert to all the cash outflows connected with purchasing a capital asset. The purchase price, transportation costs, installation costs, and training costs are examples of typical cash outflows related to an initial investment. A second category of cash outflows may result from increases in operating expenses. If a company increases output capacity by investing in additional equipment, it may experience higher utility bills, labor costs, and maintenance expenses when it places the equipment into service. These expenditures increase cash outflows. Third, increases in working capital commitments result in cash outflows. Frequently, investments in new assets must be supported by a certain level of working EXHIBIT 10.4 capital. For example, investing in a copy machine requires spending cash to maintain a supply of paper Typical Cash Flows Associated With Capital Investments and toner. Managers should treat an increased working Inflows Outflows W capital commitment as a cash outflow in the period the commitment occurs. 1. Incremental revenue 1. Initial investment I Exhibit 10.4 lists the cash inflows and outflows 2. Cost savings 2. Incremental expenses Ldiscussed above. The list is not exhaustive but does 3. Salvage values 3. Working capital commitments summarize the most common cash flows businesses 4. Recovery of working capital S experience. O TECHNIQUES FOR N COMPARING ALTERNATIVE , CAPITAL INVESTMENT OPPORTUNITIES LO 6 Compare capital investment alternatives. The management of Torres Transfer Company is considering two investment opportunities. One alternative, involving the purchase of new equipment for $80,000, would enable Q Torres to modernize its maintenance facility. The equipment has an expected useful life of U five years and a $4,000 salvage value. It would replace existing equipment that had originally cost $45,000. The existingA equipment has a current book value of $15,000 and a trade-in value of $5,000. The old equipment is technologically obsolete but can operate S for an additional five years. On the day Torres purchases the new equipment, it would H also pay the equipment manufacturer $3,000 for training costs to teach employees to operate the new equipment. The modernization has two primary advantages. One, it will E improve management of the small parts inventory. The company's accountant believes that by the end of the first year, the carrying value of the small parts inventory could be reduced by $12,000. Second, the modernization is expected to increase efficiency, result1 ing in a $21,500 reduction in annual operating expenses. 9 The other investment alternative available to Torres is purchasing a truck. Adding another truck would enable Torres to expand its delivery area and increase revenue. The 9 truck costs $115,000. It has a useful life of five years and a $30,000 salvage value. Operat7 ing the truck will require the company to increase its inventory of supplies, its petty cash account, and its accountsB receivable and payable balances. These changes would add $5,000 to the company's working capital base immediately upon buying the truck. U The working capital cash outflow is expected to be recovered at the end of the truck's useful life. The truck is expected to produce $69,000 per year in additional revenues. The driver's salary and other operating expenses are expected to be $32,000 per year. A major overhaul costing $20,000 is expected to be required at the end of the third year of operation. Assuming Torres desires to earn a rate of return of 14 percent, which of the two investment alternatives should it choose? Net Present Value Begin the analysis by calculating the net present value of the two investment alternatives. Exhibit 10.5 shows the computations. Study this exhibit. Each alternative is analyzed using three steps. Step 1 requires identifying all cash inflows; some may be annuities, and others may be lump-sum receipts. In the case of Alternative 1, the cost edm10890_ch10_442-483.indd Page 453 7/24/10 3:45 PM user-f497 /Volumes/105/PHS00142/work/indd Planning for Capital Investments EXHIBIT 10.5 Net Present Value Analysis Amount 3 Conversion Factor 5 Present Value Alternative 1: Modernize Maintenance Facility Step 1: Cash inflows 1. Cost savings $21,500 2. Salvage value 4,000 3. Working capital recovery 12,000 Total Step 2: Cash outflows 1. Cost of equipment ($80,000 cost$5,000 trade-in) $75,000 2. Training costs 3,000 Total Step 3: Net present value Total present value of cash inflows Total present value of cash outflows Net present value Alternative 2: Purchase Delivery Truck Step 1: Cash inflows 1. Incremental revenue 2. Salvage value 3. Working capital recovery Total Step 2: Cash outflows 1. Cost of truck 2. Working capital increase 3. Increased operating expense 4. Major overhaul Total Step 3: Net present value Total present value of cash inflows Total present value of cash outflows Net present value 3 3 3 3.433081* 0.519369 0.877193 5 5 5 $ 73,811 2,077 10,526 $ 86,414 3 3 1.000000 1.000000 5 5 $69,000 3 30,000 3 5,000 3 W I L S O 3.433081* N 0.519369 0.519369 , $ 75,000 3,000 $ 78,000 5 5 5 $236,883 15,581 2,597 $255,061 Q 1.000000 1.000000 U 3.433081 0.674972 A 5 5 5 5 $115,000 5,000 109,859 13,499 $243,358 $115,000 5,000 32,000 20,000 *Present value of annuity table 2, n 5 5, r 5 14%. Present value of single payment table 1, n 5 5, r 5 14%. Present value of single payment table 1, n 5 1, r 5 14%. 3 3 3 3 S H E $ 86,414 (78,000) $ 8,414 $255,061 (243,358) $ 11,703 Present value at beginning of period 1. Present value of single payment table 1, n 5 3, r 5 14%. 1 9 9 7 saving is an annuity, and the inflow from the salvage value is a lump-sum receipt. B Once the cash inflows have been identified, the appropriate conversion factors are U identified and the cash inflows are converted to their equivalent present values. Step 2 follows the same process to determine the present value of the cash outflows. Step 3 subtracts the present value of the outflows from the present value of the inflows to determine the net present value. The same three-step approach is used to determine the net present value of Alternative 2. With respect to Alternative 1, the original cost and the book value of the existing equipment are ignored. As indicated in a previous chapter, these measures represent sunk costs; they are not relevant to the decision. The concept of relevance applies to long-term capital investment decisions just as it applies to the short-term special decisions that were discussed in Chapter 5. To be relevant to a capital investment decision, costs or revenues must involve different present and future cash flows for each alternative. Since the historical cost of the old equipment does not differ between the alternatives, it is not relevant. 453 edm10890_ch10_442-483.indd Page 454 454 7/24/10 3:45 PM user-f497 /Volumes/105/PHS00142/work/indd Chapter 10 Since the net present value of each investment alternative is positive, either investment will generate a return in excess of 14 percent. Which investment is the more favorable? The data could mislead a careless manager. Alternative 2 might seem the better choice because it has a greater present value than Alternative 1 ($11,703 vs. $8,414). Net present value, however, is expressed in absolute dollars. The net present value of a more costly capital investment can be greater than the net present value of a smaller investment even though the smaller investment earns a higher rate of return. To compare different size investment alternatives, management can compute a present value index by dividing the present value of cash inflows by the present value of cash outflows. The higher the ratio, the higher the rate of return per dollar invested in the proposed project. The present value indices for the two alternatives Torres Transfer Company is considering are as follows. Present value index Present value of cash inflows $86,414 for Alternative 1 5 Present value of cash outflows 5 $78,000 5 1.108 Present value index Present value of cash inflows $255,061 W for Alternative 2 5 Present value of cash outflows 5 $243,358 5 1.048 I Management can use the present value indices to rank the investment alternatives. L In this case, Alternative 1 yields a higher return than Alternative 2. S O Internal Rate of Return Management can also rank investment alternatives using the internal rate of return N for each investment. Generally, the higher the internal rate of return, the more profit, able the investment. We previously demonstrated how to calculate the internal rate of return for an investment that generates a simple cash inflow annuity. The computations are significantly more complex for investments with uneven cash flows. Recall Q that the internal rate of return is the rate that produces a zero net present value. U Manually computing the rate that produces a zero net present value is a tedious trialand-error process. You must first estimate the rate of return for a particular investA ment, then calculate the net present value. If the calculation produces a negative net S present value, you try a lower estimated rate of return and recalculate. If this calculation produces a positive net present value, the actual internal rate of return lies H between the first and second estimates. Make a third estimate and once again recalE culate the net present value, and so on. Eventually you will determine the rate of return that produces a net present value of zero. Many calculators and spreadsheet programs are designed to make these computa1 tions. We illustrate the process with a Microsoft Excel spreadsheet. Excel uses the syntax IRR (values, guess) in 9 which values refers to cells that specify the cash flows for which you want to calculate the internal rate of return and guess is a number you 9 estimate is close to the actual internal rate of return (IRR). The IRRs for the two investment alternatives available to Torres Transfer Company are shown in Exhibit 10.6. 7 Study this exhibit. Excel requires netting cash outflows against cash inflows for each B period in which both outflows and inflows are expected. For your convenience, we have labeled the net cash flows U the spreadsheet. Labeling is not necessary to execute in the IRR function. The entire function, including values and guess, can be entered into a single cell of the spreadsheet. Persons familiar with spreadsheet programs learn to significantly simplify the input required. The IRR results in Exhibit 10.6 confirm the ranking determined using the present value index. Alternative 1 (modernize maintenance facility), with an internal rate of return of 18.69 percent, ranks above Alternative 2 (purchase a truck) with an internal rate of return of 17.61 percent, even though Alternative 2 has a higher net present value (see Exhibit 10.5). Alternative 2, however, still may be the better investment option, depending on the amount available to invest. Suppose Torres has $120,000 of available funds to invest. Because Alternative 1 requires an initial investment of only $78,000, $42,000 ($120,000 2 $78,000) of capital will not be invested. If Torres has edm10890_ch10_442-483.indd Page 455 7/24/10 3:45 PM user-f497 /Volumes/105/PHS00142/work/indd Planning for Capital Investments 455 REALITY BYTES Developing proficiency with present value mathematics is usually the most difficult aspect of capital budgeting for students taking their first managerial accounting course. In real-world companies, the most difficult aspect of capital budgeting is forecasting cash flows for several years into the future. Consider the following capital budgeting project. In 1965 representatives from the Georgia Power Company visited Ms. Taylor's fifth grade class to tell her students about the Edwin I. Hatch Nuclear Plant that was going to be built nearby. One of the authors of this text was a student in that class. In 1966 construction began on the first unit of the plant, and the plant started producing electricity in 1975. The next year, 10 years after hearing the presentation in his fifth grade class, the author worked on construction of the second unit of the plant during the W summer before his senior year of college. This second unit began operations in 1978. I In its 2009 annual report, the Southern Company, which is now the major owner of the plant, stated that the Hatch plant is expected to operate until 2038, and that decommissioning of the plant will continue until 2061. The cost to construct both units L of the plant was $934 million. The estimated cost to dismantle and decommission the plant is over $1 billion. S It seems safe to assume that the students in Ms. Taylor's fifth grade class were not among the first to hear about the power company's plans for the Hatch plant. Thus, we can reasonably conclude that the life of this capital project will be over O 100 years, from around 1960 until 2061. N Try to imagine that you were assigned the task of predicting the cost inflows and outflows for a project that was expected to last 100 years. Clearly, mastering present value mathematics would not be your biggest worry. , Q U EXHIBIT 10.6 A Microsoft Excel Spreadsheet Internal Rate of Return Function S H E 1 9 9 7 B U edm10890_ch10_442-483.indd Page 456 456 7/24/10 3:45 PM user-f497 /Volumes/105/PHS00142/work/indd Chapter 10 no other investment opportunities for this $42,000, the company would be better off investing the entire $120,000 in Alternative 2 ($115,000 cost of truck 1 $5,000 working capital increase). Earning 17.61 percent on a $120,000 investment is better than earning 18.69 percent on a $78,000 investment with no return on the remaining $42,000. Management accounting requires exercising judgment when making decisions. Relevance and the Time Value of Money Suppose you have the opportunity to invest in one of two capital projects. Both projects require an immediate cash outflow of $6,000 and will produce future cash inflows of $8,000. The only difference between the two projects is the timing of the inflows. The receipt schedule for both projects follows. Year Project 1 Project 2 1 2 3 4 Total $2,000 W $3,500 3,000 2,000 1,000 2,000 I 500 2,000 L $8,000 $8,000 S O Because both projects cost the same and produce the same total cash inflows, they N may appear to be equal. Whether you select Project 1 or Project 2, you pay $6,000 and receive $8,000. Because of the,time value of money, however, Project 1 is preferable to Project 2. To see why, determine the net present value of both projects, assuming a 10 percent desired rate of return. Q U Computation of Net Present Value for Project 1 and Project 2 A Net Present Value for Project 1 S Conversion Factor H Period Cash Inflow 3 Table 1, r 5 10% 5 Present Value E 1 $3,500 3 0.909091 5 $3,182 2 3,000 3 3 1,000 3 13 4 500 Present value of future cash inflows 9 Present value of cash outflow 9 Net present value Project 1 0.826446 0.751315 0.683013 5 5 5 7 B Cash Inflow U Annuity 3 Conversion Factor Table 2, r 5 10%, n 5 4 $2,000 3 3.169865 2,479 751 342 6,754 (6,000) $ 754 Net Present Value for Project 2 Present value of cash inflow Present value of cash outflow Net present value Project 2 $6,340 (6,000) $ 340 The net present value of Project 1 ($754) exceeds the net present value of Project 2 ($340). The timing as well as the amount of cash flows has a significant impact on capital investment returns. Recall that to be relevant, costs or revenues must differ between alternatives. Differences in the timing of cash flow payments or receipts are also relevant for decision-making purposes. edm10890_ch10_442-483.indd Page 457 7/24/10 3:45 PM user-f497 /Volumes/105/PHS00142/work/indd Planning for Capital Investments 457 One way to answer your client's ques- Answers to The Curious Accountant tion is to determine which option has t the highest net present value. The t present value of the lump-sum pay- ment option is simple; it is the $115.5 [$231 4 2] million the lottery is prepared to pay them now. The present value of the annuity option must be calculated, and it consists of two parts. The first of the 26 payments of $7,076,692 will be paid immediately, so it is worth $7,076,692 today. The remaining 25 payments will occur at one-year intervals, so their present value is computed as: $7,076,692 3 11.653583* 5 $82,468,818 Adding $7,076,692 to $82,468,818 yields a present W of $89,545,510, which is a lot less than $115.5 million. value This suggests your client should take the lump-sum Ipayment. Of course, the risk of the lottery not making its L annual payments is very low. There is a greater risk that a financial planner may not find investments to earn a 7% S annual return, so the winner would have to consider his or her tolerance for risk before making a final decision. In the case of these particular lottery winners,O chose the lump-sum payment and the other chose one N , the annuity. *This factor is not included in the tables at the end of the chapter, so it is provided here for the purposes of this illustration. Q U A Tax Considerations The previous examples have ignored the effect of income taxes on capital investment S decisions. Taxes affect the amount of cash flows generated by investments. To illusH trate, assume Wu Company purchases an asset that costs $240,000. The asset has a four-year useful life, no salvage value, and is depreciated on a straight-line basis. The E asset generates cash revenue of $90,000 per year. Assume Wu's income tax rate is 40 percent. What is the net present value of the asset, assuming Wu's management 1 desires to earn a 10 percent rate of return after taxes? The first step in answering this question is to calculate the annual cash flow generated by the asset, as shown 9 in Exhibit 10.7. EXHIBIT 10.7 Determining Cash Flow from Investment 9 7 B U Period 1 Cash revenue Depreciation expense (noncash) Income before taxes Income tax at 40% Income after tax Depreciation add back Annual cash inflow Period 2 Period 3 Period 4 $ 90,000 (60,000) 30,000 (12,000) 18,000 60,000 $ 78,000 $ 90,000 (60,000) 30,000 (12,000) 18,000 60,000 $ 78,000 $ 90,000 (60,000) 30,000 (12,000) 18,000 60,000 $ 78,000 $ 90,000 (60,000) 30,000 (12,000) 18,000 60,000 $ 78,000 edm10890_ch10_442-483.indd Page 458 458 7/24/10 3:45 PM user-f497 /Volumes/105/PHS00142/work/indd Chapter 10 Because recognizing depreciation expense does not require a cash payment (cash is paid when assets are purchased, not when depreciation is recognized), depreciation expense must be added back to after-tax income to determine the annual cash inflow. Once the cash flow is determined, the net present value is computed as shown here. Present value Conversion factor Net present Present value Cash flow 3 5 2 5 cash inflows Table 2, r 5 10%, n 5 4 value cash outflows annuity $78,000 3 3.169865 5 $247,249 2 $240,000 5 $7,249 The depreciation sheltered some of the income from taxation. Income taxes apply to income after deducting depreciation expense. Without depreciation expense, income taxes each year would have been $36,000 ($90,000 3 0.40) instead of $12,000 ($30,000 3 0.40). The $24,000 difference ($36,000 $12,000) is known as a depreciation tax shield. The amount of the depreciation tax shield can also be computed by multiplying the depreciation expense by the tax rate ($60,000 3 0.40 5 $24,000). Because of the time value of money, companies benefit by maximizing the depreciation tax shield early in the life W an asset. For this reason, most companies calculate of depreciation expense for tax purposes using the modified accelerated cost recovery system I (MACRS) permitted by tax law rather than using straight-line depreciation. MACRS recognizes depreciation on an accelerated basis, assigning larger amounts of depreciation L in the early years of an asset's useful life. The higher depreciation charges result in lower amounts of taxable income andS lower income taxes. In the later years of an asset's useful life, the reverse is true, and lower depreciation charges result in higher taxes. Accelerated O depreciation does not allow companies to avoid paying taxes but to delay them. The N longer companies can delay paying taxes, the more cash they have available to invest. LO 7 Determine the payback period for an investment opportunity. , TECHNIQUES THAT IGNORE THE TIME VALUE OF MONEY Q U Several techniques for evaluating capital investment proposals ignore the time value of money. Although these techniques are less accurate, they are quick and simple. When A investments are small or the returns are expected within a short time, these techniques S are likely to result in the same decisions that more sophisticated techniques produce. H Payback Method E The payback method is simple to apply and easy to understand. It shows how long it will take to recover the initial cash outflow (the cost) of an investment. The formula for computing the payback period,1 measured in years, is as follows. Payback period 5 Net cost of investment Annual net cash inflow 9 To illustrate, assume Winston Cleaners can purchase a new ironing machine that 9 will press shirts in half the time of the one currently used. The new machine costs 7 $100,000 and will reduce labor cost by $40,000 per year over a four-year useful life. The payback period is computed as B follows. Payback period 5 $100,000 $40,000 5 2.5 years U Interpreting Payback Generally, investments with shorter payback periods are considered better. Because the payback method measures only investment recovery, not profitability, however, this conclusion can be invalid when considering investment alternatives. To illustrate, assume Winston Cleaners also has the opportunity to purchase a different machine that costs $100,000 and provides an annual labor savings of $40,000. However, the second machine will last for five instead of four years. The payback period is still 2.5 years ($100,000 4 $40,000), but the second machine is a better investment because it improves profitability by providing an additional year of cost savings. The payback analysis does not measure this difference between the alternatives. edm10890_ch10_442-483.indd Page 459 7/24/10 3:45 PM user-f497 /Volumes/105/PHS00142/work/indd Planning for Capital Investments Unequal Cash Flows The preceding illustration assumed Winston's labor cost reduction saved the same amount of cash each year for the life of the new machine. The payback method requires adjustment when cash flow benefits are unequal. Suppose a company purchases a machine for $6,000. The machine will be used erratically and is expected to provide incremental revenue over the next five years as follows. 2007 2008 2009 2010 2011 $3,000 $1,000 $2,000 $1,000 $500 Based on this cash inflow pattern, what is the payback period? There are two acceptable solutions. One accumulates the incremental revenue until the sum equals the amount of the original investment. Year Annual Amount Cumulative W Total 2007 2008 2009 $3,000 1,000 2,000 $3,000 L 4,000 6,000 I S O This approach indicates the payback period is three years. A second solution uses an averaging concept. TheN average annual cash inflow is determined. This figure is then used in the denominator of the payback equation. Using , the preceding data, the payback period is computed as follows. 1. Compute the average annual cash inflow. Q U $3,000 1 $1,000 1 $2,000 1 $1,000 1 $500 5 $7,500 4 5 5 $1,500 A Compute the payback period. S Net cost of Average annual 4 5 6,000 4 H 1,500 5 4 years net cash inflow investment E The average method is useful when a company purchases a number of similar assets 2007 1 2008 1 2009 1 2010 1 2011 5 Total 4 5 5 Average 2. with differing cash return patterns. 1 9 The unadjusted rate of return method is another common evaluation technique. Investment cash flows are not adjusted to reflect the time value9 money. The unadjusted rate of of return is sometimes called the simple rate of return. It is computed as follows. 7 Average incremental increase B annual net income in Unadjusted 5 rate of return Net cost of originalU investment Unadjusted Rate of Return To illustrate computing the unadjusted rate of return, assume The Dining Table, Inc., is considering establishing a new restaurant that will require a $2,000,000 original investment. Management anticipates operating the restaurant for 10 years before significant renovations will be required. The restaurant is expected to provide an average after-tax return of $280,000 per year. The unadjusted rate of return is computed as follows. Unadjusted rate of return 5 $280,000 4 $2,000,000 5 14% per year The accuracy of the unadjusted rate of return suffers from the failure to recognize the recovery of invested capital. With respect to a depreciable asset, the capital investment is normally recovered through revenue over the life of the asset. To illustrate, assume we purchase a $1,000 asset with a two-year life and a zero salvage value. For LO 8 Determine the unadjusted rate of return for an investment opportunity. 459 edm10890_ch10_442-483.indd Page 460 460 7/24/10 3:45 PM user-f497 /Volumes/105/PHS00142/work/indd Chapter 10 simplicity, ignore income taxes. Assume the asset produces $600 of cash revenue per year. The income statement for the first year of operation appears as follows. Revenue Depreciation expense Net income $ 600 (500) $ 100 What is the amount of invested capital during the first year? First, a $1,000 cash outflow was used to purchase the asset (the original investment). Next, we collected $600 of cash revenue of which $100 was a return on investment (net income) and $500 was a recovery of investment. As a result, $1,000 was invested in the asset at the beginning of the year and $500 was invested at the end of the year. Similarly, we will recover an additional $500 of capital during the second year of operation, leaving zero invested capital at the end of the second year. Given that the cash inflows from revenue are collected somewhat evenly over the life of the investment, the amount of invested capital W will range from a beginning balance of $1,000 to an ending balance of zero. On average, we will have $500 invested in the asset (the midpoint between $1,000 and zero). The I average investment can be determined by dividing the total original investment by L 2 ($1,000 4 2 5 $500). The unadjusted rate of return based on average invested capital can be calculated as follows. S Unadjusted rate of return O Average incremental increase in annual net income 5 (Based on average investment) Net cost of original investment 4 2 N ,5 $100 5 20% $1,000 4 2 To avoid distortions caused by the failure to recognize the recovery of invested capital, the unadjusted rate of Q return should be based on the average investment when working with investments in depreciable assets. U A S CHECK YOURSELF 10.3 H EZ Rentals can purchase a van that costs $24,000. The van has an expected useful life of three years and no salvage value. EZ expects rental revenue from the van to be $12,000 per year. Determine the payback E period and the unadjusted rate of return. Answer 1 Payback 5 Cost of the investment 4 Annual cash inflow 9 Payback 5 $24,000 4 $12,000 5 2 years 9 Unadjusted rate of return 5 Net income 4 Average cost of the investment 7 Revenue B Depreciation expense Net income U $12,000 (8,000) $ 4,000 [$24,000 4 3 years] Unadjusted rate of return 5 $4,000 4 ($24,000 4 2) 5 33.33% REAL-WORLD REPORTING PRACTICES In a study, researchers found that companies in the forest products industry use discounted cash flow techniques more frequently when the capital project being considered is a long-term timber investment. The use of techniques that ignore the time value of money increased when other shorter-term capital investment projects were being considered. Exhibit 10.8 shows the researchers' findings. edm10890_ch10_442-483.indd Page 461 7/24/10 3:45 PM user-f497 /Volumes/105/PHS00142/work/indd Planning for Capital Investments EXHIBIT 10.8 Forestry Industry Investments Long-term investments in timber Net present 38% value Internal 38% rate of return 9% Unadjusted rate of return 15% Payback period Investments in other assets Net present 22% value Internal 33% rate of return 13% Unadjusted rate of return 32% Payback period Data Source: J. Bailes, J. Nielsen, and S. Lawton, \"How Forest Product Companies Analyze Capital Budgets,\" Management Accounting, October 1998, pp. 24-30. W I L POSTAUDITS S O The analytical techniques for evaluating capital investment proposals depend highly on estimates of future cash flows. Although predictions cannot be perfectly accurate, gross N miscalculations can threaten the existence of an organization. For example, optimistic , projections of future cash inflows that do not materialize will lead to investments that do not return the cost of capital. Managers must take their projections seriously. A postaudit policy can encourage managers to carefully consider their capital investment Q decisions. A postaudit is conducted at the completion of a capital investment project, using the same analytical technique that was used to justify the original investment. For U example, if an internal rate of return was used to justify approving an investment projA ect, the internal rate of return should be computed in the postaudit. In the postaudit computation, actual rather than estimated cash flows are used. Postaudits determine S whether the expected results were achieved. H Postaudits should focus on continuous improvement rather than punishment. Managers who are chastised for failing to achieve expected results might become overly E cautious when asked to provide estimates for future projects. Being too conservative can create problems as serious as those caused by being too optimistic. Managers can err two ways with respect to capital investment decisions. First, a manager might accept 1 a project that should have been rejected. This mistake usually stems from excessively 9 optimistic future cash flow projections. Second, a manager might reject a project that should have been accepted. These missed opportunities 9 usually the result of underare estimating future cash flows. A too cautious manager can become unable to locate 7 enough projects to fully invest the firm's funds. B Idle cash earns no return. If projects continue to outperform expectations, managers are probably estimating future cash flows too conservatively. If projects consistently fail U to live up to expectations, managers are probably being too optimistic in their projections of future cash flows. Either way, the company suffers. The goal of a postaudit is to provide feedback that will help managers improve the accuracy of future cash flow projections, maximizing the quality of the firm's capital investments. A Look Back