10 Capital Investment Decisions
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Learning Objectives
After studying Chapter 10, you will be able to:
• Explain the nature and importance of capital investment decisions.
• Identify the relevant cash inflows and outflows in an investment proposal.
• Use four different evaluation methods to evaluate investments.
• Appreciate ethical issues relating to capital investment decisions.
• Comprehend how income taxes and depreciation impact the cash flows of capital investments.
• Understand how the cost of capital is determined.
• Evaluate investment decisions that include inflation, working capital, uneven project lives, differing initial
investments, and asset disposal gains and losses.
• Understand the basic principles of time value of money.
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Chapter Outline
10.1 The Importance of Capital Investment Decisions
10.2 The Capital Investment Decision
Cash Flows
Decision Criteria
Time Perspectives
An Example—Equipment Replacement and Capacity Expansion
Formatting the Relevant Data
10.3 The Evaluation Methods
Net Present Value Method
Internal Rate of Return (IRR) Method
Payback Period Method
Accounting Rate of Return Method
10.4 Ethical Issues and Pressures on Management
10.5 Taxes and Depreciation
Income Taxes and Capital Investments
Depreciation Expense
The Tax Shield
10.6 Cost of Capital
10.7 Calculation Issues
Inflation and Future Cash Flows
Working Capital
Uneven Project Lives
Evaluation of Projects With Different Initial Investments
Gains and Losses on Asset Disposals
10.8 The Time Value of Money
Present Value of Money
Present Value of a Series of Future Cash Flows
Present Value Analysis Applied
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413
Capital Investment Alternatives
Rose Stanley, President of Eddington Instruments, grabs her
iefcase and heads for
the airport. After clearing security, running to her gate, and just making her flight, Rose
settles into her coach seat, in front of two screaming kids and behind two salespeople who
apparently have just made the deal of the century. She opens her
iefcase and finds the
Capital Spending Proposals file. The deadline for submitting proposals to her was yesterday.
She plans to review these on her cross-country flight. The variety surprises her.
• Engineering is pushing to integrate a newly announced semiconductor into an aging
product. The new technology will push Eddington into new markets with great sales
potential but against stiff competition.
• Adding space to the corporate headquarters will
ing three administrative
departments together, increase efficiency, and reduce operating expenses.
• Her Production Planning Manager proposes rea
anging several work centers to
improve production efficiency for a family of cu
ent products.
• Another project adds capacity to a specialized assembly operation.
• The Plant Manager requests funding for an air purification system, which must be
installed by year-end to meet new state air quality requirements.
• An information systems proposal would automate several manual operations, save
personnel, and reduce inventory by an estimated 10%.
• Her Finance Manager is negotiating for controlling interest in a firm with technical
expertise that Eddington needs for new product development.
• Marketing has proposed a major jump in advertising spending for a product line that
has not been meeting sales targets.
Rose clearly wants to get the “biggest bang for the bucks” from Eddington’s limited capital
investment budget. A quick calculation shows her that this year’s investment dollars will
fund about half of these proposals. Some proposals are risky, while others have predictable
outcomes. Some are straightforward, but many include a host of extraneous issues. Also,
financial data are overstated for some proposals and understated for others. Some generate
immediate returns; others promise big cash flows years from now.
This chapter extends the study of incremental analysis begun in Chapter 9 into multiperiod
decisions, which are called capital investment decisions. This chapter discusses:
1. Identification of relevant cash flows in capital investments
2. Techniques and methods for analyzing project data
Capital investment analysis is a planning task and is directly linked to budgeting, as discussed
in Chapter 7. Capital budgeting is the process of evaluating specific projects, estimating ben-
efits and costs of the projects, and selecting which projects to fund.
Capital budgeting depends on an understanding of the time value of money. For those who
are unfamiliar with the time value of money or have not applied present values in financial
accounting or other courses, section 10.8 explains the concept. Present value tables neces-
sary for discounting future cash flows are located in section 10.8.
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414
Section 10.2 The Capital Investment Decision
Relevant revenues and operating costs for multiperiod decisions are assumed to be cash
inflows and cash outflows, respectively. Since these decisions extend over a period of years,
timing of these cash flows is a major factor.
10.1 The Importance of Capital Investment Decisions
Capital investment is the acquisition of assets with an expected life greater than a year.
These decisions attract managers’ interest for good reasons:
1. Long-term commitments. Capital decisions often lock the firm into assets for many
years.
2. Large amounts of dollars. Capital projects often involve large dollar amounts. From
Ford Motor Company with an annual investment budget of $7 billion to a small firm
uying a $50,000 truck, large relative dollar amounts get attention.
3. Key areas of the firm. New products, new production technology, and research
efforts are crucial to a firm’s ongoing competitiveness.
4. Source of future earnings. Investing with foresight is the key to the firm’s future
profits and financial performance.
5. Scarce capital dollars. In most firms, more demands exist for capital funds than the
firm can meet. Only the best opportunities should be funded.
Excellent analyses and decisions increase the firm’s capacity, technology, efficiency, and cash
generating power. Poor decisions waste resources, lose opportunities, and impact profits for
many years.
10.2 The Capital Investment Decision
A capital investment generally includes a cash outflow, which is the investment, and cash
inflows, which are the returns on the investment. The decision maker expects cash inflows to
exceed cash outflows. The typical investment project has cash outflows at the beginning and
cash inflows over the life of the project.
Cash Flows
Cash flows are the key data inputs in capital investment analyses. Cash has an opportunity
cost, since it could be used to buy a productive or financial asset with earning power. Cash is
a basic asset. Prices, costs, and values can all be expressed in cash amounts. If the decision
impacts several time periods, cash-flow timing becomes a relevant factor.
Cash outflows commonly include:
1. The cash cost of the initial investment plus any startup costs
2. Incremental cash operating costs incu
ed over the project’s life
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415
Section 10.2 The Capital Investment Decision
3. Incremental working capital such as inventories and accounts receivable
4. Additional outlays needed to overhaul, expand, or update the asset during the proj-
ect’s life
5. Additional taxes owed on incremental taxable income
Cash inflows include:
1. Incremental cash revenues received over the project’s life
2. Reduced operating expenses received over the project’s life (A reduction of a cash
outflow is treated as a cash inflow.)
3. Cash received from selling old assets being replaced in the new project, net of any
tax impacts
4. Released working capital, perhaps at the project’s end
5. Salvage value (net of taxes) realized from asset disposition at the project’s end
These relevant cash flows occur after the “go” decision is made to proceed with the project.
Therefore, we are estimating future cash flows. Certain cash flows are estimated based on
cu
ent prices and known technology, whereas others are estimates based on vague facts and
unproven methods. Often, cost savings and project benefits are not easily quantified. Much
time and expense are spent to develop supporting forecast data. It is important to understand
that the same cash-flow estimates are used regardless of the project evaluation method used.
Decision Criteria
Capital investment decisions are either:
Accept or reject or Select A or B or C, etc. (or some combination of these)
In the first type, we decide whether the return is acceptable or unacceptable. This is a screen-
ing decision. Is the return “good enough?” The second type is a preference or ranking deci-
sion—select the best choice from a set of mutually exclusive projects. By picking A, we reject
B, C, and any other choices. One possible choice is to do nothing—the status quo.
Generally, projects are ranked on a scale of high to low returns. The highest-ranking proj-
ects are selected, until the capital investment budget is spent. Often, funds are limited; many
acceptable projects will go unfunded. The firm’s goal is to select projects with the highest
eturns. As in Chapter 9, pertinent nonquantitative factors may sway a decision and cause
lower-ranked projects to be selected.
Time Perspectives
In the real world, every conceivable combination of cash-flow timing can exist. However,
we assume a simplified timeline. The present point in time is today, Year 0. This is when
we assume investments are made—new assets acquired, old assets sold, and any tax conse-
quences of these changes assessed. In real life, several years of cash outflows may precede the
start of a project’s operation.
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Section 10.2 The Capital Investment Decision
Generally, annual time periods are used. Using shorter time periods is possible, such as one-
month periods for monthly lease payments. Annual flows of cash are assumed to occur at
year-end due to the mathematics underlying the construction of the present value tables.
An Example—Equipment Replacement and Capacity Expansion
As an illustration, Clairmont Timepieces is considering a device costing $100,000 to replace
an obsolete production device:
1. The new device’s expected life is five years and can probably be sold at the end of
Year 5 for $10,000.
2. The vendor recommends an overhaul in Year 3 at a cost of $20,000.
3. Capacity will immediately increase by 1,000 units per year. Each unit sells for $55
and has $30 of