IMAppendix

Appendix - Capital Investment Decisions: An Overview
Appendix
Capital Investment Decisions: An Overview
Appendix Outline
I. INTRODUCTION
II. ANAL!IN" CA#$ %LO&# %OR 'R(#(NT )ALU( ANAL#I#
* Distin+uis,in+ -etween revenues. costs. and cas, /lows
III. N(T 'R(#(NT )ALU(
* Appl0in+ present value anal0sis
I). CA'ITAL IN)(#T1(NT ANAL#I#: AN (2A1'L(
). CAT("ORI(# O% 'RO3(CT CA#$ %LO&#
A. Investment cas, /lows
4. 'eriodic operatin+ cas, /lows
C. Cas, /lows /rom t,e depreciation tax s,ield
D. Disinvestment cas, /lows
)I. 'R('ARIN" T$( N(T 'R(#(NT )ALU( ANAL#I#
)II. U#IN" 1ICRO#O%T (2C(L TO 'R('AR( T$( N(T 'R(#(NT )ALU(
ANAL#I#
5e0 Concepts
* Capital investment decisions are t,e responsi-ilit0 o/ mana+ers o/ investment centers.
6 #peci/ic investments over a certain dollar amount re7uire approval -0 t,e -oard o/
directors in man0 companies.
6 Cost accountants estimate t,e amount and timin+ o/ t,e cas, /lows used in capital
investment decision models to ,elp mana+ers ma8e t,ose decisions.
* Capital investment models are -ased on t,e /uture cas, /lows expected /rom a particular asset
investment opportunit0.
6 T,e amount and timin+ o/ t,e cas, /lows /rom a capital investment pro9ect determine its
economic value.
6 4ecause o/ t,e timin+ o/ cas, /lows. an0 investment pro9ect ,as an opportunit0 cost /or
cas, committed to it.
6 T,e time value of money conve0s t,e concept t,at cas, received earlier is wort, more
t,an cas, received later.
6 T,e /uture cas, /lows associated wit, a pro9ect are ad9usted to t,eir present value usin+
a predetermined discount rate to reco+ni:e t,e time value o/ mone0.
App-;
< =>;? -0 1c"raw-$ill (ducation. T,is is proprietar0 material solel0 /or aut,ori:ed instructor use. Not aut,ori:ed /or sale or
distri-ution in an0 manner. T,is document ma0 not -e copied. scanned. duplicated. /orwarded. distri-uted. or posted on a we-site. in
w,ole or part.
6 T,e discount rate is t,e interest rate used to compute net present value.
6 Net present value (NPV) represents t,e economic value o/ a pro9ect at a point in time.
Net present value @ #um o/ discounted /uture cas, /lows A Initial investment.
6 I/ t,e net present value o/ a pro9ect is positive. t,e pro9ect will earn a rate o/ interest
,i+,er t,an its discount rate.
6 T,e decision models used /or capital investments attempt to optimi:e t,e economic
value to t,e /irm -0 maximi:in+ t,e net present value o/ /uture cas, /lows.
* It is important to distin+uis, cas, /lows /rom revenues and costs w,en timin+ di//erence exists.
6 Capital investment anal0sis uses cas, /lows. not revenues and costs as reco+ni:ed in
accrual concept.
* T,e present value o/ cas, /lows is t,e amount o/ /uture cas, /lows discounted to t,eir
e7uivalent wort, toda0.
6 T,e net present value o/ a pro9ect can -e computed as
N') @
>
B; C
N
n
n
n
C d

=
+
. w,ere
C
n
@ Cas, to -e received or dis-ursed at t,e end o/ time period n.
d @ Appropriate discount rate /or t,e /uture cas, /lows.
n @ Time period w,en t,e cas, /low occurs. and
N @ Li/e o/ t,e investment Bin 0earsC.
6 T,e term (1+d)
-n
is called a present value /actor. Ta-les o/ present value /actors are at
t,e end o/ t,is appendix in (x,i-it A.D.
(xample ;: On ,is ;E
t,
-irt,da0. 3o,n was noti/ied -0 an attorne0 t,at ,e will in,erit
F;G>.>>> /rom a ric, uncle w,en ,e reac,es =; 0ears o/ a+e. Assumin+ a discount rate
o/ E percent. w,at is 3o,nHs wort, now wit, respect to t,e in,eritance mone0I
T,e mone0 Bcas, in/lowC will -e vested in G 0ears. T,at is.
ear
> ; = J ? G
App-=
w,ole or part.
I F;G>.>>>

T,e present value /actor o/ (1 + 6%)
-5
is >.K?K. T,e present value o/ 3o,nHs /uture
in,eritance is F;G>.>>> L >.K?K @ F;;=.>G>.
6 An annuit0 is a constant Be7ualC pa0ment over a period o/ time. T,e present value
/actors /or an annuit0. -ased on t,e /ormula M
-
; - B; C
n
d
d
+
N. are s,own in (x,i-it A.O.
6 T,e present value o/ an annuit0 can -e calculated -0 summin+ t,e present value o/ t,e
individual pa0ments over t,e annuit0 period. or it can -e calculated -0 multipl0in+ t,e
annuit0 pa0ment -0 t,e sum o/ t,e present value /actors.
(xample =: 3enn0 is K; 0ears old. #,e -ou+,t an insurance polic0 0ears a+o t,at pa0s
,er F;G.>>> ever0 0ear to supplement ,er income. &it, a li/e expectanc0 o/ DE 0ears
and an assumed discount rate o/ D percent. w,at is t,e remainin+ value o/ t,e annuit0
nowI BT,e cost o/ t,e polic0 is considered sun8 and not relevant /or t,is 7uestion.C
T,e timeline -elow s,ows t,e pattern o/ cas, in/lows /or t,e next ;G 0ears.
ear
> ; = J ? P ;G
I F;G.>>> F;G.>>> F;G.>>> F;G.>>> P F;G.>>>

T,e present value /actor o/ t,e annuit0. [1 - (1 + 8%)
-15
] 8%. is D.GGO. T,e present
value o/ 3enn0Hs annuit0 /or ,er expected remainin+ li/e is wort, F;G.>>> L D.GGO @
F;=D.JDG.
(xample J: A developer is considerin+ t,ree possi-le investment opportunities. All
t,ree re7uire t,e same initial investment o/ F=>.>>> and will last /or J 0ears. 'ro9ect ;
will return FO.>>> ever0 0ear at t,e end o/ next t,ree 0ears. 'ro9ect = is expected to
+enerate F;=.>>> at 0ear = and F;G.>>> at 0ear J. %inall0. 'ro9ect J will return F=K.>>>
at t,e end o/ t,e t,ird 0ear. T,e developer uses a discount rate o/ ;= percent. &,ic,
pro9ect s,ould t,e developer c,ooseI
App-J
w,ole or part.
'ro9ect ;
Cas, in/low FO.>>> L =.?>=
a
F=;.E;D
Cas, out/low B=>.>>>C
Net present value F;.E;D
a
'resent value /actor o/ an annuit0 at ;=Q /or t,ree 0ears.
'ro9ect =
Cas, in/low F;=.>>> L >.KOK
-
R F;G.>>> L >.K;=
c
F=>.=??
Net present value F=??
-
'resent value /actor at ;=Q /or two 0ears.
c
'resent value /actor at ;=Q /or t,ree 0ears.
'ro9ect J
Cas, in/low F=K.>>> L >.K;=
c
F;O.==?
Net present value FBKKEC
c
'resent value /actor at ;=Q /or t,ree 0ears.
(ven t,ou+, t,e total BundiscountedC cas, in/lows are t,e same. F=K.>>>. /or t,e
pro9ects under consideration. t,e timin+ o/ t,e cas, /lows does ma8e a di//erence. 40
receivin+ cas, in/lows earl0 and o/ten. 'ro9ect ; outper/orms t,e ot,er two in terms o/
t,e net present value. 'ro9ect = is less appealin+ -ut still accepta-le wit, a positive
N'). A ne+ative N'). suc, as t,at o/ 'ro9ect J. indicates a return less t,an t,e
discount rate used.
* %our ma9or cate+ories o/ cas, /lows /or a pro9ect are:
B;C Investment cas, /lows.
B=C 'eriodic operatin+ cas, /lows.
BJC Cas, /lows /rom t,e depreciation tax s,ield. and
B?C Disinvestment cas, /lows.
6 T,ere are t,ree t0pes o/ investment cas, /lows: Asset ac7uisitions. wor8in+ capital
commitments. and investment tax credit. i/ an0.
App-?
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6 Asset acquisition involves t,e costs o/ purc,asin+ and installin+ an asset. includin+ an0
resultin+ +ain or loss on disposal.
6 All ac7uisition costs are listed as cas, out/lows in t,e 0ears in w,ic, t,e0 occur.
Installation costs are also considered a cas, out/low.
6 T,e tax e//ect as a result o/ t,e di//erence -etween depreciation tax -asis and proceeds
/rom t,e sale o/ t,e replaced e7uipment will -e considered a cas, in/low B/or a lossC or a
cas, out/low B/or a +ainC.
6 Working capital represents cas,. accounts receiva-le. and ot,er s,ort-term assets
re7uired to maintain an activit0.
6 T,e wor8in+ capital committed to a pro9ect normall0 remains constant over t,e li/e o/
t,e pro9ect. alt,ou+, it is sometimes increased -ecause o/ in/lation.
6 Investment tax credit (IT) reduces /ederal income taxes as a result o/ certain asset
purc,ases.
6 Investment tax credits e//ectivel0 s,rin8s t,e cost o/ ma8in+ investments -0 +ivin+
companies a credit a+ainst t,eir corporate income taxes e7ual to a certain percenta+e o/
t,e purc,ase price.
6 T,e primar0 reason /or ac7uirin+ lon+-term assets is usuall0 to +enerate positive
periodic operatin+ cas, /lows as t,e results o/ revenue-+eneratin+ activities and cost-
savin+ pro+rams.
6 'eriodic operatin+ /lows include
B;C 'eriodic cas, in/lows BRC and out/lows B-C -e/ore taxes. and
B=C Income tax e//ects o/ in/lows B-C and out/lows BRC.
6 Costs t,at do not involve cas, Bsuc, as depreciation. depletion. and amorti:ationC are
excluded. so are /inancin+ costs Bunder t,e assumption t,at t,e /inancin+ decision is
separate /rom t,e asset-ac7uisition decisionC.
6 T,e cost o/ /inancin+ is included in t,e discount rate.
6 A tax s!ield re/ers to t,e reduction in tax pa0ments -ecause o/ depreciation deducted
/or tax purposes. It is one o/ t,e primar0 incentives used -0 tax polic0 ma8ers to promote
investment in lon+-term assets.
6 T,e depreciation deduction computed /or t,e tax s,ield Busin+ accelerated write-o//sC is
not necessaril0 t,e same amount as t,e depreciation computed /or /inancial reportin+
purposes Busin+ predominantl0 strai+,t-line met,odC.
App-G
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@@@@@@@@@@@@@@@@@@@@@@
Demonstration 'ro-lem ;
5a,n Industr0. Inc. decides to add a new mac,ine to its assem-l0 line. T,e new mac,ine costs
F;=>.>>> wit, a use/ul li/e o/ E 0ears and no salva+e value. T,e new mac,ine is expected to
-rin+ cas, in/lows o/ FD>.>>> w,ile incurrin+ cas, out/lows o/ FG>.>>> ever0 0ear. T,e
compan0 uses strai+,t-line met,od to calculate its depreciation. T,e tax rate is assumed to -e ?>
percent.
Re7uired:
Determine t,e tax s,ield o/ t,e purc,ase.
#olution:
T,e annual depreciation c,ar+e associated wit, t,e new mac,ine is F=>.>>> B@ F;=>.>>> S E
0earsC.
!ange in
net income
!ange in
cas! flo"s
!ange in
cas! flo"s
"it!out
depreciation
Cas, in/lows FD>.>>> FD>.>>> FD>.>>>
Cas, out/lows BG>.>>>C BG>.>>>C BG>.>>>C
4e/ore-tax net /lows FJ>.>>> FJ>.>>> FJ>.>>>
Depreciation B=>.>>>C
4e/ore-tax NI F;>.>>>
Tax B?>QC B?.>>>C B?.>>>C B;=.>>>C
A/ter-tax NI FE.>>>
A/ter-tax net /lows F=E.>>> F;D.>>>
T,e tax s,ield is wort, FD.>>> B@ F=>.>>> L ?>Q. or F;=.>>> - F?.>>>C as t,e result o/
depreciation deduction.
@@@@@@@@@@@@@@@@@@@@@@
6 T,e /aster an assetHs cost can -e written o// /or tax purposes. t,e sooner t,e tax
deductions are reali:ed and. t,ere/ore. t,e ,i+,er t,e net present value o/ t,e tax s,ield.
6 T,e depreciation tax s,ield a//ects t,e net present value anal0sis in two wa0s:
B;C Depreciation tax s,ield on ac7uired assets. and
B=C %or+one depreciation tax s,ield on disposed assets.
App-E
w,ole or part.
6 #isinvestment flo"s are cas, /lows t,at ta8e place at t,e termination o/ a capital
pro9ect. includin+
B;C Cas, /reed /rom wor8in+ capital commitment.
B=C #alva+e value o/ t,e lon+-term assets.
BJC Tax conse7uences /or di//erences -etween salva+e proceeds and t,e remainin+
depreciation tax -asis o/ t,e asset. and
B?C Ot,er cas, /lows. suc, as emplo0ee severance pa0ments and restoration costs.
6 T,e tax $asis is t,e remainin+ tax-deprecia-le T-oo8 valueU o/ an asset /or tax
purposes.
6 T,e di//erence -etween t,e -oo8 value Btax -asisC and t,e net salva+e value can result in
a taxa-le +ain or loss.
6 %or an asset replacement decision. t,e /or+one salva+e value Band related tax e//ectsC
/rom t,e old assets must -e considered.
@@@@@@@@@@@@@@@@@@@@@@
Demonstration 'ro-lem =
A compan0 wants to expand its operations. One capital investment proposal under consideration
is t,e ac7uisition o/ additional e7uipment. T,e cost o/ initial investment is estimated to -e
FKG.>>> wit, use/ul li/e o/ E 0ears and t,e disposal value o/ F;G.>>>. #trai+,t-line depreciation
met,od will -e used /or -ot, /inancial and tax purposes.
T,e expansion will -rin+ in an estimated FJD.>>> cas, ever0 0earV t,e annual operatin+ expenses
are around F;K.>>>. At t,e end o/ t,e t,ird 0ear. a one-time tune-up is re7uired /or a cost o/
FD.>>>. 4ecause o/ t,e expansion. wor8in+ capital in t,e amount o/ F;?.>>> must -e committed.
T,e tax rate and t,e discount rate are ?> percent and ;= percent. respectivel0.
Re7uired:
;. (valuate t,e expansion proposal usin+ t,e net present value anal0sis.
=. Assume t,at at t,e end o/ t,e /ourt, 0ear. -ecause o/ un/oreseen reasons. t,e e7uipment
is salva+ed /or FG>.>>>. &,at are t,e tax conse7uences o/ t,e disposalI
#olution:
;. As soon as t,e cas, /low data ,ave -een +at,ered. t,e0 are assem-led into t,e /ollowin+
sc,edule t,at s,ows t,e cas, /lows /or eac, 0ear o/ t,e pro9ectHs li/e. T,ese /lows are
classi/ied into t,e /our cate+ories discussed earlier.
B;C Investment cas, /lows.
App-K
w,ole or part.
B=C 'eriodic operatin+ cas, /lows.
App-D
w,ole or part.
BJC Cas, /lows /rom t,e depreciation tax s,ield.
B?C Disinvestment cas, /lows.
ear
> ; = J ? G E
Investment /lows:
New e7uipment FBKG.>>>C
&or8in+ capital B;?.>>>C
Annual cas, /lows:
Operatin+ cas, /lows
a
F;=.E>> F;=.E>> FK.D>> F;=.E>> F;=.E>> F;=.E>>
Depreciation tax s,ield
-
?.>>> ?.>>> ?.>>> ?.>>> ?.>>> ?.>>>
Disinvestment /lows:
Return o/ wor8in+ capital ;?.>>>
'roceeds on disposal ;G.>>>
Total cas, /lows FBDO.>>>C F;E.E>> F;E.E>> F;;.D>> F;E.E>> F;E.E>> F?G.E>>
'resent value /actor at ;=Q ;.> >.DOJ >.KOK >.K;= >.EJE >.GEK >.G>K
'resent value FBDO.>>>C F;?.D=? F;J.=J> FD.?>= F;>.GGD FO.?;= F=J.;;O
Net present value FBO.?GGC
a
%or 0ears ; t,rou+, E. except 0ear J. t,e operatin+ cas, /lows are calculated as
BFJD.>>> - F;K.>>>C L B; A ?>QC @ F;=.E>>.
%or 0ear J. t,e operatin+ cas, /lows are calculated as
BFJD.>>> - F;K.>>> - FD.>>>C L B; A ?>QC @ FK.D>>.
-
T,e annual depreciation expense is F;>.>>> B@ BFKG.>>> - F;G.>>>C S E 0earsC. T,e tax s,ield
represents tax savin+s as a result o/ depreciation deduction. calculated as
F;>.>>> L ?>Q @ F?.>>>.

T,e ne+ative net present value indicates t,at t,e expansion will earn less t,an t,e ;= percent
used to discount t,e cas, /lows. ma8in+ t,is proposal less desira-le.
=. At t,e end o/ t,e /ourt, 0ear. t,e tax -asis will -e FJG.>>> B@ FKG.>>> Cost - F;>.>>>
Annual depreciation L ?C. same as t,e net -oo8 value. since t,e strai+,t-line met,od is used
/or -ot,.
T,e tax pa0ment due to disposal will -e FE.>>> B@ BFG>.>>> 'roceeds /rom disposal -
FJG.>>> Tax -asisC L ?>QC.
T,e a/ter-tax cas, in/low -ecomes F??.>>> B@ FG>.>>> 'roceeds /rom disposal - FE.>>> Tax
pa0mentC.
@@@@@@@@@@@@@@@@@@@@@@
6 (x,i-it A.= contains t,e anal0sis /or an investment decision.
6 All t,e calculations are availa-le in spreads,eet pro+rams suc, as 1icroso/t (xcel wit,
-uilt-in /unctions. as s,own in (x,i-its A.J A A.K.
App-O
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1atc,in+
A. Asset ac7uisition %. 'resent value
4. Discount rate ". Tax -asis
C. Disinvestment /lows $. Tax s,ield
D. Investment tax credit I Time value o/ mone0
(. Net present value 3. &or8in+ capital
WWWWW ;. Cas, /lows t,at ta8e place at t,e termination o/ a capital pro9ect.
WWWWW =. T,e reduction in tax pa0ment -ecause o/ depreciation deducted /or tax purposes.
WWWWW J. Cas,. accounts receiva-le. and ot,er s,ort-term assets re7uired to maintain an
activit0.
WWWWW ?. Reduces /ederal income taxes as a result o/ certain asset purc,ases.
WWWWW G. Involves t,e costs o/ purc,asin+ and installin+ an asset. includin+ an0 resultin+ +ain
or loss on disposal.
WWWWW E. T,e amount o/ /uture cas, /lows discounted to t,eir e7uivalent wort, toda0.
WWWWW K. Conve0s t,e concept t,at cas, received earlier is wort, more t,an cas, received later.
WWWWW D. T,e interest rate used to compute net present value.
WWWWW O. T,e economic value o/ a pro9ect at a point in time.
WWWWW ;>. T,e remainin+ tax-deprecia-le T-oo8 valueU o/ an asset /or tax purposes.
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Answers
;. C
=. $
J. 3
?. D
G. A
E. %
K. I
D. 4
O. (
;>. "
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Appendix - Capital Investment Decisions: An Overview

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