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long-term nature, the short-term impact on cash is mitigated, resulting in a series of annual debt service outlays
(principal and interest payments) rather than the initial cash outlay that otherwise would be necessary.
Resources and Returns
The decision to purchase a fixed asset usually is assessed in terms of its long-term impact on financial status,
but it also has some short-term consequences. In particular, it will affect cash management via either the use of
cash to purchase it or an increase in equity or debt to finance its acquisition. In this latter instance, assuming the
debt is of a long-term nature, the short-term impact on cash is mitigated, resulting in a series of annual debt
service outlays (principal and interest payments) rather than the initial cash outlay that otherwise would be necessary.
CAPITAL INVESTMENT ANALYSES
A typical capital investment proposal involves an outlay of money at the present time (the investment) so as
to realize a stream of benefits (cash inflows) over some future period of time. That is, the acquisition of a fixed
assetgenerally a piece of equipment or machinery, but occasionally a new or renovated facility of some sort
will almost always result in some future cash inflows. These inflows generally come about as a result of the assets ability to decrease operating expenses or increase revenues by an amount that exceeds the associated increase in expenses. The period during which these effects are felt is known as the economic life of the asset.
Three basic techniques can be used to determine whether the cash flows are sufficient to justify the initial
outlay of funds: the payback period, net present value, and internal rate of return.
Technique #1. Payback Period
The payback period is the easiest technique. It consists of dividing the net investment amount by the estimated annual cash inflows attributable to the investment. The net investment amount is the purchase price of the
new asset, plus installation costs, plus disposal costs of the asset being replaced, minus any revenue received
from its sale. Annual cash flows are the reduced expenses or increased contribution attributable to the new asset.
The quotient of the two is the number of years of cash inflows necessary to recover the investment.
Example: Nido Escondido Bank is considering the purchase of a $100,000 piece of equipment for its check processing activities. The new equipment will replace an existing piece of equipment, which the vendor has offered to repurchase for $20,000.
It will also result in labor savings of approximately $40,000 a year. Thus, the net investment amount is $80,000 ($100,000 $20,000 for the old equipment). The labor savings of $40,000 a year constitute the cash inflows attributable to the investment.
The resulting payback period is two years ($80,000 $40,000).
The principal advantage of the payback period is its simplicity, and it frequently is used to gain a rough
sense of the feasibility of an investment opportunity. Its two main disadvantages are that it excludes the time
value of money and does not permit comparisons among competing projects unless all have the same economic
lives.
These disadvantages are related, and rest on the idea that a dollar saved a year from today is worth less than
a dollar saved today, a dollar saved two years from today is worth even less, and so on. If the payback period is
relatively short, as it was in the above example, this is not a particularly serious limitation, but with longer time
horizons, the payback periods utility is quite limited.
Technique #2. Net Present Value (NPV)
The NPV technique avoids the time-related disadvantage of the payback period by incorporating the time
value of money into the analysis. It does so, as its name implies, by calculating the value in todays terms of the
future cash inflows resulting from the investment. In effect, it discounts cash flows received in the future to their
present value.(If you do not understand present value, you should work through Appendix A at the end of the
note before reading any further.)
A capital investment analysis using the technique of net present value involves five steps:
1. Determine the estimated annual cash inflows from the investment. These may be either increased
contribution (increased revenues less the associated expenses from, say, a new product line) or decreased expenses from, say, a labor-saving piece of equipment. In either case, they must result exclusively from the investment itself and not from activities that would have taken place anyway.
2. Estimate the economic life of the investment. This is not the physical life of the new asset, but rather
the time period over which it will generate the cash flows. This distinction has become quite important in purchasing personal computers, which tend to have long physical lives but quite short (2 to 3
years) economic lives.
3. Determine the net amount of the investment. This is its purchase price, plus installation costs, plus
disposal costs for the old asset, less any cash received from selling the old asset.
4. Determine the required rate of return. Ordinarily, this is the organizations weighted cost of capital,
increased to reflect the mix of assets on the balance sheet and the level of risk associated with the investment. This issue is discussed in detail later in the note.
5. Compute the net present value according to the following formula:
Net present value = Present value of cash inflows - Net investment amount
Many hand-held calculators and spreadsheet software packages have present-value functions that can be
used to make these computations. For our purposes here, we will use the present-value factors in Tables A and B
in Appendix A. As a result, the formula is slightly different from above:
Net present value = (Cash inflows x present value factor) - Net investment amount
or
NPV = (CF x pvf) - I
Present-value factors for one-time cash flows are in Table A, and present-value factors for even annual cash
flows are in Table B. In both tables, the appropriate present-value factor lies at the intersection of the year row
and percent column selected in steps 2 and 4 above.
Example: Nido Escondido Bank has an opportunity to purchase some equipment that will result in labor savings of approximately $33,000 a year. The equipment has a purchase price of $120,000 (net) and is expected to produce the labor savings for
approximately 5 years. The banks board has decided that an acceptable project must have a rate of return of at least 8 percent
a year. To determine if the proposed investment is financially feasible, the bank would do the following analysis:
1.
2.
3.
4.
5.
The investment, therefore, is financially feasible, i.e. the present value of the annual cash flows is greater than the amount of
the investment.
It is important to note that once we have determined our desired rate of return a project that yields a net present value of zero or greater should be acceptable. That is, it is not important for the project to produce a present
value greater than zero since, if this were the case, the implication would be that the required rate of return is
too low.
Technique #3. Internal Rate of Return
The internal rate of return (IRR) method is similar to that of net present value; however, instead of specifying a required rate of return for making the calculations (8 percent in the above example), we set net present
value equal to zero and calculate the effective rate of return for the investment. Although this method is slightly
more complicated than the net present value approach, it has the advantage of giving an exact rate of return
rather than simply concluding that a proposed project meets (or fails to meet) an organizations stipulated rate of
return.
The IRR approach begins with the net present value formula: NPV = (CF x pvf) - I, but sets NPV equal to
zero, so that CF x pvf = I, or
pvf = I CF
Once the present value factor has been determined, it can then be located on Table B in the row corresponding to the number of years of economic life of the project. The resulting rate of return, can be determined from
the column in which the pvf is found. Again, some calculators and spreadsheet programs have functions that can
compute IRR quite easily, so our approach here is a bit more cumbersome than it would be in practice.
Effect of Taxes
Since an increase in income will be taxed, the tax effects of a proposed project are important considerations.
In effect, they mean that an organization will not receive the full amount of a projects cash flows. At the same
time, however, depreciation serves as a tax shield, reducing the amount of taxes that otherwise would be paid.
It does so by increasing the organizations expenses which, other things equal, reduces income before taxes.1
Example: Nido Escondido is in a 37 percent tax bracket. Therefore, of the $33,000 in anticipated cost savings, $12,210
($33,000 x .37) will be taxed. Additionally, however, with annual depreciation of $24,000 (120,000 5), $8,880 ($24,000 x
.37) of tax savings will be realized. The net effect of $3,330 ($12,210 - $8,880) can be computed in one of two ways. The first
uses the above numbers, as follows: $33,000 - $12,210 + $8,880 = $29,670. The second, is perhaps somewhat more intuitive,
and can be calculated as follows:
1. Annual cash flows
Income Statement Cash Flow
Annual increase in before-tax income from cost savings
$33,000
Annual cash flows from cost savings (assuming all are in cash)
$33,000
Less: Depreciation expense for the investment
24,000
Equals: incremental taxable income
$ 9,000
3,330
Less: Incremental income tax (at 37%)
3,330
Equals: incremental after tax effect
$ 5,670
$29,670
2.
3.
4.
5.
Economic life
Net investment amount
Rate of return
NPV= (CF x pvf) - I
= 5 years
= $120,000
= 8 percent
= ($29,670 x 3.993) - $120,000
= $118,472 - $120,000
= ($1,528)
Conclusion: When taxes are considered, the investment is no longer financially feasible.
Example: Assume that Nido Escondido Bank uses the sum-of-years-digits method to calculate its depreciation for tax
purposes.2 The result is the following annual depreciation expense figures:
Year
Rate
Beginning Book Value Depreciation Expense Ending Book Value
1
5/15 =.333
$120,000
$39,960
$80,040
2
4/15 =.267
80,040
32,040
48,000
3
3/15 =.200
48,000
24,000
24,000
4
2/15 =.133
24,000
15,960
8,040
5
1/15 =.067
8,040
8,040
0
Recall that depreciation is a non-cash expense, which is why we do not include it in the cash flows from the project. (We also
would be double counting if we did so since the investment is what we depreciate). However, it is a legitimate operating expense
and thus can serve, other things equal, to reduce taxes.
2 Sum-of-years-digits is one of several approaches to computing accelerated depreciation. Other approaches can be found in almost
any financial accounting textbook. Note that the denominator for computing each years rate is the sum of the digits of the assets economic life (i.e., 1+2+3+4+5 = 15)
$(6,960)
960
9,000
17,040
24,960
$45,000
$(2,575)
355
3,330
6,305
9,235
$16,650
$35,575
32,645
29,670
26,695
23,765
$148,350
pvf
Gross
Present Value
.926
.857
.794
.735
.681
$32,943
27,977
23,558
19,621
16,184
$120,282
120,000
$ 282
Conclusion: When accelerated depreciation is used, the investment again becomes financially feasible.
Because the depreciation expense is different each year, we now must compute GPV on an annual basis.
An exception to this simplifying approach is made when there are varying inflation rates for different elements of the proposal
(e.g., labor versus raw materials), or when the inflation rate differs considerably from the required rate of return. Most textbooks
on finance discuss this issue in some detail.
Project Ranking
Since most organizations do not have sufficient funds to undertake all financially feasible projects, senior
management must devise a method to rank projects by their desirability. One approach is to compute the IRR
for each proposal and then to rank them from highest to lowest. Another is to calculate each projects ratio of
Gross Present Value to the Investment amount, as follows:
GPV/I ratio
=
To illustrate this approach, suppose we have two proposals. Proposal A requires an investment of $2,000 and
yields a cash inflow of $2,400 one year from now; Proposal B requires an investment of $3,000 and yields cash
inflows of $900 a year for five years. If the required rate of return is 8 percent, the GPV/I ratio indicates that
Proposal B is preferable, as shown below:
Investment
Cash Inflow
pvf at 8%
GPV
GPV/I Ratio
Proposal
A
$2,000
$2,400, Year 1
0.926
$2,222
1.11
B
$3,000
$900, Years 1-5
3.993
$3,594
1.20
CHOOSING A DISCOUNT RATE
In the examples so far, we have been using a discount rate of 8 percent. A question that may have occurred
to you is How does management determine this number? Clearly, the discount rate can have a significant impact on a projects financial feasibility. Thus, the way it is determined is of considerable importance to the
decision-making effort.
Weighted Cost of Capital
As a first step in determining a discount rate, many companies calculate their weighted cost of capital, or
WCC. This approach is based on the fact that an organizations assets are financed by a combination of liabilities and equity. Although some liabilities, such as accounts payable, are usually interest free, others, such as
short- and long-term debt, bonds, mortgages, and the like carry an interest rate that the organization must pay.
Unlike debt, equity does not have a stipulated interest rate, and agreeing on a rate to use for it in computing
the WCC can be somewhat controversial. Conceptually, this interest rate should be the amount that the companys shareholders expect to earn on their investment. Thus, it would be higher in a company in a high risk industry than one in a low risk industry. However, these rates are not easily determined. Many companies use an
opportunity cost approach, looking, for example, at what their investments have earned historically, and using
that rate as the interest rate for equity. Others use a somewhat more arbitrary approach, although always, one
would hope, with the interests of the shareholders in mind.
Once an interest rate for equity has been determined, the approach to computing an organizations WCC begins by identifying the interest rate for each liability. We then (1) determine the percentage of the total liabilities
and equity that each source represents, (2) multiply this by the associated interest rate, and (3) add the resulting
totals together. A sample set of calculations, using a 12 percent interest rate for equity, is shown in Exhibit 1. As
it shows, the WCC is just over 10 percent.
____________________________________________________________________________________________________________
____________________________________________________________________________________________________________
.000
.001
.001
.013
.011
.045
.025
.096
Weight
0.026
0.175
0.227
0.105
0.456
0.010
1.000
In making the computations in Exhibit 2, the rate for PP&E is the unknown in the equation. That is, the
weighted ROA is set equal to the WCC, and the rates of return for all assets except PP&E are determined (e.g.,
10 percent for invested cash). The unweighted rate for PP&E is what is needed to achieve an overall ROA equal
to the WCC (9.6 percent in this example).
Of course, some PP&E projects will not yield the required return. For instance, expenditures to meet some
regulatory requirements may have a very low return. When this is the case, the organization will need some
high return projects to subsidize those that fall short of the required PP&E percentage (20 percent in Exhibit 2).
INCORPORATING RISK INTO THE ANALYSIS
Capital investment proposals are not risk free. Since they involve future cash flows, there is always the possibility that the future will not be as anticipated. If this risk element is not incorporated into the analysis, a very
risky proposal would be evaluated in the same way as one that has a high probability of success.
There are several ways to incorporate risk into an analysis. With all of them, as a proposals risk increases,
its NPV or IRR decreases.
Increase the Discount Rate. Some organizations increase the discount rate for projects with a high perceived risk. The problem with this approach is the difficulty in establishing a meaningful risk scale. Statistical
techniques are available for incorporating the relative riskiness of a project, but they require analysts to estimate
the probabilities of possible outcomes. This is quite difficult to do.
Shorten the Economic Life. Many organizations heavily discount any projected cash flows beyond a predetermined time period, such as 5 years. They use the regular discount rate for all cash flows in, say, the first five
years of an investment, but use a much higher rate for subsequent years. Some even exclude all cash flows beyond a certain number of years. Their reasoning is that the future is highly uncertain, and the farther out the projections the greater the uncertainty. This approach tends to bias decisions in favor of projects with short payback
periods, which many organizations in industries experiencing rapid technological change believe is justified.
Distinguish Among Sources of Cash Flows. Some organizations give greater weight to cash flow projections that are based on cost savings rather than additional revenues. For example, when a particular technological improvement has demonstrated an ability to produce some quantifiable cost savings, senior management
usually will conclude that the associated projections are quite reliable. By contrast, a project proposing an investment that will result in new business and hence additional revenue has far more uncertain cash flows. It is
quite difficult to predict factors such as customers willingness to purchase the new product, competition, manufacturing costs, and a variety of other items. To deal with the resulting uncertainty, some organizations raise the
discount rate for projects that forecast additional revenues.
In summary, when we consider the formula NPV = (CF x pvf) - I, the only element that is reasonably certain
is the amount of the investment. Both cash flow estimates and economic life can be highly speculative. Organizations can include adjustments for uncertainty by either shortening the economic life or raising the required
rate of return. Even so, when it comes to risk, managers and analysts need to exercise considerable judgment.
NON-QUANTITATIVE CONSIDERATIONS
NPV or IRR computations are only one aspect of the programming phase. There usually are a variety of
considerations that are difficult to quantify, but that can influence a programming decision. They include strategic and competitive concerns, employee morale, union grievances, the need to make quality improvements, a
desire to expand the range of products or services, a requirement to abide by the policies of a regulatory agency
(such as the Occupational Health and Safety Administration or the Environmental Protection Agency), and
many others.
Benefit/Cost Analyses
In some organizations, a benefit/cost analysis is used in an attempt to incorporate non-quantitative considerations into the decision-making process. To do so, senior management must consider several factors.
Focus on Organizational Goals. Perhaps most importantly, a non-quantitative benefit must be related to the
organizations goals. Clearly, there is no point in making a benefit/cost analysis unless all concerned agree on
these goals. Because various members of the senior management team and/or various staff analysts may have
different ideas of an organizations goals, these individuals must reconcile their views. Otherwise, middle managers will find it difficult to formulate program proposals designed to help reach the goals.
Example. Several years ago, the U.S. government began to support local transportation for handicapped people. Since the U.S.
Department of Transportation then subsidized local bus and subway lines, its natural inclination was to modify buses to provide lifts that would permit easy access for wheelchairs. The extra capital and maintenance costs of such equipment turned out
to be huge, and usage was not high because handicapped people had no way of getting from their homes to the buses. The
resulting cost per passenger was high$1,283 per trip in one city. Subsequently, transportation was provided by vans that
picked up handicapped people at their doors and took them directly to their destinations. This was both more convenient and
less expensivebetween $5 and $14 per passenger trip in most cities that tried it.
Secondary Benefits. For proposals that involve the introduction of a new product or product line, analysts
may have difficulty estimating the monetary effects of a variety of associated benefits. For example, in addition
to the revenue inflows from a new product line (less the costs associated with those inflows), there may be a variety of secondary revenues and costs that arise from the new products impact on existing or related products.
Example. A project to introduce a new line of laser-jet printers may not look attractive if the only benefits are the revenues
(minus costs) from with the printers alone. If, however, the analysis incorporated the secondary benefits from the sale of toner
cartridges, the project would become more attractive.
Secondary benefits from existing products can cut the other way, however, and may impede an organization
from introducing a strategically important new product.
Example. Both Kodak and Polaroid delayed the introduction of digital cameras for several years, largely, one might imagine,
because of the impact such cameras would have had on the sale of film for non-digital cameras. Only when it became abundantly clear that digital photography was here to stay did they begin to make the strategic shift. For Polaroid it was too late,
and the company filed for bankruptcy. For Kodak it was almost too late, but the company managed to survive.
Alternative Ways of Reaching the Same Objective. Even if benefits cannot be quantified, a benefit/cost
analysis can be useful in situations where an objective has been determined to be strategically important, and
there is more than one way to achieve it. If several alternatives would achieve the objective, then management
ordinarily will prefer the lowest cost one. This approach is useful because it does not require that the objectives
be stated in monetary terms, or even that they be quantified. Nor is there a need to measure the degree to which
each alternative meets the objective; only to determine which of several proposed alternatives will achieve it. Of
these, the least costly is the preferred one.
Example. The objective of one benefit/cost analysis was to provide the optimal airport and ground transportation facilities for
passengers arriving and departing Washington, D.C. by air. Analysts estimated the costs of various airport locations and associated ground transport services. Senior management chose the proposal that provided adequate service with the lowest cost.
There was no need to measure the benefits of adequate service in monetary terms.
Constrained Tradeoffs. Since funds are limited, there is an opportunity cost associated with any given investment. However, it may not be feasible to make tradeoffs across divisions or other organizational units, especially when the units have been established as investment centers.
Example. In a multidivisional organization, where each division is an investment center, funds that are used for new equipment in, say, the home appliance division most likely would not have been available for another division unless all capital
decisions, even the smallest, were made centrally. In many large multidivisional corporations, only capital decisions above a
significant amount are made centrally.
Causal Connections. Many benefit/cost analyses implicitly assume that there is a causal relationship between costs and benefits, such that spending X dollars produces Y benefits. If there is no such relationship,
however, the benefit/cost analysis is fallacious.
Example. A human resources department defended its personnel training program with an analysis indicating that the program
would lead participants to advance more quickly in the organization. The more rapid advancement would increase their lifetime contribution to the company by $1,000,000 per person. Thus, the $50,000 average cost per person trained seemed well
justified. However, the assertion that the proposed program would indeed generate these benefits was completely unsupported;
it was strictly a guess. There was no plausible link between the amount requested and the projected results.
See Alice L. London, Transportation Services for the Disabled, The GAO Review, Spring 1986, pp. 21-27.
For a discussion of culture, see Edgar H. Schein, Organizational Culture and Leadership, Second Edition, San Francisco, Jossey
Bass Publishers, 1992. In Sheins model, basic assumptions about decision making are at the core of an organizations culture.
For additional discussion on this point, see David W. Young, Managing Organizational Culture, Business Horizons, SeptemberOctober 2000.
For additional discussion of this issue, see David Solomons, Divisional Performance: Measurement and Control, Homewood,
Illinois, Dow Jones-Irwin, Inc., 1965.
Presumably, unless you were a good friend or somewhat altruistic, you would not lend her $1,000 today.
You could invest your $1,000, earn something on it over the course of the year, and have more than $1,000 a
year from now. If, for example, you could earn 10 percent on your money, you could invest your $1,000 and
have $1,100 in a year. Alternatively, if you had $909, and invested it at 10 percent, you would have $1,000 a
year from today.
Thus, if your colleague offers to pay you $1,000 a year from today, and you are an investor expecting a 10
percent return, you would most likely lend her only $909 today. With a 10 percent interest rate, $909 is the present value of $1,000 received one year hence.
Question: Under the same circumstances as the previous question, how much would you lend your colleague if she
offered to pay you $1,000 two years from today?
Here we must incorporate compound interest; that is, the fact that interest is earned on the interest itself. For
example, at a 10 percent rate, $826 invested today would accumulate to roughly $1,000 in two years, as shown
by the following:
=
=
=
$ 82.60
$ 90.86
$ 999.46
The answer requires combining the analyses in each of the above two examples. Specifically, for the $1,000
received two years from now, you would lend her $826, and for the $1,000 received one year from now you
would lend her $909. Thus, the total you would lend would be $1,735.
Our ability to make these determinations is simplified by present value tables. Two such tables, A and B, are
contained on the next page. Table A, Present Value of $1, is the table we would use to determine the present
value of a single payment received at some specified time in the future. For instance, in the first example above,
we could find the answer to the problem by looking in the column for 10% and the row for one year; this gives
us 0.909. Multiplying 0.909 by $1,000 gives us the $909 we would lend our colleague. Similarly, if we look in
the row for two years and multiply the entry of 0.826 by $1,000, we arrive at the answer to the second example:
$826.
Table B, Present Value of $1 Received Annually for N Years, is used for even payments received over a
given period. Looking at Table B, we can see that the present value of 1.735 (for a payment of $1 received each
year for two years at 10 percent) multiplied by $1,000 is $1,735. This is the amount we calculated in the third
example above. We also can see that the 1.735 is the sum of the two amounts shown on Table A (.909 for one
year hence, and .826 for two years hence). Thus, Table B simply sums the various elements in Table A to facilitate calculations.
1%
2%
4%
6%
8%
10%
12%
14%
15%
16%
18%
20%
22%
24%
25%
26%
28%
30%
1
2
3
4
5
0.990
0.980
0.971
0.961
0.951
0.980
0.961
0.942
0.924
0.906
0.962
0.925
0.889
0.855
0.822
0.943
0.890
0.840
0.792
0.747
0.926
0.857
0.794
0.735
0.681
0.909
0.826
0.751
0.683
0.621
0.893
0.797
0.712
0.636
0.567
0.877
0.769
0.675
0.592
0.519
0.870
0.756
0.658
0.572
0.497
0.862
0.743
0.641
0.552
0.476
0.847
0.718
0.609
0.516
0.437
0.833
0.694
0.579
0.482
0.402
0.820
0.672
0.551
0.451
0.370
0.806
0.650
0.524
0.423
0.341
0.800
0.640
0.512
0.410
0.328
0.794
0.630
0.500
0.397
0.315
0.781
0.610
0.477
0.373
0.291
0.769
0.592
0.455
0.350
0.269
6
7
8
9
10
0.942
0.933
0.923
0.914
0.905
0.888
0.871
0.853
0.837
0.820
0.790
0.760
0.731
0.703
0.676
0.705
0.665
0.627
0.592
0.558
0.630
0.583
0.540
0.500
0.463
0.564
0.513
0.467
0.424
0.386
0.507
0.452
0.404
0.361
0.322
0.456
0.400
0.351
0.308
0.270
0.432
0.376
0.327
0.284
0.247
0.410
0.354
0.305
0.263
0.227
0.370
0.314
0.266
0.225
0.191
0.335
0.279
0.233
0.194
0.162
0.303
0.249
0.204
0.167
0.137
0.275
0.222
0.179
0.144
0.116
0.262
0.210
0.168
0.134
0.107
0.250
0.198
0.157
0.125
0.099
0.227
0.178
0.139
0.108
0.085
0.207
0.159
0.123
0.094
0.073
11
12
13
14
15
0.896
0.887
0.879
0.870
0.861
0.804
0.788
0.773
0.758
0.743
0.650
0.625
0.601
0.577
0.555
0.527
0.497
0.469
0.442
0.417
0.429
0.397
0.368
0.340
0.315
0.350
0.319
0.290
0.263
0.239
0.287
0.257
0.229
0.205
0.183
0.237
0.208
0.182
0.160
0.140
0.215
0.187
0.163
0.141
0.123
0.195
0.168
0.145
0.125
0.108
0.162
0.137
0.116
0.099
0.084
0.135
0.112
0.093
0.078
0.065
0.112
0.092
0.075
0.062
0.051
0.094
0.076
0.061
0.049
0.040
0.086
0.069
0.055
0.044
0.035
0.079
0.062
0.050
0.039
0.031
0.066
0.052
0.040
0.032
0.025
0.056
0.043
0.033
0.025
0.020
1%
2%
4%
6%
8%
10%
12%
14%
15%
16%
18%
20%
22%
24%
25%
26%
28%
30%
1
2
3
4
5
0.990
1.970
2.941
3.902
4.853
0.980
1.941
2.883
3.807
4.713
0.962
1.887
2.776
3.631
4.453
0.943
1.833
2.673
3.465
4.212
0.926
1.783
2.577
3.312
3.993
0.909
1.735
2.486
3.169
3.790
0.893
1.690
2.402
3.038
3.605
0.877
1.646
2.321
2.913
3.432
0.870
1.626
2.284
2.856
3.353
0.862
1.605
2.246
2.798
3.274
0.847
1.565
2.174
2.690
3.127
0.833
1.527
2.106
2.588
2.990
0.820
1.492
2.043
2.494
2.864
0.806
1.456
1.980
2.403
2.744
0.800
1.440
1.952
2.362
2.690
0.794
1.424
1.924
2.321
2.636
0.781
1.391
1.868
2.241
2.532
0.769
1.361
1.816
2.166
2.435
6
7
8
9
10
5.795
6.728
7.651
8.565
9.470
5.601
6.472
7.325
8.162
8.982
5.243
6.003
6.734
7.437
8.113
4.917
5.582
6.209
6.801
7.359
4.623
5.206
5.746
6.246
6.709
4.354
4.867
5.334
5.758
6.144
4.112
4.564
4.968
5.329
5.651
3.888
4.288
4.639
4.947
5.217
3.785
4.161
4.488
4.772
5.019
3.684
4.038
4.343
4.606
4.833
3.497
3.811
4.077
4.302
4.493
3.325
3.604
3.837
4.031
4.193
3.167
3.416
3.620
3.787
3.924
3.019
3.241
3.420
3.564
3.680
2.952
3.162
3.330
3.464
3.571
2.886
3.084
3.241
3.366
3.465
2.759
2.937
3.076
3.184
3.269
2.642
2.801
2.924
3.018
3.091
11
12
13
14
15
10.366
11.253
12.132
13.002
13.863
7.138
7.535
7.903
8.243
8.558
6.494
6.813
7.103
7.366
7.605
5.938
6.195
6.424
6.629
6.812
5.454
5.662
5.844
6.004
6.144
5.234
5.421
5.584
5.725
5.848
5.028
5.196
5.341
5.466
5.574
4.655
4.792
4.908
5.007
5.091
4.328
4.440
4.533
4.611
4.676
4.036
4.128
4.203
4.265
4.316
3.774
3.850
3.911
3.960
4.000
3.657
3.726
3.781
3.825
3.860
3.544
3.606
3.656
3.695
3.726
3.335
3.387
3.427
3.459
3.484
3.147
3.190
3.223
3.248
3.268
Debt
Equity
Total
The Decision
Although funds were available to finance Dr. Michaels proposed new equipment purchase, Dr. Larson and
Mr. Hershey were both concerned about the mistake made two years ago, and wanted to be sure that a similar
mistake would not be made again.
Assignment
1.
What is the proposals net present value, using a discount rate of 20 percent? 5 percent?
2.
3.
If the company decides to purchase the new equipment for Dr. Larson, a mistake has been made somewhere, because good
equipment bought only two years ago is being scrapped. How did this mistake come about?
5.
What non-quantitative factors should the company consider in making this decision? How important are they? Would it make a
difference if the proposal were for new technology rather than replacement of existing technology? If it were for new technology with the same dollar amounts, but in the Maintenance Department? Why?
Part A. As a discount rate of 20 percent, the net present value is calculated as follows:
Cash Flows:
Economic Life:
Investment Amount:
Net Present Value:
$ 60,000
10 years
$300,000
= ($60,000 x 4.192) - $300,000
= $251,520 - $300,000 = ($48,480)
Cash Flows:
Economic Life:
Investment Amount:
Net Present Value
$ 60,000
10 years
$300,000
= ($60,000 x 7.735*) - $300,000
= $464,130 - $300,000 = $164,130
* At 5 percent, we need to estimate the pvf by using the midpoint between 4 and 6 percent.
Question 2
Question 3
Since we dont know the mix of assets, we cannot compute a weighted ROA and determine the return
needed from PP&E. However, the rate certainly should be no less than the weighted cost of capital, or, more
specifically, the weighted cost of capital after the additional borrowing takes place (which is not the same as the
interest rate on the incremental borrowing).
In terms of equity, the key point is that it is not free, as the boards finance chair suggests. Shareholders expect a return on their invested funds, and, in general, the higher the companys risk , the higher their expected
return. The result will be a figure that is somewhat higher than 4.8 percent but probably not as high as 20 percent.
Question 4
The mistake came about because the economic life was estimated at 10 years when it in fact was only two
years. If Dr. Michaels' proposed equipment also has an economic life of only two years, it would have an internal rate of return of less than one percent, as the following calculations show:
The fact that a mistake was made in the past does not change the conclusion that the new investment is financially feasible at 15 percent, assuming that the economic life and cash flows have been estimated accurately.
Since, we cannot change the past, we simply must move on. The mistake should not be incorporated into the
calculations for the present decision since this would distort them
What is relevant here, however, is Dr. Michaels' ability to estimate economic lives. Dr. Larson should question Dr. Michaels' 10-year estimate carefully, to satisfy himself that it is as accurate as possible. No matter how
much he questions Dr. Michaels, though, it is impossible to predict the future with certainty, and thus a similar
mistake may be made again. While each decision must stand on its own, unaffected by prior mistakes, a series
of mistakes of the sort made two years ago will soon result in the company facing some serious financial difficulties.
Additionally, if the companys PP&E needs a return of, say, 15 percent, Dr. Michaels proposal is financially
feasible only if its economic life is 10 years. If it is 6 years, the IRR would be about 5 percent, just slightly
above the absurdly low WCC proposed by the chair of the finance committee. At a 5-year economic life, the
IRR falls to slightly below 1 percent. Given even a slight doubt about Dr. Michaels ability to predict economic
lives, this project is probably financially infeasible from an IRR perspective.
Question 5
There are a variety of non-quantitative factors to consider in this decision. Product quality, competition, researcher satisfaction, image as an company with the latest in technology, and others. Indeed, non-quantitative
factors would usually tip the scales if a choice were being made between replacement technology and new technology, or between research technology and technology for a service center, such as the maintenance department. On the other hand, if the company has the funds to invest, and if it is convinced that the estimates of cash
flows and economic lives are accurate, then an investment that is financially feasible in the maintenance department has just as much financial payoff as one in a research department.
Where the process becomes complicated is in a situation where the investment in, say, the maintenance department has an internal rate of return that is higher than one in a research department. It is here where nonquantitative factors may influence the institution to make the investment in research. Ultimately, the question of
the feasibility of Dr. Michaels proposal may rest on the opportunity cost to Erie of having her resign to take a
similar position with a competitor!