COST MANAGEMENT

Measuring, Monitoring, and

Motivating Performance
Third Canadian Edition
ELDENBURG WOLCOTT CHEN COOK
Chapter 13: Strategic Investment Decisions

Learning Objectives

LO1 Explain how strategic investment decisions are made

LO2 Identify relevant cash flows and perform net present value (NPV)
analysis for capital investment decisions
LO3 Identify the uncertainties of NVP analysis
LO4 Apply alternative methods in analyzing strategic investment
decisions
LO5 Identify additional issues to be considered for strategic investment
decisions
LO6 Explain how income taxes affect strategic investment decision
cash flows
LO7 Explain how real and nominal methods are used to address
inflation in an NPV analysis
 LO1

Explain how strategic investment decisions

are made
 Capital Budgeting

 Strategic investment decisions have long-term

effects.
 Capital budgeting is a process that managers
use when they choose among strategic
investment opportunities.
 Capital budgeting decisions affect cash flows in
future years which introduces an important
concept, the time value of money, which refers to
the idea that a dollar received today is worth
more than a dollar received in the future.
Identifying and Prioritizing Investment
Opportunities
 Relevant Cash Flows

• Relevant cash flows must arise in the future

and differ among decision alternatives
(possible courses of action)
• At the beginning of the project, at time 0, the
company faces initial cash outflows
• During years 1 through n, the life of the
project, there are annual, incremental
operating cash flows for the project
• Any terminal cash flows appear at the end of
the project’s life (time n)
 Relevant Cash Flows

 Examples of relevant cash outflows include:

 Initial investment outlay

 Future operating costs

 Project closing and cleanup costs

 Examples of relevant cash inflows include:

 Future revenues

 Decreased operating costs

 Salvage value of assets at project’s end

 Quantitative Analysis Techniques

 Methods that consider the time value of money

(discounted cash flow methods):
 Net present value (NPV) method

 Internal rate of return (IRR) method

 Methods that do not consider the time value of

money:
 Payback method

 Accrual Accounting rate of return method

 LO2

Identify relevant cash flows and perform net

present value (NPV) analysis for capital
investment decisions
 Net Present Value Method

• Future value:
The amount received in the future, for a
given number of years at a given interest
rate, for a given investment today.

• Present value:
The value in today’s dollars of a sum
received in the future.
 Net Present Value (NPV) Method

The NPV of a project is the sum of the project’s

discounted cash flows:
n
Expected cash flow , where
NPV = t=0 1  r 
t
t

t = time period (year)

n = life of the project
r = discount rate
If a project’s NPV > 0, it is acceptable

The expected cash flows include the initial investment,

incremental operating cash flows, and terminal cash flows
 Profitability Index
 NPV analysis is often used to screen projects as
to whether they are acceptable.
 After screening, acceptable projects may be
ranked according to their profitability index.

Profitability Present value of cash inflows

index =
Present value of of investment cash
outflows

 The profitability index allows for rankings of

projects of various sizes.
 Identifying a Reasonable Discount Rate

• The discount rate is the interest rate that is used

across time to reduce the value of future dollars
to today’s dollars.
• Many decision makers simply set the discount
rate at the organization’s weighted average cost
of capital (WACC).
 NPV Example

Joseph Leasing is considering an investment in a new apartment building. The Lindie

Lane building will cost $450,000 and the net annual cash inflows are expected to be
$45,000 for 7 years. At the end of the 7th year, Joseph expects to be able to sell Lindie
Lane building for $400,000. Joseph demands a minimum required rate of return of 8% on
all investments. Assume all cash inflows occur at the end of each year. Compute the NPV
of the Lindie Lane building. Is it an acceptable investment?

PV of cash inflows:
Annuity of cash inflows:
$45,000 x PV annuity factor of 5.206 $234,270
Sale of building:
$400,000 x PV of $1 factor of 0.583 233,200
467,470 The NPV > 0, so
PV of cash outflows: the investment
Initial investment 450,000 is acceptable
NPV $17,470
 NPV Example

Joseph Leasing is also looking at the purchase of a lot with a double-wide trailer on it.
The cost is $65,000 and the expected net cash inflows are $6,800 per year for 10 years.
At the end of the 10th year, Joseph expects to be able to sell the lot and trailer for
$45,000. Compute the NPV of the trailer investment. Is it an acceptable investment?

PV of cash inflows:
Annuity of cash inflows:
$6,800 x PV annuity factor of 6.710 $45,628
Sale of lot and trailer:
$45,000 x PV of $1 factor of 0.463 20,835
66,463
PV of cash outflows: The NPV >
Initial investment 65,000 0, so the
investment
NPV $1,463 is
acceptable
 NPV Example

Compare the two investments for Joseph using the profitability index,
and describe to him what the index means. Which investment (or both)
should he make?

Profitability
index
Lindie Lane building: The Lindie Lane
PV of cash inflows 467,470 yields a slightly
= 1.0388
PV of cash outflows 450,000 greater PV for
each invested
Trailer: dollar than does
PV of cash inflows 66,463 the trailer.
= 1.0225
PV of cash outflows 65,000

If Joseph has sufficient capital, he should invest in both unless he

has alternatives that have even greater profitability indices.
 LO3

Identify the uncertainties of NVP analysis

 Uncertainties and Sensitivity Analysis

 The uncertainty about future cash flows increases the

further the cash flow is in the future.
 The expected life of a project is uncertain
 Several factors affect the discount rate for NPV analysis,
including interest rates, inflation, and the riskiness of the
project.
 Other uncertainties exist such as the life of the project,
cost of the initial investment and factors which may
impact the discount rate.
 Sensitivity analysis helps managers evaluate how their
NPV results would change with variations in the input
data.
 Internal Rate of Return (IRR) Method

 The IRR method determines the discount rate

necessary for the present value of the
discounted cash flows to be equal to the
investment (solve for the discount rate at which a
project’s NPV equals zero).
 The IRR is the interest rate (X %) at which:
Initial investment = NPV of cash inflows.
 IRR Example

Graham Enterprises is considering the purchase of a new machine.

The cost is $100,000 and the machine is expected to generate cost
savings of $17,700 each year for 10 years. The machine is not
expected to have any salvage value at the end of its life. Assume the
cost savings are realized at the end of the year. Graham requires a
10% rate of return on all new investments. Compute the IRR for the
proposed machine. Should Graham purchase the machine?

Locate the 5.65 factor in the present value

$100,000 of an annuity table, using n = 10 years
= 5.650
$17,700 and note that it is found in the 12%
column, so the IRR = 12%.

Since the machine’s IRR exceeds Graham’s minimum rate of

return, the machine is an acceptable investment, but of course
should still be compared to other, potentially better, investments.
 Comparison of NPV and IRR Methods

• The net present value method is

computationally simpler than the internal rate
of return method.
• The IRR method assumes that cash inflows
can be reinvested to earn the same return
that the project would generate.
• The NPV method assumes that cash inflows
can be reinvested and earn the discount.
 LO4

Apply alternative methods in analyzing

strategic investment decisions
 Payback Method

 The payback method computes the number of years before the

initial investment is recovered.

 If cash inflows are the same each year and the project has only one
initial outlay, the payback period is computed as:

Initial investment
Number of years to
pay back the investment =
Annual incremental operating
cash flow

 For projects where annual cash inflows are not equal, the payback
period is calculated by taking the cumulative incremental operating
cash flows until the initial investment amount has been fully
recovered.
 Payback Method

• The payback method is widely used because of

its simplicity.
• However, the payback method is flawed
because it ignores the time value of money.
• It ignores cash flows that occur after the
payback period.
• If used at all, the payback method should be
used in conjunction with the NPV or IRR
methods to help assess project risk.
 Payback Method Example

Graham Enterprises is considering the purchase of a new machine.

The cost is $100,000 and the machine is expected to generate cost
savings of $17,700 each year for 10 years. The machine is not
expected to have any salvage value at the end of its life. Compute the
payback period for the proposed machine.

$100,000
= 5.650 years
$17,700

Notice that the payback period is the same as the PV factor computed
in the IRR example.
 Payback Method Example

Cophil, Inc. is considering the purchase of a new machine. There are

two alternatives, and the cash flow information is given below.
Compute the payback period for each and comment on your findings.

Time Cash Flow

period Machine A Machine B The payback period for Machine
0 ($100,000) ($100,000) B is 2 years.
1 $10,000 $50,000 The payback period for Machine
2 $20,000 $50,000 A is 3.5 years ($60,000 covered
3 $30,000 after 3 years, and $40,000 is ½ of
4 $80,000 year 4’s cash inflow).
5 $80,000
The payback method shows Machine B
6 $80,000 to be preferable to Machine A, but
ignores the large cash inflows of Machine
A that occur after the payback period.
 Accrual Accounting Rate of Return Method

• The accrual accounting rate of return (AARR) is

the expected increase in average annual
operating income as a percentage of the initial
increase in required investment.
• This method is widely used because the
financial accounting information is readily
available.
• It ignores the time value of money.
 Accrual Accounting Rate of Return
Method Example
Blanche Manufacturing is considering the purchase of a new machine.
The cost is $100,000 and it is expected to last 5 years and have no
salvage value. The machine is expected to generate cost savings of
$32,000 per year. Ignoring income tax effects, compute the accrual
accounting rate of return for this investment.

Annual cost savings $32,000

Annual depreciation expense ($100,000/5 years) 20,000
Effect on annual operating income $12,000

Accrual
accounting rate $12,000
= = 12%
of return $100,000
 LO5

Identify additional issues to be considered

for strategic investment decisions
 Other Considerations for Strategic
Investment Decisions
• Qualitative factors as follows often influence
strategic investment decisions:
• the effects of the decision on the company’s
reputation,
• the effects on the quality of the company’s
products and services,
• the effects on the company’s community
• the effects on the environment
• After a capital budgeting decision is made, a
post-investment audit should be performed to
assess the decision process.
Making and Monitoring Strategic Investment
Decisions

• Accountants often prepare analyses of projects

that align with an organization’s strategic plans.
• After a project has been accepted, accountants
and managers monitor its progress and compare
actual performance to the capital budget
expectations.
 LO6

Explain how income taxes affect strategic

investment decision cash flows
 Income Tax Considerations

• All cash flows should first be converted to an

after-tax amount.
• The tax savings that result from the capital cost
allowance (CCA) deduction is called the CCA
tax shield. All capital assets are eligible for CCA
deductions.
 Income Tax Considerations

• CCA deductions are as allowed by Canada Revenue

Agency (CRA).
• CCA rates dictate the maximum CCA that can be
deducted on a firm’s tax return each year.
• Rates use a declining balance method and are applied to
the opening balance of undepreciated capital cost (UCC)
for each asset class.
• CCA claimed in any given year reduces the deductions
that can be used in future years.
• Due to significant capital costs of some projects, CCA
deductions can be a critical factor in determining
whether a project will generate a positive return.
 Calculating Incremental Tax Cash Flows

1. Find the total amount of tax amortization that

accumulated from the time of the initial investment
to its disposal.
2. Subtract the total amortization from the initial
investment. The remainder is the tax basis.
3. Subtract the tax basis from the disposal value.
The remainder is a taxable gain or loss.
4. Multiply the taxable gain or loss by the marginal
income tax rate to find the incremental tax cash
flow at the end of the project.
 CCA tax shield formula

The tax savings that are provided by CCA can

be calculated with the following formula:

PV of tax savings: Investment * Tax Rate* CCA

Rate
CCA Rate + Required Rate of Return
X
1 + 0.5 * Required Rate of Return
1 + Required Rate of Return
 Inflation and NPV Analysis

 When the purchasing power of the dollar

declines over time, it is known as inflation.
 The real rate of interest does not consider
changes in the purchasing power of a dollar.
 The nominal rate of interest is the rate that
investors demand when inflation is taken into
consideration in their decisions.
 LO7

Explain how real and nominal methods are

used to address inflation in an NPV analysis
Real and Nominal Methods for NPV Analysis
 The risk-free rate is the rate of interest that is
paid on long-term government bonds.
 The risk premium is the additional rate of return
investors demand to compensate them for taking
risk.
 The risk premium increases for riskier
investments.
 The real rate of interest is the nominal rate plus
the risk premium demanded for that investment.
It is the rate of return required on investments
when inflation is not a factor.
Real and Nominal Methods for NPV Analysis

• The nominal rate of interest is the rate of

return required on investments when
inflation is present. It is calculated by
increasing the real rate of interest by the
expected rate of inflation.
 Nominal and Real Methods of
NPV Analysis
 The real and nominal rates of interest are related
as follows:
Nominal
rate of = (1 + real rate) x (1 + inflation rate) -1
interest
 Nominal future cash flows are real cash flows
inflated to future dollars:
Nominal
cash flow = Real cash flow x (1 + i)t, where

i = rate of inflation, and

t = the number of time periods in the future the cash
flow occurs
 Nominal and Real Methods of
NPV Analysis

 In the real method of NPV analysis, future cash

flows are state in real dollars (without
considering changes in the purchasing power of
the dollar) and a real rate of interest is used as
the discount rate.
 In the nominal method of NPV analysis, future
cash flows and the terminal project value must
be inflated to future dollars and a nominal rate of
interest is used as the discount rate.
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