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I'm Larry Walther.
This is principlesofaccounting.com, Chapter 24.
And in this final module, we will look at tools for evaluating capital projects.
The basic principles that apply here are to determine how dollars are impacted by
compound interest, and
present value calculations enabling us to make better business decisions.
Starting with the concept of net present value.
The net present value method is a technique that offsets the present value
of an investments cash outflows and cash inflows.
Amounts are discounted by an assumed cost of capital.
The cost of capital may be determined by reference to interest rates on debt, or
by blending of debt and equity cost in aggregate.
Management could also simply adopt a minimum threshold rate of
return that must be exceeded before an investment can be undertaken.
If a prospective investment has a positive net present value
then it clears the minimum cost of capital and should be accepted as an undertaking.
If the investment has a negative net present value
then the investment opportunity should be rejected.
And so let's return or think back to the illustration we had for
Markum Real Estate in the previous module.
We assume that the firm's cost of capital was 5%.
Let's assume the upfront purchase price for the building was $575,000.
And we were going to spend $60,000 per year during the first two years remodeling
that business.
Maintenance and insurance and taxes on the building amount to $10,000 per year for
each of the five years we anticipate holding the investment.
And so the net present value of our cash outflows looks like this.
We have $575,000 that we spend at the beginning of
the first year has a present value of 575.
We expend 70,000 per years 2 and
3 that's the 60,000 remodelling cost plus the 10,000 holding cost.
That first $70,000 payment has a present value of 66,667, and so it would go.
And then the last three years,
we have the $10,000 per year in ongoing operating expenses.
So, the net present value at 5% of the cash outflows is 729,859.
Again, it's important that you
review the previous module to see how we calculate present values.
Present value of the cash outflows is 729,859 compared to the present value
of the cash inflows of $807,828.
That was evident in the previous module.
And so this project actually has a positive net present value of $77,969.
The present value of the inflows exceed the present value of the outflows,
we would accept that project.
If we change the investment slightly and assume that the up-front cost was
$675,000 instead of 575,000 then the present value
of the outflows would be 829,859, $100,000 higher.
And now the project would have a negative net present value and
we would not want to make that investment at that price.
Generally as we increase interest rates present values come down and vice versa.
This affects the logic of how we're going to consider certain investment decisions.
But let's see how this is going to affect us in the case of Greenspan,
who is considering a $500,000 investment that returns $128,000 each year, for
five years.
The following spreadsheet shows certain calculations,
this same spreadsheet is repeated in your textbook.
It compares the present value of the $500,000 investment to the present value
of the stream of $128,000 inner returns.
Here at a 6% discount, we've got a positive net present value of $39,183.
At 8% interest rate, the present value, the inflows is dropping.
Our net present value is now $11,067.
If we jump on up to 10%, this investment goes negative.
So we can afford to make this investment at 6% or 8% but
not if our cost of capital or required rate of return was 10%.
In calculating the present value, the focus is on cash flow not income.
Certain items like depreciation do not impact cash flows and
should not be included in present value calculations.
One must be very careful to consider tax effects,
certain noncash expenses can reduce taxable income,
thereby reducing the amount of cash that we have to pay for taxes.
To show that, let's look at Mirage company that purchased a tract of land with
a spring-fed creek for $100,000.
$50,000 was spent constructing a water bottling facility.
We're expecting to sell $40,000 in water each year.
And the bottling plant will have a 5-year life and
be depreciated by the straight-line method.
At the end of five years we'll sell the land for $100,000.
Our cost of capital is 8% and our tax rate is 35%.
And so here is an analysis of our income calculation.
Annual sales of $40,000 minus depreciation of $10,000 gives us
income before tax of $30,000 minus $10,500 in taxes paid, that's a 35% rate.
That gives us after tax net income of $19,500.
Compare that to our cash flows, however, if we have 40,000 in sales minus 10,500
in tax, our cash inflows are 29,500 in this case.
And so here we have an analysis where we're calculating the net present value.
Notice that our cash inflows are calculated to be
the 29,500 cash flows not the different amount of accounting that income.
Ultimately, we wind up and find this to be a very attractive investment with
a positive net present value.
Turning our attention to another form of capital project evaluation tool,
the accounting rate of return.
The accounting rate of return simply divides the average annual increase in
accounting income by the amount of initial investment.
>From Mirage's project, the accounting rate of return will be 13%,
the 19,500 annual accounting income divided by the initial $150,00 investment.
The decision rule to accept investments, typically,
which exceed a particular accounting a rate of return.
That's a good tool but it certainly doesn't tell us all about the life of
the investment, when it will cease, what we'll get at the end of the project.
Another tool is the Internal Rate of Return.
It calculates the discount rate that equates the present value
inflows with the present value of outflows.
Essentially it's the right that causes the net present value to be zero.
You can use the internal rate of return to rank various projects.
The decision rules to accept projects with the highest internal rates of return so
long as those rights are at least equal to a firm's cost of capital.
Spreadsheets are very helpful in calculating internal rates of return.
A manual process would involve a lot of guessing and an iterative process of
trying and trying again to zero in on the right rate of return.
Here I've worked up a spreadsheet for the Mirage Corporation.
And you can see that at 8.8361%, discounting the inflows and
outflows of that right, it returns the net present value of zero.
And so the internal rate of return is 8.8361.
A final method I wanna look at is the payback method.
The payback method is a very simple term.
It's simply the amount of time it takes for
the cumulative cash inflows to exceed the net cumulative cash outflows.
For Greenspan, we had a $500,000 investment.
It returned 128,000 each year.
The payback period was 3.9 years in that example.
If an investment involves uneven cash flows the computation could become more
involved because you would need to schedule the period of cash flows.
Although it's a simple method, the payback method does not take into account
the time value of money or what happens after the payback period.
For example,an investment made payback rapidly but
have little additional returns after that.
It may hardly be worth making the investment even though it
has a short payback period.
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