CHAPTER 8
ANALYSIS OF
INVESTMENT DECISIONS
The decision to invest resources is one of the key drivers of the business finan-
cial system, as we established in Chapter 2. Sound investments that implement
well-founded strategies are essential to creating shareholder value, and they must
be analyzed both in a proper context and with sound analytical methods. Whether
the decision involves committing resources to new facilities, a research and de-
velopment project, a marketing program, additional working capital, an acquisi-
tion, or investing in a financial instrument, an economic trade-off must be made
between the resources expended now and the expectation of future cash benefits
to be obtained. Analyzing this trade-off is essentially a valuation process that
makes an economic assessment of a combination of positive and negative cash
flow patterns. The task is difficult by nature because it deals with future condi-
tions subject to uncertainties and risks—yet this basic valuation principle is com-
mon to all investments, large and small.
In this chapter, we’ll examine in some detail both the key conceptual and
practical aspects of investment decisions, using the analytical techniques de-
scribed in Chapter 7. In Chapters 9 and 10, we’ll address the related issues of fi-
nancing costs and the choice among financing alternatives. In Chapters 11 and 12,
we’ll expand on these concepts and demonstrate how the process applies to valu-
ing a business and to the creation of shareholder value. From time to time, we’ll
introduce applicable portions of managerial economics and financial theory. In
keeping with the scope of this book, however, we’ll avoid the esoteric in favor of
the practical and useful. At the end of each chapter, we’ll summarize, as before,
the key conceptual issues underlying the analytical approaches covered, both as a
reminder and as a guide for the interested reader in exploring the references listed.
The analysis of decisions about new investments (as well as the opposite,
disinvestments) involves a particularly complex set of issues and choices that
must be defined and resolved by management. We’ll discuss these in several
categories:

Investments in land, productive equipment, buildings, natural resources, research
facilities, product development, employee development, marketing programs,
working capital acquisitions, and other resource deployments made for future
economic gain should represent physical expressions of a company’s strategy—
which management must carefully develop and periodically reevaluate. Invest-
ment choices should always fit into the desired strategic direction the company
wishes to take, with due consideration of:
• Expected economic conditions.
• Outlook for the company’s specific industry or business segment.
• Competitive position of the company.
• Core competencies of the organization.
An almost infinite variety of business investments is available to most
firms. It doesn’t matter how the resource commitment is reflected on the com-
pany’s books, whether in the form of an asset or as an expense for the period—the
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CHAPTER 8 Analysis of Investment Decisions 257
critical point is that the outlay is being made with an expectation of future returns.
A company might invest in new facilities for expansion, expecting that incre-
mental profits from additional volume will make the investment economically
desirable. Investments might also be made for upgrading worn or outmoded
facilities to improve cost-effectiveness. Here, savings in operating costs are the
justification.
Some strategies call for entering new markets, which could involve setting
up entirely new facilities and associated working capital, or perhaps a major repo-
sitioning of existing facilities through rebuilding or through sale and reinvestment.
In a service business, expansion strategies could involve significant employee
training outlays and electronic infrastructure investments. Other strategic propos-
als might involve creating a new business model of Internet connectivity, or es-
tablishing a research program, justified on the basis of its potential for developing
new products or processes. Business investment also could involve significant
promotional outlays, targeted on raising the company’s market share over the long
term and, with it, the profit contribution from higher volumes of operation. At
times, acquiring a company whose product or service lines fit into the company’s

258 Financial Analysis: Tools and Techniques
the principal through sale of the investment instrument—which over time might
have appreciated or declined in market value. In capital budgeting, the commit-
ment of company funds is made in exchange for future cash inflows from incre-
mental after-tax profits and from the potential recovery of a portion of the capital
invested, or from the value of a going business at the end of the planning horizon.
However, the analogy carries only so far. In a typical company, managing
business investments is complicated by the need not only to select a portfolio of
sound projects, but also to implement them well and to operate the facilities, ser-
vice functions, or other new resources deployed with quality and cost effective-
ness. In addition, analyzing potential investments in a business context is far more
complex than selecting among stocks and bonds because the outlays often involve
multiple expenditures spread over a period of time and a wide variety of opera-
tional cash flows that are expected over the economic life. Examples are con-
structing and equipping a new factory, or the gradual building up of a service
business and its infrastructure.
Determining the economic benefits to be derived from the outlay is even
more complex. An individual investor generally receives specific contractual in-
terest payments or regular dividend checks. In contrast, a business investment typ-
ically generates additional profit contributions from higher volume, new products
and services, or cost reduction. The specific incremental cash flow from a busi-
ness investment might be difficult to identify, because it’s intermingled in the
company’s financial reports with other accounting information. As we’ll see, the
analysis of potential capital investments involves a fair degree of economic rea-
soning and projection of future conditions that goes beyond merely using normal
financial statements.
If we follow the analogy between a capital budget and an investment port-
folio to its logical conclusion, capital budgeting would ideally amount to arraying
all business investment opportunities in the order of their expected economic re-
turns, and choosing a combination that would meet the desired portfolio return

organization.
In this chapter, we’ll explore the decisional framework and apply the ana-
lytical techniques discussed in Chapter 7 to the decision process for analyzing and
choosing business investments. We won’t delve into the broader conceptual issues
of capital budgeting and portfolio theory, except to point out some of the key is-
sues. Readers wanting more information on these topics should check the refer-
ences at the end of the chapter. The important question of the cost of capital as
related to capital budgeting will be taken up in the next chapter. Then, Chapter 10
will cover analytical reasoning behind the choice among types of potential fund-
ing sources for capital investments.
Decisional Framework
Effective analysis of business investments requires that both the analyst and the
decision maker be very conscious of and specific about the many dimensions in-
volved. We need to set a series of ground rules to ensure that our results are thor-
ough, consistent, and meaningful. These ground rules cover:
• Problem definition.
• Nature of the investment.
• Estimates of future costs and benefits.
• Incremental cash flows.
• Relevant accounting data.
• Sunk costs.
A good rule of thumb to keep in mind is that of the total time and effort re-
quired to analyze a business investment, at least 85 percent should be spent on
meeting the important requirements of framing and refining these elements of the
decision, and only 15 percent on various forms of “running the numbers.” Be-
cause of the ease with which our spreadsheets can calculate data, however, there
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260 Financial Analysis: Tools and Techniques
is the strong temptation to develop numerical approaches before proper framing
has been done. Thus, unfortunately, the proportions of effort are often reversed in

situation? What problems are likely to arise?
Is the present business no longer viable?
Are there better opportunities to redeploy your
capital? Competition?
What is the life cycle of products, technology?
Where are you relative to competition?
What advantages are gained?
Decision
point
What real improvements can be made? What are
the economics of such change?
How about competition?
What are the economics of the new market
opportunity? What competition is there?
What success factors are to be met?
Etc.
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CHAPTER 8 Analysis of Investment Decisions 261
new machine when we decide whether or not to replace it. But the alternative of
doing nothing always exists for any investment project, and sound analysis re-
quires that its implications be tested before proceeding.
But there are some not-so-obvious alternatives. Perhaps the company
should stop making the product or providing the service altogether! This “go out
of business” option should at least be considered—painful as it might be to think
about—before new resources are committed.
The reasoning behind this seemingly radical notion is quite straightforward.
While the improved efficiency of a new machine or a whole new service infra-
structure might raise this particular operation’s economic performance from poor
to average, there might indeed be alternatives elsewhere in the company that
would yield greater returns from the overall funds committed. By going ahead

262 Financial Analysis: Tools and Techniques
this condition will become apparent when we discuss some of the specific exam-
ples later on. A similar condition can, of course, arise when management sets a
strict limit on the amount of spending, often called capital rationing, which will
preclude investing in some worthy projects once others have been accepted. This
situation is quite common, because companies will more often than not find their
funding potential limited, whether due to debt proportions that already are at tar-
get levels, fluctuations in profitability, or exercising caution in preserving cash
flow for yet unspecified needs.
Another type of investment involves sequential outlays beyond the initial
expenditure. For example, any major capital outlay for plant and equipment also
might entail additional future outlays for major maintenance, upgrading, and par-
tial replacement some years hence. These future outlays—to which the company
is committing itself by the initial decision—must be formally considered when the
initial analysis is made. Another example is the introduction of a new product or
service with high growth potential, where additional working capital and perhaps
future capacity expansions are a natural consequence of the decision to proceed.
The most logical evaluation of such investments comes from taking into
account the whole pattern of major outlays recognizable at the time of analysis.
If this isn’t done, such a project might be viewed more favorably than a more
straightforward one, because a number of future negative cash flows have been
left out of the cash flow pattern. Moreover, if the project is chosen, management
could become trapped into having to approve these unanticipated future outlays as
they arise later—on the argument that these incremental funds are clearly justifi-
able because the project is “already in place.” While that argument might be true
given the earlier decision, the fact remains that the project originally was not
judged on its full implications, and under those conditions might not have been
justifiable to begin with. This type of incrementalism invariably causes undesir-
able economic results.
Future Costs and Benefits

scious economic trade-off of risk versus reward, as we established earlier, the im-
portance of explicitly addressing key areas of uncertainty should be obvious.
Identifying key variables also will be helpful in judging the actual performance of
the project after implementation. This is because tracking of these elements is usu-
ally much easier than trying to reconstruct the full scope of the incremental proj-
ect from the overall accounting data flow into which it has been merged.
Incremental Cash Flows
The economic reasoning behind any capital outlay is based strictly on the in-
cremental changes which result directly from the decision to make the investment.
In other words, the test question must always be “what is different between the
current state of affairs and the new situation introduced by the decision,” and the
differences will be reflected in the form of
• Incremental investment.
• Incremental revenues.
• Incremental costs and expenses.
Moreover, proper economic analysis recognizes only cash flows, that is, the
after-tax cash effect of positive or negative funds movements caused by the in-
vestment. Any accounting transactions related to the decision but not affecting
cash flows are irrelevant for the purpose.
The first basic question to be asked is: What additional investment funds
will be required to carry out the chosen alternative? For example, the investment
proposal can, in addition to the outlay for new equipment, entail the sale or other
disposal of assets that will no longer be used. Therefore, the decision might actu-
ally free some previously committed funds. In such a case, it’s the net outlay that
counts, after any applicable incremental tax effects have been factored in.
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264 Financial Analysis: Tools and Techniques
Similarly, the next question is: What additional revenues will be created
over and above any existing ones? If an investment results in new revenues, but at
the same time causes the loss of some existing revenues, only the net impact, af-

sis. The analyst must constantly judge whether there has been a change in the true
cash outlays and revenues—not whether the accounting system is redistributing
existing costs in a different way. Asound rule that helps prevent being trapped by
allocations is to avoid unit costs whenever possible and to perform the analysis on
the basis of annual changes in the various cost categories expected to be caused by
the investment decision.
We should point out that the growing use of activity-based costing, which
we mentioned earlier, is a very positive development insofar as determining
relevant data for economic analysis is concerned. Essentially a system which
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CHAPTER 8 Analysis of Investment Decisions 265
expresses the economic costs and benefits of activities, product lines, and organi-
zational units, activity-based analysis and accounting establishes a flow of infor-
mation that directly relates to economic choices and trade-offs. Based on a careful
assessment of the physical flow of activities, the data collected and stored in the
system are in most cases representative of the type of information that must be
stipulated when analyzing the changes in revenues and costs brought about by a
business investment. The nature of cost assessments and economic allocations is
much more transparent than in customary cost accounting systems, although the
need for judgment in selecting appropriate data still remains.
Sunk Costs
There’s a common temptation to include in the analysis of a new investment all or
some portion of outlays that occurred in the past, expenditures that perhaps were
incurred preparatory to making the new commitment being considered. No basis
in economic analysis exists, however, that would justify such backtracking to ex-
penditures that have already been made and that are not recoverable in part or as
a whole. Past decisions simply do not count in the economic trade-off underlying
a current investment decision. The basic reason for this is that such sunk costs,
even if they are connected in some way to the decision at hand, simply cannot be
altered by making the investment now.

ment proposition on its full set of implications, and to view the specific proposi-
tion within the larger context of the company’s strategy and future plans.
Economic decisions are always forward-looking and must involve only
those things that can be changed by the action being decided. This is the essential
test of relevance for any element to be included in the analysis.
Refinements of Investment Analysis
We’ll now turn to some more realistic and complex examples in order to refine
various aspects of both the components of analysis and the methodology itself. No
new concepts or techniques will be introduced here; instead, some expanded prac-
tical examples will help us work through the implications of many of the points
that so far we’ve only mentioned in passing. As we go through the projects step
by step, the essentials of economic investment analysis should become firmly im-
planted in your mind.
At this point, we’ll stress once more that it’s always essential as the first step
in any economic analysis to carefully define the problem in all of its aspects. From
this flows the rationale for deriving the net investment, operating cash flows, the
economic life, and any terminal values. Once these detailed aspects have been
properly established and understood, the actual calculation of the appropriate
yardsticks becomes almost automatic, as we’ll see in the examples we’re about to
discuss.
A Machine Replacement
A company is analyzing whether to replace an existing 5-year-old machine with a
more automatic and faster model. Acquiring a new machine of some sort is
viewed as the only reasonable alternative under the circumstances, because the
product fabricated on the equipment is expected to continue to be profitable for at
least 10 years. Moreover, the markets served could absorb additional output be-
yond the current capacity, as much as one-third more than the present volume.
The old machine is estimated to have at most 5 years’ life left before it be-
comes physically worn out, while the new machine will operate acceptably for
10 years before it has to be scrapped. The old machine originally cost $25,000 and
Team-Fly

We now have all the components of the initial net investment figure relevant
for this example:
Cost of the new machine . . . . . . . . . . . $40,000
Cash from sale of old machine. . . . . . . (15,000)
Tax payable on capital gain . . . . . . . . . 850
Net investment . . . . . . . . . . . . . . . . . $25,850
In this economic analysis, we don’t recognize the remaining book value of
the old machine, except for its brief role in the income tax calculation. As we’ve
observed before, any funds expended in the past are irrelevant because they are
sunk, and we’re interested only in the changes caused by the current decision.
Therefore, the proceeds from the equipment sale and the incremental tax due on
the capital gain are the only relevant elements.
Had the old machine not been salable despite its stated book value of
$12,500, the only item of relevance would be the tax savings on the capital loss
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268 Financial Analysis: Tools and Techniques
incurred with this condition. While there might be a temptation to include the loss
of sizable book values in such analyses, doing so would confuse accounting with
cash flow economics.
The net investment shown represents the difference between current cash
movements, both in and out, that are direct consequences of the investment deci-
sion. If we assume that the decision caused working capital (incremental receiv-
ables and inventories less incremental payables) to rise in support of the expected
higher sales volume, any funds committed for this purpose would also become
relevant for our analysis. Similarly, if the current decision were expected to di-
rectly cause further capital outlays in later years, such amounts would have to be
recognized in the analysis. In our second example, we’ll demonstrate how incre-
mental working capital and sequential investments are handled.
Operating Cash Inflows Refined
As we established before, operating cash inflows are the net after-tax cash

spending, such as higher property taxes, insurance premiums, additional mainte-
nance, and technical and other staff support, would a change have to be reflected
in the calculation. Under those conditions, we’d estimate the annual overhead ex-
penditures before and after the installation of the new machine, and calculate the
differential cost to be included in the analysis, just as we did for the other differ-
ential operating cash inflows.
Whenever we’re comparing operating costs, it’s usually more appropriate to
use annual totals rather than to rely on per-unit figures. The latter could cause the
analyst to inadvertently apply accounting allocations, which as a rule are irrele-
vant for this type of economic analysis—even though they are necessary and ap-
propriate for cost accounting (determining cost of goods sold, inventory values,
price estimating, and so on) in line with generally accepted accounting principles.
Stage 2: Contribution from Additional Volume. Now we’re ready to deter-
mine the incremental contribution from the increased output. This change must be
FIGURE 8–2
Differential Benefit and Cost Analysis
Relevant
Old New Annual
Machine Machine Differences
1. Operating savings from current volume
of 100,000 units:
Labor (operator plus setup) . . . . . . . . . . . . . $ 31,000 $ 30,000 $ 1,000
Material . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38,000 36,000 2,000
Overhead (120% of direct labor) . . . . . . . . . 37,200 36,000 —*
$106,200 $102,000 $ 3,000
2. Contribution from additional volume
25,000 units sold at $1.50 per unit . . . . . . . . $ 37,500
Less:
Labor (no additional operators) . . . . . . . . —
Material cost at 36¢/unit . . . . . . . . . . . . . . (9,000)

than before, such a difference must be reflected as a change in the tax shield.
For our replacement example, the differential depreciation for the next
5 years will be $1,500, an increase due to the higher cost basis of the new ma-
chine. We’re assuming that straight-line depreciation also is used for tax purposes,
to keep the calculations simple.
As is shown in Figure 8–2, the analysis results in taxable operating im-
provements of $7,000, an incremental tax of $1,870, and a change in after-tax
profit of $3,630. The applicable tax rate normally is the rate a company would be
paying on any incremental profit. As the final step, the differential depreciation is
added back to arrive at the after-tax operating cash flow of $5,130.
In following these steps, we have correctly reflected a tax reduction due to
the differential depreciation, but then removed depreciation itself from the picture
to leave us with the economic cash effect of the investment.
We could have obtained the same result by doing the analysis in two phases:
(1) determining the tax on the operating improvement before depreciation, and
(2) directly determining the tax shield effect of the differential depreciation. This
would appear as shown below, and as we might expect, the result is exactly the
same.
Operating improvement before depreciation . . . . . . . . $7,000
Tax at 34%. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,380
After-tax operating improvement . . . . . . . . . . . . . . . . . $4,620
Tax shield at 34%* of depreciation of $1,500. . . . . . . . 510
After-tax operating cash flow . . . . . . . . . . . . . . . . . . . . $5,130
*Each dollar of depreciation provides a tax shield of $1 times the applicable tax rate.
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CHAPTER 8 Analysis of Investment Decisions 271
Unequal Economic Lives
In Chapter 7, we defined economic life as the length of time over which an in-
vestment yields economic benefits. Now we find that a complication has been in-
troduced because of the expected difference in the physical lives of the two

3
45
0–2 –1
12
3
45678910
0
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272 Financial Analysis: Tools and Techniques
An alternative way of dealing with the problem is to assume that the old
machine will be replaced by a new one in Year 5, and that a similar replacement
will be made in Year 10 when the current new machine wears out. This approach
involves a great deal of sequential guessing about possible replacement options
5 and 10 years hence. Moreover, in spite of such extra analytical effort, the eco-
nomic lives of the two machines still will not be the same. Admittedly, the power
of discounting will make the estimates of the later years almost immaterial. On
balance, unless there are compelling reasons to develop such a series of replace-
ment assumptions, the cutoff analysis described earlier is far more straightforward
and less fraught with judgmental traps.
Capital Additions and Recoveries
The treatment of terminal values deserves a few more comments here. It’s quite
common for larger projects to require a series of additional capital outlays over
time, and eventually provide likely recoveries of at least part of these funds. As a
practical matter, any increments of capital committed or recovered must be en-
tered in the present value framework as cash outflows or cash inflows at the point
in time when they occur. This also applies to incremental working capital com-
mitments, which must be shown as outflows when incurred, and which can be as-
sumed to be recovered in part or in total at the end of the economic life of the
project.
In our replacement example, we’ve made no provision for additional work-

in row 4 of the analysis by netting the present values of the investment cash flows.
Remember, economic analysis requires that the recovery value must be counted as
a cash benefit at the end of Year 5, even though there might be no intention of
actually selling the machine at that point.
This value inclusion is relevant because the company would have the option
of selling the machine at the end of Year 5 and thereby realizing this economic
value. After the 5 years are over, the alternative of selling could, of course, be
compared with the alternative of recommitting the realizable value of $20,000 in
order to preserve the profitable business at the level of 125,000 units. But these
latter considerations deal with a future set of decisions and therefore are not rele-
vant today.
The profitability index (BCR) of the project is positive, as we might expect
from the sizable net present value of about $6,000. Dividing $13,430 (net invest-
ment less recovery) into the operating benefits of $19,443 results in an index of
1.45, which should give the project a favorable ranking against an implied aver-
age return of only 10 percent from the company’s investment opportunities. Be-
cause of the uncertainty implicit in establishing a terminal value, many analysts
prefer to express the profitability index by relating the original net investment to
the total of all inflows, including capital recoveries. In our example, this alterna-
tive result would be $31,863 Ϭ $25,850 ϭ 1.23, again a very favorable showing
FIGURE 8–4
Present Value Analysis of Machine Replacement*
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year-end 5 Totals
Net investment outlay
and recovery . . . . . . . . . . . . . . . . $Ϫ25,850 0 0 0 0 0 $20,000 $Ϫ5,850
Operating cash inflows . . . . . . . . . 0 $ 5,130 $ 5,130 $ 5,130 $ 5,130 $ 5,130 0 25,650
Present value factors @ 10% . . . . 1.000 0.909 0.826 0.751 0.683 0.621 0.621
Present values of investment
cash flows . . . . . . . . . . . . . . . . . . Ϫ25,850 0 0 0 0 0 12,420 Ϫ13,430
Present values of operating

ing a few years’ time.
A minor technical question arises here as to whether we should bring the
assumed recovery at the end of Year 5 forward in time nearer the payback point to
obtain a more precise calculation of minimum life. This would involve a process
of iteration, because not only would the present value of the recovery rise, but the
sales value of the machine would also be higher in earlier years. Such a refine-
ment normally is not called for even though it can be handled readily by altering
the magnitudes on the spreadsheet or by a simulation routine.
FIGURE 8–5
Present Value Analysis to Find Internal Rate of Return*
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year-end 5 Totals
Investment outlay
and recovery . . . . . . . . . . . . . . . . . . . $Ϫ25,850 0 0 0 0 0 $20,000 $Ϫ5,850
Operating cash inflows . . . . . . . . . . . . 0 $5,130 $5,130 $ 5,130 $5,130 $5,130 0 25,650
Present value factors @ 15% . . . . . . . 1.000 ——3.352 (annuity) — 0.497
Present values of cash flows . . . . . . . . Ϫ25,850 ——17,196 ——9,940
Net present value @ 15% . . . . . . . . . 1,286
Present value factors @ 16% . . . . . . . 1.000 ——3.274 (annuity) — 0.476
Present values of cash flows . . . . . . . . $Ϫ25,850 ——$16,796 ——$ 9,520
Net present value @ 15% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 466
Internal rate of return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16.6%
*This exhibit is available in an interactive format (TFA Template)—see “Analytical Support” on p. 295.
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CHAPTER 8 Analysis of Investment Decisions 275
The annualized net present value can be found when we divide the net pres-
ent value in Figure 8–4 by the 10 percent annuity factor in Year 5 from Table 7–II
on page 253, or $6,013 Ϭ 3.791, which amounts to $1,586 per year. On a spread-
sheet, we would use the pmt function and specify the 10 percent discount rate, the
five periods, and the net present value to obtain this amount. All other aspects be-
ing equal, the project would still meet the minimum standard of 10 percent if the

sumed to represent the expected incremental revenues and expenses caused by the
decision to invest, and they have been adjusted for tax consequences along the
lines we discussed in our first example. The periodic operating cash flows show a
growth stage, a peak in the middle years, and decline toward the end.
No new concepts are required for us to deal with this investment example.
As we know from Chapter 3, new working capital additions (incremental in-
ventories and receivables less new trade obligations) represent a commitment of
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276 Financial Analysis: Tools and Techniques
resources just as definite as an expenditure for buildings and equipment, except
that no depreciation write-off is involved. If all inventories and receivables are ex-
pected to be successfully liquidated at the end of the economic life, these funds
(net of payables) will become a cash inflow at that point, a capital recovery. If we
assume some fraction of this investment to be not salable or uncollectible, the fig-
ure must be lowered accordingly.
Additional capital expenditures for equipment during the life of the project
are simply recognized as cash outflows when incurred. We must take care, how-
ever, to reflect the additional depreciation pattern in each case as additional tax
shields during future operating periods and we can assume that this was done in
the cash flows shown. Of course, it’s quite easy to lay out these patterns over time
in successive series. The uneven cash flows of this project present no problems
when we use spreadsheets or calculators to find the net present value of the over-
all cash flow pattern and derive directly the other measures listed. For the present
value payback, the present values for each period must be calculated and ac-
cumulated period by period. But to demonstrate the background structure of the
calculations, we’ve again employed the present value tables to show the factors
involved.
As was shown in Figure 8–6, the expected result of the project is a positive
net present value of almost $12 million. The profitability index is about 1.1, while
the internal rate of return is approximately 14 percent, and present value payback

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TEAMFLY


$11,815 Ϭ 4.968, or at most, by about $2.4 million per year.
We’ve gone about as far as we can to carry out the quantitative financial as-
pects of the analysis with the data at hand. The various judgments leading to the
final decision call for much more insight into the nature of the product, the tech-
nology, the requirements and outlook of the market place, the competitive setting,
and so on. As we outlined in the first section of this chapter, we cannot overem-
phasize the importance of those areas for any well-informed business investment
decision.
Mutually Exclusive Alternatives
So far we’ve dealt with individual investment projects without regard to the
broader question of how these projects fit into the whole range of possibilities
open to a company. We’ve assumed that our examples were independent invest-
ment projects that could be evaluated and ranked against other independent proj-
ects. At times, however, managers face the issue of evaluating projects that are not
independent of each other. Such is the case with sets of different alternatives
which might be available for achieving the same purpose. These are called mutu-
ally exclusive alternatives, because if one is chosen, the others are eliminated by
that very decision.
Analyzing such a situation is merely a special case of economic analysis
which uses the same underlying concepts as before but emphasizes incremental
reasoning. To illustrate, let’s first take the simple case of a choice between con-
tinuing a current process through relatively high maintenance outlays versus an
up-front expenditure to replace the equipment, which entails low maintenance
costs and a significant terminal value. Next, we’ll take up the issue of choosing
between a full-fledged, state-of-the-art solution to a facility upgrade versus an
economy solution with lower capital costs and somewhat lower benefits, each of
which can serve the purpose equally well. Finally, we’ll discuss three individually
feasible alternatives of investing in facilities and working capital to produce and
sell a modified product and compare the economic implications of the choice.
Maintain versus Replace

After-tax cost . . . . . . . . . . . . . . . . . . . . . . . 0 Ϫ25,600 Ϫ38,400 Ϫ115,200 Ϫ19,200 Ϫ25,600 Ϫ224,000
Depreciation tax shield . . . . . . . . . . . . . . . . 0 0 0 0 0 0 0
Total project cash outflows . . . . . . . . . . . . . 0 Ϫ25,600 Ϫ38,400 Ϫ115,200 Ϫ19,200 Ϫ25,600 Ϫ224,000
Present value factors @ 12% . . . . . . . . . . . 1.000 0.893 0.797 0.712 0.636 0.567
Present values of cash outflows . . . . . . . . . 0 Ϫ22,861 Ϫ30,605 Ϫ82,022 Ϫ12,211 Ϫ14,515
Cumulative present values . . . . . . . . . . . . . 0 $Ϫ22,861 $Ϫ53,466 $Ϫ135,488 $Ϫ147,699 $Ϫ162,214
Net present value cost @ 12% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Ϫ162,214
Annualized net present value cost @ 12% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Ϫ45,000
*This exhibit is available in an interactive format (TFA Template)—see “Analytical Support” on p. 295.
FIGURE 8–8
Comparison of Maintain versus Replace: 2. Replace*
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Totals
Equipment outlay and recovery . . . . . . . . . $Ϫ400,000 0 0 0 0 $ 100,000 $Ϫ300,000
Maintenance expenditures . . . . . . . . . . . . . 0 $ Ϫ8,000 $ Ϫ9,000 $ Ϫ10,000 $ Ϫ11,000 Ϫ12,000 Ϫ50,000
Tax rate . . . . . . . . . . . . . . . . . . . . . . . . . . . 36% 36% 36% 36% 36%
After-tax cost . . . . . . . . . . . . . . . . . . . . . . . 0 Ϫ5,120 Ϫ5,760 Ϫ6,400 Ϫ7,040 Ϫ7,680 Ϫ32,000
Depreciation tax shield ($80,000 ϫ .36) . . . 0 28,800 28,800 28,800 28,800 28,800 144,000
Total project cash flows (incl.
recovery) . . . . . . . . . . . . . . . . . . . . . . . . . Ϫ400,000 23,680 23,040 22,400 21,760 121,120 $Ϫ188,000
Present value factors @ 12% . . . . . . . . . . . 1.000 0.893 0.797 0.712 0.636 0.567
Present values of cash flows . . . . . . . . . . . Ϫ400,000 21,146 18,363 15,949 13,839 68,675
Cumulative present values . . . . . . . . . . . . . $Ϫ400,000 $Ϫ378,854 $Ϫ360,491 $Ϫ344,542 $Ϫ330,703 $Ϫ262,028
Net present value cost @ 12% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Ϫ262,028
Annualized net present value cost @ 12% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Ϫ72,689
*This exhibit is available in an interactive format (TFA Template)—see “Analytical Support” on p. 295.
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CHAPTER 8 Analysis of Investment Decisions 279
If we assume that either alternative will serve the product/service requirements
equally well, the first alternative is far superior from an economic standpoint, rep-
resenting about $100,000 less in present value cost. As we mentioned, the critical

After-tax benefits. . . . . . . . . . . . . . . . . . . . . . . . 0 2,560 2,560 2,560 2,560 2,560 2,560 2,560 17,920
Depreciation tax shield ($1,500 ϫ .36) . . . . . . 0 540 540 540 540 540 540 540 3,780
Total project cash flows (including recovery) . . $Ϫ11,500 3,100 3,100 3,100 3,100 3,100 3,100 4,100 11,200
Present value factors @ 14%. . . . . . . . . . . . . . 1.000 0.877 0.769 0.675 0.592 0.519 0.456 0.400
Present values of cash flows . . . . . . . . . . . . . . Ϫ11,500 2,719 2,384 2,093 1,835 1,609 1,414 1,640
Cumulative present values . . . . . . . . . . . . . . . . $Ϫ11,500 $Ϫ8,781 $Ϫ6,397 $Ϫ4,305 $Ϫ2,470 $ Ϫ861 $ 553 $2,193
Net present value @ 14% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,193
Profitability index (BCR) @ 14% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.19
Internal rate of return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19.9%
Present value payback @ 14% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Year 6
*This exhibit is available in an interactive format (TFA Template)—see “Analytical Support” on p. 295.
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