Vegetrons CFO Calls Again

(The first episode of this story was presented in Section 5.1.)

Later that afternoon, Vegetron's CFO bursts into your office in a state of anxious confusion. The problem, he explains, is a last-minute proposal for a change in the design of the fermentation tanks that Vegetron will build to extract hydrated zirconium from a stockpile of powdered ore. The CFO has brought a printout (Table 5.1) of the forecasted revenues, costs, income, and book rates of return for the standard, low-temperature design. Vegetron's engineers have just proposed an alternative high-temperature design that will extract most of the hydrated zirconium over a shorter period, five instead of seven years. The forecasts for the high-temperature method are given in Table 5.2.16

TABLE 5.1

Income statement and book rates of return for high-temperature extraction of hydrated zirconium ($ thousands).

*Straight-line depreciation over five years is 400/5 = 80, or $80,000 per year. fCapital investment is $400,000 in year 0.

Year

Year

TABLE 5.1

Income statement and book rates of return for high-temperature extraction of hydrated zirconium ($ thousands).

*Straight-line depreciation over five years is 400/5 = 80, or $80,000 per year. fCapital investment is $400,000 in year 0.

1

2

3

4

5

1. Revenue

180

180

180

180

180

2. Operating costs

70

70

70

70

70

3. Depreciation*

80

80

80

80

80

4. Net income

30

30

30

30

30

5. Start-of-year book value*

400

320

240

160

80

6. Book rate of return (4 5)

7.5%

9.4%

12.5%

18.75%

Income statement and book rates of return for low-temperature extraction of hydrated zirconium ($ thousands).

*Rounded. Straight-line depreciation over seven years is 400/7 = 57.14, or $57,140 per year. fCapital investment is $400,000 in year 0.

TABLE 5.2

Income statement and book rates of return for low-temperature extraction of hydrated zirconium ($ thousands).

*Rounded. Straight-line depreciation over seven years is 400/7 = 57.14, or $57,140 per year. fCapital investment is $400,000 in year 0.

Year

1

2

3

4

5

6

7

1. Revenue

140

140

140

140

140

140

140

2. Operating costs

55

55

55

55

55

55

55

3. Depreciation*

57

57

57

57

57

57

57

4. Net income

28

28

28

28

28

28

28

5. Start-of-year

book value*

400

343

286

229

171

114

57

6. Book rate of

return (4 5)

7%

8.2%

9.8%

12.2%

16.4%

24.6%

49.1%

16For simplicity we have ignored taxes. There will be plenty about taxes in Chapter 6.

CHAPTER 5 Why Net Present Value Leads to Better Investment Decisions Than Other Criteria

CFO: Why do these engineers always have a bright idea at the last minute? But you've got to admit the high-temperature process looks good. We'll get a faster payback, and the rate of return beats Vegetron's 9 percent cost of capital in every year except the first. Let's see, income is $30,000 per year. Average investment is half the $400,000 capital outlay, or $200,000, so the average rate of return is 30,000/200,000, or 15 percent—a lot better than the 9 percent hurdle rate. The average rate of return for the low-temperature process is not that good, only 28,000/200,000, or 14 percent. Of course we might get a higher rate of return for the low-temperature proposal if we depreciated the investment faster—do you think we should try that?

You: Let's not fixate on book accounting numbers. Book income is not the same as cash flow to Vegetron or its investors. Book rates of return don't measure the true rate of return.

CFO: But people use accounting numbers all the time. We have to publish them in our annual report to investors.

You: Accounting numbers have many valid uses, but they're not a sound basis for capital investment decisions. Accounting changes can have big effects on book income or rate of return, even when cash flows are unchanged.

Here's an example. Suppose the accountant depreciates the capital investment for the low-temperature process over six years rather than seven. Then income for years 1 to 6 goes down, because depreciation is higher. Income for year 7 goes up because the depreciation for that year becomes zero. But there is no effect on year-to-year cash flows, because depreciation is not a cash outlay. It is simply the accountant's device for spreading out the "recovery" of the up-front capital outlay over the life of the project. CFO: So how do we get cash flows?

You: In these cases it's easy. Depreciation is the only noncash entry in your spreadsheets (Tables 5.1 and 5.2), so we can just leave it out of the calculation. Cash flow equals revenue minus operating costs. For the high-temperature process, annual cash flow is:

Cash flow = revenue - operating cost = 180 - 70 = 110, or $110,000.

CFO: In effect you're adding back depreciation, because depreciation is a noncash accounting expense.

You: Right. You could also do it that way:

Cash flow = net income + depreciation = 30 + 80 = 110, or $110,000.

CFO: Of course. I remember all this now, but book returns seem important when someone shoves them in front of your nose.

You: It's not clear which project is better. The high-temperature process appears to be less efficient. It has higher operating costs and generates less total revenue over the life of the project, but of course it generates more cash flow in years 1 to 5.

CFO: Maybe the processes are equally good from a financial point of view. If so we'll stick with the low-temperature process rather than switching at the last minute.

You: We'll have to lay out the cash flows and calculate NPV for each process.

CFO: OK, do that. I'll be back in a half hour—and I also want to see each project's true, DCF

rate of return.

Questions

1. Are the book rates of return reported in Table 5.1 useful inputs for the capital investment decision?

2. Calculate NPV and IRR for each process. What is your recommendation? Be ready to explain to the CFO.

6. Making Investment Decisions with the Net Present Value Rule

CHAPTER /IX

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