Capital Equipment Planning

Kevin Hirst

Brigham Young University

Overview

• Capital equipment planning defined• How is it used?• Capital budgeting techniques• Examples and Real World Exercise• Summary• Reading List• Exercise Solution

What Is Capital Equipment Planning?

• Planning for the purchase or replacement of capital equipment

• Reasons for purchase or replacement include obsolescence, desire for increased capacity, and introduction of a new product or process

• Planning is put into action through capital budgeting and cash flow analysis

Capital Equipment Planning—Why?

• Equipment is becoming obsolete• Purchase additional equipment to

increase productivity• Need new equipment for a new

product or process• Find best investment from several

capital equipment options

Capital Equipment Planning—How?

• Capital budgeting techniques are used to determine best investment

• Obsolescence planning can be used to plan for the replacement of old or obsolete equipment

Capital Budgeting• Determining which capital investment

projects to do

• Best capital budgeting techniques:1. Consider the time-value of money

2. Include all incremental cash flows

3. Incorporate the required rate of return for the project

Capital Budgeting Techniques

• Payback Period

• Net Present Value (NPV)

• Internal Rate of Return (IRR)

Payback Period• The time it takes to for an investment to

pay for itself or recoup the initial outlay– When positive cash flows are equal:

Initial InvestmentAnnual Cash Flow

Example: A machine that costs $50,000 will earn $20,000 a year. What is the payback period?

Payback = $50,000$20,000 = 2.5 years, or 2 years 6 months

Payback =

Payback Period

Example: A machine that costs $50,000 will earn $15,000 in year 1, $25,000 in year 2, and $30,000 in year 3. What is the payback period?

  Inflow (50,000)

Year 1 15,000 (35,000)

Year 2 25,000 (10,000)

Year 3 30,000 20,000

– When cash flows are not equal, subtract the cash inflows from the initial investment until it reaches zero

Payback occurs between year 2 and 3. To figure this out, divide remainder ($10,000) by the cash flow in year 3 ($30,000)

$10,000$30,000

= .33 + 2 years = 2.33 years, or

2 years 4 months

Payback PeriodPros

• Easy to calculate

• Easy to understand

Cons

• Doesn’t take into account the time- value of money

• Doesn’t consider cash flows after payback period

n

t = 1Σ

Net Present Value• The sum of the present values of all the

annual net cash flows minus the initial investment

CFt

(1+ r)t - initial investmentNPV =

Net Present Value• Decision criteria:

– If NPV > 0, the investment is acceptable– If NPV < 0, the investment is not acceptable

Net Present ValueExample: A machine that costs $50,000 will produce cash flows of $25,000 in

year 1, $20,000 in year 2, and $10,000 in year 3. Assume a 12% required rate

of return. What is the NPV? Should we purchase the machine?

Initial Investment = $50,000

Year Cash Flow

Present Value of

Cash Flow

1 $ 25,000 $ 22,321.43

2 $ 20,000 $ 15,943.88

3 $ 10,000 $ 7,117.80

Sum of PV ofCash Flows= $ 45,383.11

NPV = PV of Cash Flows – Initial Investment

= 45,383.11 – 50,000

= - 4,616.89

Because NPV < 0, we should NOT purchase this machine.

Discount each cash flow

Net Present ValuePros

• Incorporates time-value of money

• Considers all cash flows• Clear decision criteria• Shows the amount of

wealth that could be created from investment

Cons• Can’t easily compare two

projects if they differ in size (comparing apples to oranges)

Internal Rate of Return• The rate of return that an investment earns

• More specifically, the rate of return that makes the present value of the annual cash flows equal to the initial investment– No way to calculate IRR by hand (besides trial

and error). Excel and financial calculators have built-in functions to solve for IRR.

Internal Rate of Return• Decision criteria:

– If IRR >= required rate of return, a.k.a. the hurdle rate, the investment is acceptable

– If IRR < required rate of return, the investment is not acceptable

Internal Rate of ReturnExample: A machine that costs $50,000 will produce cash flows of $25,000 in

year 1, $20,000 in year 2, and $10,000 in year 3. Assume a 12% required rate

of return. What is the IRR? Is this machine acceptable?

Year Cash Flow

0 (50,000)

1 25,000

2 20,000

3 10,000

IRR= 5.73%

IRR = 5.73%

Because IRR < 12% (the hurdle rate), we should NOT invest in this machine.

Internal Rate of ReturnPros

• Incorporates time-value of money

• Considers all cash flows

• Clear decision criteria• Can compare IRRs of

different investments regardless of size

Cons• Assumes that cash can

be reinvested at the IRR, which could be unrealistic if the IRR is very high

• Can exist multiple IRRs if there is more than one negative net cash flow

NPV vs. IRR• Traditionally, IRR has been most the popular

capital budgeting technique among Fortune 1000 firms.

• Over the years, NPV use has grown and is now the most popular technique among the Fortune 1000 firms.– This is largely due to professors that have been

stressing to MBA students over the years that NPV is a better technique than IRR

Real World ExerciseLumberjack Inc. wants to purchase a wood-cutting machine to increase

production. It is considering two different machines, the Cutter 500 and the Saw-tooth 3000. The Cutter costs $600,000 and would increase production by 60,000 pieces a year. The machine would be depreciated straight-line over 6 years with no salvage value. The Saw-tooth costs $1,000,000 and would increase production by 110,000 pieces a year. The machine would be depreciated straight-line over 6 years with no salvage value. The sales price per unit is $5 and the variable cost per unit is $1.50. Fixed costs to run either machine are $30,000 per year. Lumberjack’s tax rate is 35% and the cost of capital (required rate of return) is 14%. Using the capital budgeting techniques, which machine is the better investment?

Real World ExerciseCutter 500 Saw-tooth 3000

Initial Investment 600,000 1,000,000

Production Increase 60,000 110,000

Sale Price/unit 5.00 5.00

Variable Cost/unit 1.50 1.50

Fixed Costs/year 30,000 30,000

Years 6 6

Depreciation Exp/year 100,000 166,667

Tax Rate 35% 35%

Required Rate 14% 14%

This chart summarizes this information in the exercise. Using this information, calculate the payback period, NPV, and IRR. Then determine which machine is the better investment.

Summary• Capital equipment planning is important

for knowing when to purchase new equipment or replace old or obsolete equipment

• Capital budgeting techniques are helpful in finding profitable capital equipment investments

Reading List• Mayes, Timothy R. and Todd M. Shank. Financial

Analysis with Microsoft Excel 2002. Minnesota: South-Western, 2004.

• Keown, Martin, Petty, and Scott. Financial Management: Principles and Applications. New Jersey: Prentice Hall, 2000.

• Ryan, Patricia A. and Glenn P. Capital Budgeting Practices of the Fortune 1000: How Have Things Changed? Journal of Business and Management, Vol. 8, No. 4, Oct 2002.

Reading List• Cheng, C.S. Agnes, D. Kite, and R. Radtke. The

Applicability and Usage of NPV and IRR Capital Budgeting Techniques. Managerial Finance, Vol. 20, No. 7, 1994.

• Bozarth, Cecil C. and Robert B. Handfield. Introduction to Operations and Supply Chain Management. New Jersey: Prentice Hall, 2006.

• MacEwen, Bruce. IRR vs. NPV and What You Need to Know. URL: http://www.bmacewen.com/blog/archives/ 2004/09/irr_vs_npv_and.html

Exercise Solution

Payback = 600,000 / 152,000 = 3.95 years

NPV = (133,333 + 116,959 + 102,596 + 89,996 + 78,944 + 69,249) – 600,000

= -8,923

IRR = 13.5%

Cutter 500

Exercise SolutionSaw-tooth 3000

Payback = 1,000,000 / 289,083 = 3.46 years

NPV = (253,582 + 222,440 + 195,123 + 171,161 + 150,141 + 131,702) – 1,000,000

= 124,149

IRR = 18.4%

Exercise SolutionCutter 500 Saw-tooth 3000

Payback 3.95 yrs 3.46 yrs

NPV $ (8,923) $ 124,149

IRR 13.5% 18.4%

Because the Saw-tooth 3000 has a shorter payback period, higher net present value, and higher internal rate of return than the Cutter 500, Lumberjack Inc. should invest in the Saw-tooth 3000.