Supplement

F
Financial
Analysis

Many decisions in operations and supply chain management involve large capital in-
vestments. Automation, outsourcing decisions, capacity expansion, layout revisions, building a
new distribution center, and installing a new ERP system are only a few examples. In fact, most of
a firm’s assets are tied up in the operations function. Therefore, management should seek high-
yield capital projects and then assess their costs, benefits, and risks.
Such projects require strong cross-functional coordination, particularly with finance and ac-
counting. The projects must fit in with the organization’s financial plans and capabilities. If a firm
plans to open a new production facility in 2015, it must begin lining up financing in 2011. The
projects must also be subjected to one or more types of financial analysis to assess their attractive-
ness relative to other investment opportunities. This supplement presents a brief overview of ba-
sic financial analyses and the types of computer support available for making such decisions. See
your finance textbook for a more comprehensive treatment of the subject.

Learning Goals  After reading this supplement, you should be able to:
1 Explain the time value of money concept. 3 Discuss the importance of combining managerial judg-
2 Demonstrate the use of the net present value, internal ment with quantitative techniques when making invest-
rate of return, and payback methods of financial analysis. ment decisions.

Time Value of Money time value of money

An important concept underlying many financial analysis techniques is that a dollar in hand today The concept that a dollar in hand
is worth more than a dollar to be received in the future. A dollar in hand can be invested to earn can be invested to earn a return
a return so that more than one dollar will be available in the future. This concept is known as the so that more than one dollar will
time value of money. be available in the future.

Future Value of an Investment

If $5,000 is invested at 10 percent interest for 1 year, at the end of the year the $5,000 will have
earned $500 in interest and the total amount available will be $5,500. If the interest earned is al-
lowed to ­accumulate, it also earns interest and the original investment will grow to $12,970 in
10 years. The process by which interest on an investment accumulates and then earns interest

F-1

Z02_KRAJ7395_10_SE_SUPF.indd 1 16/12/11 5:34 PM

 F-2 Supplement F Financial Analysis

compounding interest itself for the remainder of the investment period is known as compounding interest. The value
The process by which interest of an investment at the end of the period over which interest is compounded is called the future
on an investment accumulates value of an investment.
and then earns interest itself for To calculate the future value of an investment, you first express the interest rate and the time
the remainder of the investment period in the same units of time as the interval at which compounding occurs. Let us assume that
period. interest is compounded annually, express all time periods in years, and use annual interest rates.
To find the value of an investment 1 year in the future, multiply the amount invested by the sum
future value of an investment of 1 plus the interest rate (expressed as a decimal). The value of a $5,000 investment at 12 percent
per year, 1 year from now is
The value of an investment at
the end of the period over which $5, 00011.122 = $5, 600
interest is compounded.
If the entire amount remains invested, at the end of 2 years you would have

$5, 60011.122 = $5, 00011.122 2 = $6, 272

In general,
F = P11 + r2 n

where
F = future value of the investment at the end of n periods
P = amount invested at the beginning, called the prinicipal
r = periodic interest rate
n = number of time periods for which the interest compounds

Present Value of a Future Amount

Let us look at the converse problem. Suppose that you want to make an investment now that will
be worth $10,000 in 1 year. If the interest rate is 12 percent and P represents the amount invested
now, the relation becomes

F = $10, 000 = P11 + 0.122

Solving for P gives

F 10, 000
P = = = $8, 929
11 + r2 n 11 + 0.122 1
The amount that must be invested now to accumulate to a certain amount in the future at a
present value of an investment specific interest rate is called the present value of an investment. The process of finding the present
The amount that must be value of an investment when the future value and the interest rate are known is called discounting
­invested now to accumulate to a the future value to its present value. If the number of time periods n for which discounting is desired
certain amount in the future at is greater than 1, the present value is determined by dividing the future value by the nth power of the
a specific interest rate. sum of 1 plus the interest rate. The general formula for determining the present value is

F
discounting P =
11 + r2 n
The process of finding the pres-
ent value of an investment when The interest rate is also called the discount rate.
the future value and the interest
rate are known.
Present Value Factors
discount rate Although you can calculate P from its formula in a few steps with most pocket calculators, you also
The interest rate used in can use a table. To do so, write the present value formula another way:
­discounting the future value F 1
to its present value. P = = Fc d
11 + r 2 n 11 + r 2 n

Let 31> 11 + r 2 n 4 be the present value factor, which is called pf and which you can find in
­Table F.1. This table gives you the present value of a future amount of $1 for various time periods
and interest rates. To use the table, locate the column for the appropriate interest rate and the row
for the appropriate period. The number in the body of the table where this row and column inter-
sect is the pf value. Multiply it by F to get P. For example, suppose that an investment will generate
$15,000 in 10 years. If the interest rate is 12 percent, Table F.1 shows that pf = 0.3220. Multiplying
it by $15,000 gives the present value, or

P = F1pf2 = $15, 00010.32202

= $4, 830

Z02_KRAJ7395_10_SE_SUPF.indd 2 16/12/11 5:34 PM



Table F.1    Present Value Factors for a Single Payment

Interest Rate (r )
Number of
Periods (n) 0.01 0.02 0.03 0.04 0.05 0.06 0.08 0.10 0.12 0.14 0.16 0.18 0.20 0.22 0.24 0.26 0.28 0.30

Z02_KRAJ7395_10_SE_SUPF.indd 3
1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9259 0.9091 0.8929 0.8772 0.8621 0.8475 0.8333 0.8197 0.8065 0.7937 0.7812 0.7692
2 0.9803 0.9612 0.9426 0.9246 0.9070 0.8900 0.8573 0.8264 0.7972 0.7695 0.7432 0.7182 0.6944 0.6719 0.6504 0.6299 0.6104 0.5917
3 0.9706 0.9423 0.9151 0.8890 0.8638 0.8396 0.7938 0.7513 0.7118 0.6750 0.6407 0.6086 0.5787 0.5507 0.5245 0.4999 0.4768 0.4552
4 0.9610 0.9238 0.8885 0.8548 0.8227 0.7921 0.7350 0.6830 0.6355 0.5921 0.5523 0.5158 0.4823 0.4514 0.4230 0.3968 0.3725 0.3501
5 0.9515 0.9057 0.8626 0.8219 0.7835 0.7473 0.6806 0.6209 0.5674 0.5194 0.4761 0.4371 0.4019 0.3700 0.3411 0.3149 0.2910 0.2693
6 0.9420 0.8880 0.8375 0.7903 0.7462 0.7050 0.6302 0.5645 0.5066 0.4556 0.4104 0.3704 0.3349 0.3033 0.2751 0.2499 0.2274 0.2072
7 0.9327 0.8706 0.8131 0.7599 0.7107 0.6651 0.5835 0.5132 0.4523 0.3996 0.3538 0.3139 0.2791 0.2486 0.2218 0.1983 0.1776 0.1594
8 0.9235 0.8535 0.7894 0.7307 0.6768 0.6274 0.5403 0.4665 0.4039 0.3506 0.3050 0.2660 0.2326 0.2038 0.1789 0.1574 0.1388 0.1226
9 0.9143 0.8368 0.7664 0.7026 0.6446 0.5919 0.5002 0.4241 0.3606 0.3075 0.2630 0.2255 0.1938 0.1670 0.1443 0.1249 0.1084 0.0943
10 0.9053 0.8203 0.7441 0.6756 0.6139 0.5584 0.4632 0.3855 0.3220 0.2697 0.2267 0.1911 0.1615 0.1369 0.1164 0.0922 0.0847 0.0725
11 0.8963 0.8043 0.7224 0.6496 0.5847 0.5268 0.4289 0.3505 0.2875 0.2366 0.1954 0.1619 0.1346 0.1122 0.0938 0.0787 0.0662 0.0558
12 0.8874 0.7885 0.7014 0.6246 0.5568 0.4970 0.3971 0.3186 0.2567 0.2076 0.1685 0.1372 0.1122 0.0920 0.0757 0.0625 0.0517 0.0429
13 0.8787 0.7730 0.6810 0.6006 0.5303 0.4688 0.3677 0.2897 0.2292 0.1821 0.1452 0.1163 0.0935 0.0754 0.0610 0.0496 0.0404 0.0330
14 0.8700 0.7579 0.6611 0.5775 0.5051 0.4423 0.3405 0.2633 0.2046 0.1597 0.1252 0.0985 0.0779 0.0618 0.0492 0.0393 0.0316 0.0254
15 0.8613 0.7430 0.6419 0.5553 0.4810 0.4173 0.3152 0.2394 0.1827 0.1401 0.1079 0.0835 0.0649 0.0507 0.0397 0.0312 0.0247 0.0195
16 0.8528 0.7284 0.6232 0.5339 0.4581 0.3936 0.2919 0.2176 0.1631 0.1229 0.0930 0.0708 0.0541 0.0415 0.0320 0.0248 0.0193 0.0150
17 0.8444 0.7142 0.6050 0.5134 0.4363 0.3714 0.2703 0.1978 0.1456 0.1078 0.0802 0.0600 0.0451 0.0340 0.0258 0.0197 0.0150 0.0116
18 0.8360 0.7002 0.5874 0.4936 0.4155 0.3503 0.2502 0.1799 0.1300 0.0946 0.0691 0.0508 0.0376 0.0279 0.0208 0.0156 0.0118 0.0089
19 0.8277 0.6864 0.5703 0.4746 0.3957 0.3305 0.2317 0.1635 0.1161 0.0829 0.0596 0.0431 0.0313 0.0229 0.0168 0.0124 0.0092 0.0068
20 0.8195 0.6730 0.5537 0.4564 0.3769 0.3118 0.2145 0.1486 0.1037 0.0728 0.0514 0.0365 0.0261 0.0187 0.0135 0.0098 0.0072 0.0053
21 0.8114 0.6598 0.5375 0.4388 0.3589 0.2942 0.1987 0.1351 0.0926 0.0638 0.0443 0.0309 0.0217 0.0154 0.0109 0.0078 0.0056 0.0040
22 0.8034 0.6468 0.5219 0.4220 0.3418 0.2775 0.1839 0.1228 0.0826 0.0560 0.0382 0.0262 0.0181 0.0126 0.0088 0.0062 0.0044 0.0031
23 0.7954 0.6342 0.5067 0.4057 0.3256 0.2618 0.1703 0.1117 0.0738 0.0491 0.0329 0.0222 0.0151 0.0103 0.0071 0.0049 0.0034 0.0024
24 0.7876 0.6217 0.4919 0.3901 0.3101 0.2470 0.1577 0.1015 0.0659 0.0431 0.0284 0.0188 0.0126 0.0085 0.0057 0.0039 0.0027 0.0018
25 0.7798 0.6095 0.4776 0.3751 0.2953 0.2330 0.1460 0.0923 0.0588 0.0378 0.0245 0.0160 0.0105 0.0069 0.0046 0.0031 0.0021 0.0014
26 0.7720 0.5976 0.4637 0.3607 0.2812 0.2198 0.1352 0.0839 0.0525 0.0331 0.0211 0.0135 0.0087 0.0057 0.0037 0.0025 0.0016 0.0011
27 0.7644 0.5859 0.4502 0.3468 0.2678 0.2074 0.1252 0.0763 0.0469 0.0291 0.0182 0.0115 0.0073 0.0047 0.0030 0.0019 0.0013 0.0008
28 0.7568 0.5744 0.4371 0.3335 0.2551 0.1956 0.1159 0.0693 0.0419 0.0255 0.0157 0.0097 0.0061 0.0038 0.0024 0.0015 0.0010 0.0006
29 0.7493 0.5631 0.4243 0.3207 0.2429 0.1846 0.1073 0.0630 0.0374 0.0224 0.0135 0.0082 0.0051 0.0031 0.0020 0.0012 0.0008 0.0005
Financial Analysis

30 0.7419 0.5521 0.4120 0.3083 0.2314 0.1741 0.0994 0.0573 0.0334 0.0196 0.0116 0.0070 0.0042 0.0026 0.0016 0.0010 0.0006 0.0004
35 0.7059 0.5000 0.3554 0.2534 0.1813 0.1301 0.0676 0.0356 0.0189 0.0102 0.0055 0.0030 0.0017 0.0009 0.0005 0.0003 0.0002 0.0001
40 0.6717 0.4529 0.3066 0.2083 0.1420 0.0972 0.0460 0.0221 0.0107 0.0053 0.0026 0.0013 0.0007 0.0004 0.0002 0.0001 0.0001 0.0000

F
P = = F (pf)
(1 + r )n
where P = present value of a single investment
Supplement F

F = future value of a single payment

n = number of periods for which P is to be invested
r periodic interest rate
F-3

=
pf = present value factor for $1 = 1> 11 + r2 n

16/12/11 5:34 PM
 F-4 Supplement F Financial Analysis

Annuities
annuity An annuity is a series of payments of a fixed amount for a specified number of years. All such pay-
A series of payments on a fixed ments are treated as happening at the end of a year. Suppose that you want to invest an amount
amount for a specified number at an interest rate of 10 percent so that you may draw out $5,000 per year for each of the next four
of years. years. You could determine the present value of this $5,000 four-year annuity by treating the four
payments as single future payments. The present value of an investment needed now, in order for
you to receive these payments for the next four years, is the sum of the present values of each of
the four payments. That is,
$5, 000 $5, 000 $5, 000 $5, 000
P = + + +
1 + 0.10 11 + 0.102 2 11 + 0.102 3 11 + 0.102 4
= $4, 545 + $4, 132 + $3, 757 + $3, 415
= $15, 849

A much easier way to calculate this amount is to use Table F.2. Look for the factor in the table
at the intersection of the 10 percent column and the fourth-period row. It is 3.1699. For annuities,
this present value factor is called af to distinguish it from the present value factor for a single pay-
ment. To determine the present value of an annuity, multiply its amount by af to get

P = A(af) = $5, 000(3.1699)

= $15, 849

where
P = present value of an investment
A = amount of the annuity received each year
af = persent value factor for an annuity

Techniques of Analysis
You can now apply these concepts to the financial analysis of proposed investments. Three basic
financial analysis techniques are as follow:
1. The net present value method
2. The internal rate of return method
3. The payback method
cash flow These methods work with cash flows. Cash flow is the cash that will flow into and out of the
The difference between the organization because of the project, including revenues, costs, and changes in assets and liabili-
flows of funds into and out of ties. Be sure to remember two points when determining cash flows for any project:
an o­ rganization over a period of 1. Consider only the amounts of cash flows that will change if the project is undertaken. These
time, including revenues, costs, amounts are called incremental cash flows and are the difference between the cash flows with
and changes in assets and the project and without it.
liabilities.
2. Convert cash flows to after-tax amounts before applying the net present value, payback, or
internal rate of return method to them. This step introduces taxes and depreciation into the
calculations.
straight-line depreciation
method
Depreciation and Taxes
The simplest method of
Depreciation is an allowance for the consumption of capital. In this type of analysis, deprecia-
­calculating annual depreciation;
tion is relevant for only one reason: It acts as a tax shield. Depreciation is not a legitimate cash
found by subtracting the esti-
flow because it is not cash that is actually paid out each year. However, depreciation does af-
mated salvage value from the
fect how an accountant calculates net income, against which the income-tax rate is applied.
amount of investment required
Therefore, depreciation enters into the calculation, as a tax shield, only when tax liability is
at the beginning of the project,
figured. Taxes must be paid on pretax cash inflows minus the depreciation that is associated
and then dividing by the asset’s
with the proposed investment. United States tax laws allow either straight-line or accelerated
expected economic life.
depreciation.
salvage value Straight-Line Depreciation  The straight-line depreciation method of calculating annual depre-
The cash flow from the sale or ciation is the simplest and usually is adequate for internal planning purposes. First, subtract the
disposal of plant and equipment estimated salvage value from the amount of investment required at the beginning of the project
at the end of a project’s life. and then divide by the number of years in the asset’s expected economic life. Salvage value is the

Z02_KRAJ7395_10_SE_SUPF.indd 4 16/12/11 5:34 PM



Table F.2    Present Value Factors of an Annuity

Interest Rate (r )
Number of
Periods (n) 0.01 0.02 0.03 0.04 0.05 0.06 0.08 0.10 0.12 0.14 0.16 0.18 0.20 0.22 0.24 0.26 0.28 0.30

Z02_KRAJ7395_10_SE_SUPF.indd 5
1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9259 0.9091 0.8929 0.8772 0.8621 0.8475 0.8333 0.8197 0.8065 0.7937 0.7812 0.7692
2 1.9704 1.9416 1.9135 1.8861 1.8594 1.8334 1.7833 1.7355 1.6901 1.6467 1.6052 1.5656 1.5278 1.4915 1.4568 1.4235 1.3916 1.3609
3 2.9410 2.8839 2.8286 2.7751 2.7232 2.6730 2.5771 2.4869 2.4018 2.3216 2.2459 2.1743 2.1065 2.0422 1.9813 1.9234 1.8684 1.8161
4 3.9020 3.8077 3.7171 3.6299 3.5460 3.4651 3.3121 3.1699 3.0373 2.9137 2.7982 2.6901 2.5887 2.4936 2.4043 2.3202 2.2410 2.1662
5 4.8534 4.7135 4.5797 4.4518 4.3295 4.2124 3.9927 3.7908 3.6048 3.4331 3.2743 3.1272 2.9906 2.8636 2.7454 2.6351 2.5320 2.4356
6 5.7955 5.6014 5.4172 5.2421 5.0757 4.9173 4.6229 4.3553 4.1114 3.8887 3.6847 3.4976 3.3255 3.1669 3.0205 2.8850 2.7594 2.6427
7 6.7282 6.4720 6.2303 6.0021 5.7864 5.5824 5.2064 4.8684 4.5638 4.2883 4.0386 3.8115 3.6046 3.4155 3.2423 3.0833 2.9370 2.8021
8 7.6517 7.3255 7.0197 6.7327 6.4632 6.2098 5.7466 5.3349 4.9676 4.6389 4.3436 4.0776 3.8372 3.6193 3.4212 3.2407 3.0758 2.9247
9 8.5660 8.1622 7.7861 7.4353 7.1078 6.8017 6.2469 5.7590 5.3282 4.9464 4.6065 4.3030 4.0310 3.7863 3.5655 3.3657 3.1842 3.0190
10 9.4713 8.9826 8.5302 8.1109 7.7217 7.3601 6.7101 6.1446 5.6502 5.2161 4.8332 4.4941 4.1925 3.9232 3.6819 3.4648 3.2689 3.0915
11 10.3676 9.7868 9.2526 8.7605 8.3064 7.8869 7.1390 6.4951 5.9377 5.4527 5.0286 4.6560 4.3271 4.0354 3.7757 3.5435 3.3351 3.1473
12 11.2551 10.5753 9.9540 9.3851 8.8633 8.3838 7.5361 6.8137 6.1944 5.6603 5.1971 4.7932 4.4392 4.1274 3.8514 3.6059 3.3868 3.1903
13 12.1337 11.3484 10.6350 9.9856 9.3936 8.8527 7.9038 7.1034 6.4235 5.8424 5.3423 4.9095 4.5327 4.2028 3.9124 3.6555 3.4272 3.2233
14 13.0034 12.1062 11.2961 10.5631 9.8986 9.2950 8.2442 7.3667 6.6282 6.0021 5.4675 5.0081 4.6106 4.2646 3.9616 3.6949 3.4587 3.2487
15 13.8651 12.8493 11.9379 11.1184 10.3797 9.7122 8.5595 7.6061 6.8109 6.1422 5.5755 5.0916 4.6755 4.3152 4.0013 3.7261 3.4834 3.2682
16 14.7179 13.5777 12.5611 11.65423 10.8378 10.1059 8.8514 7.8237 6.9740 6.2651 5.6685 5.1624 4.7296 4.3567 4.0333 3.7509 3.5026 3.2832
17 15.5623 14.2919 13.1661 12.1657 11.2741 10.4773 9.1216 8.0216 7.1196 6.3729 5.7487 5.2223 4.7746 4.3908 4.0591 3.7705 3.5177 3.2948
18 16.3983 14.9920 13.7535 12.6593 11.6896 10.8276 9.3719 8.2014 7.2497 6.4674 5.8178 5.2732 4.8122 4.4187 4.0799 3.7861 3.5294 3.3037
19 17.2260 15.6785 14.3238 13.1339 12.0853 11.1581 9.6036 8.3649 7.3658 6.5504 5.8775 5.3162 4.8435 4.4415 4.0967 3.7985 3.5386 3.3105
20 18.0456 16.3514 14.8775 13.5903 12.4622 11.4699 9.8181 8.5136 7.4694 6.6231 5.9288 5.3527 4.8696 4.4603 4.1103 3.8083 3.5458 3.3158
21 18.8570 17.0112 15.4150 14.0292 12.8212 11.7641 10.0168 8.6487 7.5620 6.6870 5.9731 5.3837 4.8913 4.4756 4.1212 3.8161 3.5514 3.3198
22 19.6604 17.6580 15.9369 14.4511 13.1630 12.0416 10.2007 8.7715 7.6446 6.7429 6.0113 5.4099 4.9094 4.4882 4.1300 3.8223 3.5558 3.3230
23 20.4558 18.2922 16.4436 14.8568 13.4886 12.3034 10.3711 8.8832 7.7184 6.7921 6.0442 5.4321 4.9245 4.4985 4.1371 3.8273 3.5592 3.3254
24 21.2434 18.9139 16.9355 15.2470 13.7986 12.5504 10.5288 8.9847 7.7843 6.8351 6.0726 5.4509 4.9371 4.5070 4.1428 3.8312 3.5619 3.3272
25 22.0232 19.5235 17.4131 15.6221 14.0939 12.7834 10.6748 9.0770 7.8431 6.8729 6.0971 5.4669 4.9476 4.5139 4.1474 3.8342 3.5640 3.3286
26 22.7952 20.1210 17.8768 15.9828 14.3752 13.0032 10.8100 9.1609 7.8957 6.9061 6.1182 5.4804 4.9563 4.5196 4.1511 3.8367 3.5656 3.3297
27 23.5596 20.7069 18.3270 16.3296 14.6430 13.2105 10.9352 9.2372 7.9426 6.9352 6.1364 5.4919 4.9636 4.5243 4.1542 3.8387 3.5669 3.3305
28 24.3164 21.2813 18.7641 19.6631 14.8981 13.4062 11.0511 9.3066 7.9844 6.9607 6.1520 5.5016 4.9697 4.5281 4.1566 3.8402 3.5679 3.3312
29 25.0658 21.8444 19.1885 16.9837 15.1411 13.5907 11.1584 9.3696 8.0218 6.9830 6.1656 5.5098 4.9747 4.5312 4.1585 3.8414 3.5687 3.3317
Financial Analysis

30 25.8077 22.3965 19.6004 17.2920 15.3725 13.7648 11.2578 9.4269 8.0552 7.0027 6.1772 5.5168 4.9789 4.5338 4.1601 3.8424 3.5693 3.3321
35 29.4086 24.9986 21.4872 18.6646 16.3742 14.4982 11.6546 9.6442 8.1755 7.0700 6.2153 5.5386 4.9915 4.5411 4.1644 3.8450 3.5708 3.3330
40 32.8347 27.3555 23.1148 19.7929 17.1591 15.0463 11.9246 9.7791 8.2438 7.1050 6.2335 5.5482 4.9966 4.5439 4.1659 3.8458 3.5712 3.3332
n
A A A j
P = + 2
+ g + n = A a 1/(1 + r ) = A(af)
(1 + r) (1 + r) (1 + r) j=1
where P = present value of a single investment
Supplement F

A = amount of annuity to be received at the end of each period

n = number of periods for which the annuity is received
r = periodic interest rate
n
F-5

af = annuity factor for an annuity of $1 = a 1/(1 + r )j

j=1

16/12/11 5:34 PM
 F-6 Supplement F Financial Analysis

cash flow from the sale or disposal of plant and equipment at the end of a project’s life.1 The gen-
eral expression for annual depreciation is

I - S
D =
n

where

D = annual depreciation
I = amount of the investment
S = salvage value
n = number of years of project life

Accelerated Depreciation  If the tax shields come earlier, they are worth more. Tax laws allow
just that with what is called accelerated depreciation. Since 1986, the only acceptable accelerated
Modified Accelerated Cost depreciation method in the United States is the Modified Accelerated Cost Recovery System
­Recovery System (MACRS) (MACRS). MACRS shortens the lives of investments, giving firms larger tax deductions. It creates
The only acceptable depreciation six classes of investments, each of which has a recovery period or class life. Depreciation for each
method for tax purposes that year is calculated by multiplying the asset’s cost by the fixed percentage in Table F.3.2 The follow-
shortens the lives of investments, ing are examples of the first four classes:
giving firms larger early tax 3-year class: specially designed tools and equipment used in research
deductions.
5-year class: autos, copiers, and computers
7-year class: most industrial equipment and office furniture
10-year class: some longer-life equipment
Table F.3 does not show the 27.5- and 31.5-year classes, which are reserved for real estate.
MACRS depreciation calculations ignore salvage value and the actual expected economic life. If
there is salvage value after the asset has been fully depreciated, it is treated as taxable income.

Table F.3   Macrs Depreciation Allowances

Class of Investment
Year 3-Year 5-Year 7-Year 10-Year
 1 33.33 20.00 14.29 10.00
 2 44.45 32.00 24.49 18.00
 3 14.81 19.20 17.49 14.40
 4   7.41 11.52 12.49 11.52
 5 11.52 8.93 9.22
 6 5.76 8.93 7.37
 7 8.93 6.55
 8 4.45 6.55
 9 6.55
10 6.55
11 3.29
100.0% 100.0% 100.0% 100.0%

1Disposal of property often results in an accounting gain or loss that can increase or decrease income tax and

affect cash flows. These tax effects should be considered in determining the actual cash inflow or outflow from
disposal of property.
2The table can be confusing because it allows a depreciation deduction for one more year than would seem

appropriate for a given class. The reason is that MACRS assumes that assets are in service for only six months
of the first year and six months of the last year. An asset in the second class still has a 5-year life, but it spans
six calendar years.

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 Financial Analysis Supplement F F-7

Taxes  The income-tax rate varies from one state or country to another. Calculation of the tax
total should include all relevant federal, state, and local income taxes. When doing a financial
analysis, you may want to use an average income-tax rate based on the firm’s tax rate over the past
several years, or you may want to base the tax rate on the highest tax bracket that applies to the
taxpaying unit. The one thing you should never do is ignore taxes in making a financial analysis.

Analysis of Cash Flows

You now are ready to determine the after-tax cash flow for each year of the project’s life. Use the
following four steps to calculate the flow year by year:
1. Subtract the new expenses attributed to the project from new revenues. If revenues are unaf-
fected, begin with the project’s cost savings.
2. Next subtract the depreciation (D), to get pretax income.
3. Subtract taxes, which constitute the pretax income multiplied by the tax rate. The difference
is called the net operating income (NOI).
4. Compute the total after-tax cash flow as NOI + D, adding back the depreciation that was de-
ducted temporarily to compute the tax.

Example F.1 Calculating After-Tax Cash Flows

A local restaurant is considering adding a salad bar. The investment required to remodel the dining area and add
the salad bar will be $16,000. Other information about the project is as follows:
1. The price and variable cost per salad are $3.50 and $2.00, respectively.
2. Annual demand should be about 11,000 salads.
3. Fixed costs, other than depreciation, will be $8,000, which cover the energy to operate the refrigerated unit
and wages for another part-time employee to stock the salad bar during peak business hours.
4. The assets go into the MACRS 5-year class for depreciation purposes, with no salvage value.
5. The tax rate is 40 percent.
6. Management wants to earn a return of at least 14 percent on the project.
Determine the after-tax cash flows for the life of this project.

Solution
The cash flow projections are shown in the following table. Depreciation is based on Table F.3. For example, de-
preciation in 2013 is $3,200 (or $16,000 * 0.20). The cash flow in 2018 comes from depreciation’s tax shield
in the first half of the year.
Year
Item 2012 2013 2014 2015 2016 2017 2018
Initial Information
Annual demand (salads) 11,000 11,000 11,000 11,000 11,000
Investment $16,000
Interest (discount) rate 0.14
Cash Flows
Revenue $38,500 $38,500 $38,500 $38,500 $38,500
Expenses: Variable costs 22,000 22,000 22,000 22,000 22,000
Expenses: Fixed costs 8,000 8,000 8,000 8,000 8,000
Depreciation (D ) 3,200 5,120 3,072 1,843 1,843 922
Pretax income $5,300 $3,380 $5,428 $6,657 $6,657 -$922
Taxes (40%) 2,120 1,352 2,171 2,663 2,663 -369
Net operating Income (NOI) $3,180 $2,208 $3,257 $3,994 $3,994 -$553
Total cash flow (NOI + D) $6,380 $7,148 $6,329 $5,837 $5,837 $369

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 F-8 Supplement F Financial Analysis

Net Present Value Method

net present value (NPV) The net present value (NPV) method is used to evaluate an investment by calculating the present
method values of all after-tax total cash flows and then subtracting the original investment amount (which
The method that evaluates an is already a present value) from their total. The difference is the project’s net present value. If it is
­investment by calculating the positive for the discount rate used, the investment earns a rate of return higher than the discount
present values of all after-tax rate. If the net present value is negative, the investment earns a rate of return lower than the dis-
­total cash flows and then sub- count rate. Most firms set the discount rate equal to the overall weighted average cost of capital,
tracting the initial investment which becomes the lowest desired return on investment. If a negative net present value results,
amount for their total. the project is not approved. The discount rate that represents the lowest desired return on invest-
ment is thought of as a hurdle over which the investment must pass and is often referred to as the
hurdle rate hurdle rate.

The interest rate that is the low-

est desired return on an invest- Internal Rate of Return Method
ment; the hurdle over which the A related technique involves calculating the internal rate of return (IRR), which is the discount
investment must pass. rate that makes the NPV of a project zero. It is “internal” because it depends only on the cash flows
of the investment, not on rates offered elsewhere. With this method, a project is acceptable only
internal rate of return (IRR) if the IRR exceeds the hurdle rate. The IRR is a single number that summarizes the merits of the
The discount rate that makes the investment. It can be used to rank multiple projects from best to worst, so it is particularly useful
NPV of a project 0. when the budget limits new investments in any year.
You can find the IRR by trial and error. Start with a low discount rate and calculate the NPV. If
it exceeds 0, increase the discount rate and try again. The NPV will eventually go to 0 and later to a
negative value. When the NPV is near 0, you have found the IRR.

Payback Method
payback method The other commonly used method of evaluating projects is the payback method which deter-
A method for evaluating projects mines how much time will elapse before the total of after-tax cash flows will equal, or pay back,
that determines how much time the initial investment.
will elapse before the total of Even though it is scorned by many academics, the payback method continues to be widely
after-tax flows will equal, or pay used, particularly at lower management levels. It can be quickly and easily applied and gives deci-
back, the initial investment. sion makers some idea of how long recovery of invested funds will take. Uncertainty surrounds
every investment project. The costs and revenues on which analyses are based are best estimates,
not actual values. An investment project with a quick payback is not considered as risky as one
with a long payback. The payback method also has drawbacks. A major criticism is that it encour-
ages managers to focus on the short run. A project that takes a long time to develop but generates
excellent cash flows later in its life usually is rejected under the payback method. The payback
method also has been criticized for its failure to consider the time value of money. For these rea-
sons, we recommend that payback analysis be combined with a more sophisticated method such
as NPV or IRR in analyzing the financial implications of a project.

Example F.2 Calculating NPV, IRR, and Payback Period

What are the NPV, IRR, and payback period for the salad bar project in Example F.1?

Solution
Management wants to earn a return of at least 14 percent on its investment, so we use that rate to find the pf
values in Table F.1. The present value of each year’s total cash flow and the NPV of the project are as follows:
2012: $6,380(0.8772) = $5,597
2013: $7,148(0.7695) = $5,500
2014: $6,329(0.6750) = $4,272
2015: $5,837(0.5921) = $3,456
2016: $5,837(0.5194) = $3,032
2017: $ 369(0.4556) = $168
NPV of project
= ($5, 597 + $5, 500 + $4, 272 + $3, 456 + $3, 032 + $168) - $16, 000
= $6, 024

Because the NPV is positive, the recommendation would be to approve the project.

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 Financial Analysis Supplement F F-9

To find the IRR, let us begin with the 14 percent discount rate, which produced a positive NPV. Increment-
ing at 4 percent with each step, we reach a negative NPV with a 30 percent discount rate. If we back up to­
28 percent to “fine tune” our estimate, the NPV is $322. Therefore, the IRR is about 29 percent. The computer
can provide a more precise answer with much less computation.

Discount Rate NPV

14% $6,025
18% $4,092
22% $2,425
26%    $977
30% -$199

To determine the payback period, we add the after-tax cash flows at the bottom of the table in
Example F.1 for each year until we get as close as possible to $16,000 without exceeding it. For 2012 and
2013, cash flows are $6, 380 + $7,148 = $13, 528. The payback method is based on the assumption that
cash flows are evenly distributed throughout the year, so in 2014 only $2,472 must be received before the
­payback point is reached. As $2,472 / $6,329 is 0.39, the payback period is 2.39 years.

Computer Support
The proliferation of microcomputers and the corresponding use of computer spreadsheets make
it easy to evaluate projected cash flows with NPV, IRR, and payback period methods. The follow-
ing computer output shows spreadsheet analysis for the salad bar in Example F.1. The analyst
inputs the investment expenditure, depreciation method, discount rate, and pretax cash flows. If
only cost savings are involved, the revenue row would be replaced by them and there would be no
separate rows for variable costs and fixed costs. The computer then computes the depreciation,
taxes, after-tax cash flows, NPV, IRR, and payback period.
OM Explorer makes it easy to evaluate projected cash flows with NPV, IRR, and payback pe-
riod methods. Figure F.1 shows the output using the Financial Analysis Solver for the salad bar in
Example F.1.

 Figure F.1
OM Explorer Output for
Salad Bar

With such spreadsheets, the analyst no longer performs present value calculations by using
formulas or tables but instead focuses on data collection and the evaluation of many different
scenarios relating to a project. They are referred to as “what-if” analyses and allow an analyst to
look at what would happen to financial performance if certain events or combinations of events
were to occur.

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 F-10 Supplement F Financial Analysis

Managing by the Numbers

The precision and analytical detachment that come from using the NPV, IRR, or payback method can
be deceiving. In fact, U.S. business has been accused of managing by the numbers, with a preference
for short-term results from low-risk projects. Part of the problem lies with managers who are on the
fast track to the top of their organizations. They occupy a rung on the ladder for a short time and then
move up, and so they perceive it to be in their career interests to favor investments that give quick
results. They establish short paybacks and high hurdle rates. They ignore or forgo long-term ben-
efits from technological advances, innovative product plans, and strategic capacity additions. Over
the long run, this narrow vision jeopardizes the firm’s competitive advantage—and even its survival.
Managing by the numbers has a second cause. Projects with the greatest strategic impact are
likely to be riskier and have qualitative benefits that cannot be easily quantified. Consider an in-
vestment in some of the newer types of flexible automation. Benefits can include better quality,
quicker delivery times, higher sales, and lower inventory. The equipment might be reprogrammed
to handle new products not yet conceived of by the firm. Enough might be learned with the new
technology that subsequent investments will pay off at an even higher rate of return. The mistake
is to ignore these benefits simply because they cannot be easily quantified. Including risks and
qualitative factors as part of the analysis is far better than ignoring them. Using a preference ma-
trix also may help an analyst recognize qualitative factors more explicitly.
The message is clear: Financial analysis is a valuable tool for evaluating investment projects.
However, it can never replace the insight that comes from hands-on experience. Managers must
use their judgment, taking into account not only NPV, IRR, or payback data, but also how the proj-
ect fits operations and corporate strategy.

Learning Goals in Review

1 Explain the time value of money concept. The section “Time for more complex problems that recognize taxes and cash flows
Value of Money,” pp. 1–4, covers this concept, including the over time.
future value of an investment, present value of a future amount,  Discuss the importance of combining managerial judgment
future value factors, and annuities. with quantitative techniques when making investment deci-
 Demonstrate the use of the net present value, internal rate of sions. See the last section “Managing by the Numbers” on
return, and payback methods of financial analysis. We explain p. 10 that cautions against relying just on financial analysis,
these three methods in the section “Techniques of Analysis,” without also bring into play insight that comes from managerial
pp. 4–10. Tables F.1 and F.2 make the calculations easy, with judgment.
software such as OM Explorer or POM for Windows ­available

MyOMLab helps you develop analytical skills and assesses your progress with ­multiple
problems.

MyOMLab Resources Titles Link to the Book

OM Explorer Solver Financial Analysis Depreciation and Taxes: MACRS or Straight-Line Depreciation (p. 6);
Net Present Value (p. 8); Internal Rate of Return (p. 8); ­Payback
Method (pp. 8–9)
OM Explorer Tutors F.1 Present Value of a Future Amount Present Value of a Future Amount (p. 2)
F.2 Present Value of an Annuity Present Value Factors (pp. 2–4)
F.3 Straight-line Depreciation Depreciation and Taxes (pp. 4–7)
F.4 NPV, IRR, Payback NPV, IRR, Payback (pp. 8–9)
POM for Windows Financial Analysis Net Present Value Method (ignoring Depreciation and Taxes) p. 8;
Internal Rate of Return (ignoring Depreciation and Taxes) p. 8
Internet Exercise Air-X-Changers Depreciation and Taxes (pp. 4–7)
Key Equations
Image Library

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 Financial Analysis Supplement F F-11

Key Equations
1. Future Value of an Investment:
F = P11 + r 2 n
2. Present Value of Future Amount:
F
P =
11 + r 2 n
3. Present Value Factors:
1
P = Fc d
11 + r 2 n
4. Present Value of an Annuity:
P = A (af)
5. Straight-Line Depreciation:
I - S
D =
n

Key Terms
annuity 4 hurdle rate 8 present value of an investment 2
cash flow 4 internal rate of return (IRR) 8 salvage value 4
compounding interest 2 Modified Accelerated Cost Recovery straight-line depreciation method 4
discounting 2 System (MACRS) 6 time value of money 1
discount rate 2 net present value (NPV) method 8
future value of an investment 2 payback method 8

Selected References
Brealey, Richard A., Stewart C. Meyers, and Alan J. Marcus. Funda- Kieso, Donald E., and Jerry J. Weygandt. Intermediate Accounting,
mentals of Corporate Finance. New York: McGraw-Hill, 1995. 4th ed. New York: John Wiley & Sons, 1983.
Brigham, Eugene F., and Louis C. Gapenski. Financial Management: Luehrman, Timothy A. “What’s It Worth? A General Manager’s
Theory and Practice, 7th ed. Orlando: Dryden, 1994. Guide to Valuation.” Harvard Business Review (May–June 1997),
Hayes, Robert H., and William J. Abernathy. “Managing Our Way to pp. 132–142.
Economic Decline.” Harvard Business Review (July–August 1980), Ross, Stephen A., Randolph W. Westerfield, and Bradford D. Jordon.
pp. 67–77. Fundamentals of Corporate Finance, 2nd ed. Homewood, Ill.: Irwin
Hodder, James E., and Henry E. Riggs. “Pitfalls in Evaluating Risky Professional Publication, 1993.
Projects.” Harvard Business Review (January–February 1985),
pp. 128–135.

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