Supplement

F
Financial
Analysis
Many decisions

in operations and supply chain management involve large capital investments. 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 firms assets are tied up in the operations function. Therefore, management should seek highyield capital projects and then assess their costs, benefits, and risks.
Such projects require strong cross-functional coordination, particularly with finance and accounting. The projects must fit in with the organizations 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 attractiveness relative to other investment opportunities. This supplement presents a brief overview of basic 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.

2 Demonstrate the use of the net present value, internal

rate of return, and payback methods of financial analysis.

3 Discuss the importance of combining managerial judg-

ment with quantitative techniques when making investment decisions.

Time Value of Money

time value of money

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

The concept that a dollar in hand

can be invested to earn a return
so that more than one dollar will
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 allowed to accumulate, it also earns interest and the original investment will grow to $12,970 in
10years. The process by which interest on an investment accumulates and then earns interest

Z02_KRAJ7395_10_SE_SUPF.indd 1

F-1

16/12/11 5:34 PM

F-2

Supplement F

compounding interest
The process by which interest
on an investment accumulates
and then earns interest itself for
the remainder of the investment
period.
future value of an investment
The value of an investment at
the end of the period over which
interest is compounded.

Financial Analysis

itself for the remainder of the investment period is known as compounding interest. The value
of an investment at the end of the period over which interest is compounded is called the future
value of an investment.
To calculate the future value of an investment, you first express the interest rate and the time
period in the same units of time as the interval at which compounding occurs. Let us assume that
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
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
$5, 00011.122 = $5, 600
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
P =

present value of an investment

The amount that must be
invested now to accumulate to a
certain amount in the future at
a specific interest rate.

10, 000
F
=
= $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
specific interest rate is called the present value of an investment. The process of finding the present
value of an investment when the future value and the interest rate are known is called discounting
the future value to its present value. If the number of time periods n for which discounting is desired
is greater than 1, the present value is determined by dividing the future value by the nth power of the
sum of 1 plus the interest rate. The general formula for determining the present value is

discounting
The process of finding the present value of an investment when
the future value and the interest
rate are known.
discount rate
The interest rate used in
discounting the future value
to its present value.

P =

F
11 + r2 n

The interest rate is also called the discount rate.

Present Value Factors

Although you can calculate P from its formula in a few steps with most pocket calculators, you also
can use a table. To do so, write the present value formula another way:
P =

F
1
= 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
TableF.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 intersect 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

0.01

0.9901
0.9803
0.9706
0.9610
0.9515
0.9420
0.9327
0.9235
0.9143
0.9053
0.8963
0.8874
0.8787
0.8700
0.8613
0.8528
0.8444
0.8360
0.8277
0.8195
0.8114
0.8034
0.7954
0.7876
0.7798
0.7720
0.7644
0.7568
0.7493
0.7419
0.7059
0.6717

Number of
Periods (n)

1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
35
40

Z02_KRAJ7395_10_SE_SUPF.indd 3

0.9804
0.9612
0.9423
0.9238
0.9057
0.8880
0.8706
0.8535
0.8368
0.8203
0.8043
0.7885
0.7730
0.7579
0.7430
0.7284
0.7142
0.7002
0.6864
0.6730
0.6598
0.6468
0.6342
0.6217
0.6095
0.5976
0.5859
0.5744
0.5631
0.5521
0.5000
0.4529

0.02
0.9709
0.9426
0.9151
0.8885
0.8626
0.8375
0.8131
0.7894
0.7664
0.7441
0.7224
0.7014
0.6810
0.6611
0.6419
0.6232
0.6050
0.5874
0.5703
0.5537
0.5375
0.5219
0.5067
0.4919
0.4776
0.4637
0.4502
0.4371
0.4243
0.4120
0.3554
0.3066

0.03
0.9615
0.9246
0.8890
0.8548
0.8219
0.7903
0.7599
0.7307
0.7026
0.6756
0.6496
0.6246
0.6006
0.5775
0.5553
0.5339
0.5134
0.4936
0.4746
0.4564
0.4388
0.4220
0.4057
0.3901
0.3751
0.3607
0.3468
0.3335
0.3207
0.3083
0.2534
0.2083

0.04
0.9524
0.9070
0.8638
0.8227
0.7835
0.7462
0.7107
0.6768
0.6446
0.6139
0.5847
0.5568
0.5303
0.5051
0.4810
0.4581
0.4363
0.4155
0.3957
0.3769
0.3589
0.3418
0.3256
0.3101
0.2953
0.2812
0.2678
0.2551
0.2429
0.2314
0.1813
0.1420

0.05

=
=
=
=
=

P =

0.9091
0.8264
0.7513
0.6830
0.6209
0.5645
0.5132
0.4665
0.4241
0.3855
0.3505
0.3186
0.2897
0.2633
0.2394
0.2176
0.1978
0.1799
0.1635
0.1486
0.1351
0.1228
0.1117
0.1015
0.0923
0.0839
0.0763
0.0693
0.0630
0.0573
0.0356
0.0221

0.10
0.8929
0.7972
0.7118
0.6355
0.5674
0.5066
0.4523
0.4039
0.3606
0.3220
0.2875
0.2567
0.2292
0.2046
0.1827
0.1631
0.1456
0.1300
0.1161
0.1037
0.0926
0.0826
0.0738
0.0659
0.0588
0.0525
0.0469
0.0419
0.0374
0.0334
0.0189
0.0107

0.12
0.8772
0.7695
0.6750
0.5921
0.5194
0.4556
0.3996
0.3506
0.3075
0.2697
0.2366
0.2076
0.1821
0.1597
0.1401
0.1229
0.1078
0.0946
0.0829
0.0728
0.0638
0.0560
0.0491
0.0431
0.0378
0.0331
0.0291
0.0255
0.0224
0.0196
0.0102
0.0053

0.14
0.8621
0.7432
0.6407
0.5523
0.4761
0.4104
0.3538
0.3050
0.2630
0.2267
0.1954
0.1685
0.1452
0.1252
0.1079
0.0930
0.0802
0.0691
0.0596
0.0514
0.0443
0.0382
0.0329
0.0284
0.0245
0.0211
0.0182
0.0157
0.0135
0.0116
0.0055
0.0026

0.16

F
= F (pf)
(1 + r )n
present value of a single investment
future value of a single payment
number of periods for which P is to be invested
periodic interest rate
present value factor for $1 = 1> 11 + r2 n

0.9259
0.8573
0.7938
0.7350
0.6806
0.6302
0.5835
0.5403
0.5002
0.4632
0.4289
0.3971
0.3677
0.3405
0.3152
0.2919
0.2703
0.2502
0.2317
0.2145
0.1987
0.1839
0.1703
0.1577
0.1460
0.1352
0.1252
0.1159
0.1073
0.0994
0.0676
0.0460

0.08

Interest Rate (r )

0.8475
0.7182
0.6086
0.5158
0.4371
0.3704
0.3139
0.2660
0.2255
0.1911
0.1619
0.1372
0.1163
0.0985
0.0835
0.0708
0.0600
0.0508
0.0431
0.0365
0.0309
0.0262
0.0222
0.0188
0.0160
0.0135
0.0115
0.0097
0.0082
0.0070
0.0030
0.0013

0.18
0.8333
0.6944
0.5787
0.4823
0.4019
0.3349
0.2791
0.2326
0.1938
0.1615
0.1346
0.1122
0.0935
0.0779
0.0649
0.0541
0.0451
0.0376
0.0313
0.0261
0.0217
0.0181
0.0151
0.0126
0.0105
0.0087
0.0073
0.0061
0.0051
0.0042
0.0017
0.0007

0.20
0.8197
0.6719
0.5507
0.4514
0.3700
0.3033
0.2486
0.2038
0.1670
0.1369
0.1122
0.0920
0.0754
0.0618
0.0507
0.0415
0.0340
0.0279
0.0229
0.0187
0.0154
0.0126
0.0103
0.0085
0.0069
0.0057
0.0047
0.0038
0.0031
0.0026
0.0009
0.0004

0.22
0.8065
0.6504
0.5245
0.4230
0.3411
0.2751
0.2218
0.1789
0.1443
0.1164
0.0938
0.0757
0.0610
0.0492
0.0397
0.0320
0.0258
0.0208
0.0168
0.0135
0.0109
0.0088
0.0071
0.0057
0.0046
0.0037
0.0030
0.0024
0.0020
0.0016
0.0005
0.0002

0.24
0.7937
0.6299
0.4999
0.3968
0.3149
0.2499
0.1983
0.1574
0.1249
0.0922
0.0787
0.0625
0.0496
0.0393
0.0312
0.0248
0.0197
0.0156
0.0124
0.0098
0.0078
0.0062
0.0049
0.0039
0.0031
0.0025
0.0019
0.0015
0.0012
0.0010
0.0003
0.0001

0.26

0.7812
0.6104
0.4768
0.3725
0.2910
0.2274
0.1776
0.1388
0.1084
0.0847
0.0662
0.0517
0.0404
0.0316
0.0247
0.0193
0.0150
0.0118
0.0092
0.0072
0.0056
0.0044
0.0034
0.0027
0.0021
0.0016
0.0013
0.0010
0.0008
0.0006
0.0002
0.0001

0.28

0.7692
0.5917
0.4552
0.3501
0.2693
0.2072
0.1594
0.1226
0.0943
0.0725
0.0558
0.0429
0.0330
0.0254
0.0195
0.0150
0.0116
0.0089
0.0068
0.0053
0.0040
0.0031
0.0024
0.0018
0.0014
0.0011
0.0008
0.0006
0.0005
0.0004
0.0001
0.0000

0.30

Financial Analysis

where P
F
n
r
pf

0.9434
0.8900
0.8396
0.7921
0.7473
0.7050
0.6651
0.6274
0.5919
0.5584
0.5268
0.4970
0.4688
0.4423
0.4173
0.3936
0.3714
0.3503
0.3305
0.3118
0.2942
0.2775
0.2618
0.2470
0.2330
0.2198
0.2074
0.1956
0.1846
0.1741
0.1301
0.0972

0.06

Table F.1 Present Value Factors for a Single Payment

Supplement F

F-3

16/12/11 5:34 PM

F-4

Supplement F

Financial Analysis

Annuities
annuity
A series of payments on a fixed
amount for a specified number
of years.

An annuity is a series of payments of a fixed amount for a specified number of years. All such payments are treated as happening at the end of a year. Suppose that you want to invest an amount
at an interest rate of 10 percent so that you may draw out $5,000 per year for each of the next four
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,
P =

$5, 000
$5, 000
$5, 000
$5, 000
+
+
+
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 payment. 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
The difference between the
flows of funds into and out of
an o rganization over a period of
time, including revenues, costs,
and changes in assets and
liabilities.

straight-line depreciation
method
The simplest method of
calculating annual depreciation;
found by subtracting the estimated salvage value from the
amount of investment required
at the beginning of the project,
and then dividing by the assets
expected economic life.

These methods work with cash flows. Cash flow is the cash that will flow into and out of the
organization because of the project, including revenues, costs, and changes in assets and liabilities. Be sure to remember two points when determining cash flows for any project:
1. Consider only the amounts of cash flows that will change if the project is undertaken. These
amounts are called incremental cash flows and are the difference between the cash flows with
the project and without it.
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.

Depreciation and Taxes

Depreciation is an allowance for the consumption of capital. In this type of analysis, depreciation is relevant for only one reason: It acts as a tax shield. Depreciation is not a legitimate cash
flow because it is not cash that is actually paid out each year. However, depreciation does affect how an accountant calculates net income, against which the income-tax rate is applied.
Therefore, depreciation enters into the calculation, as a tax shield, only when tax liability is
figured. Taxes must be paid on pretax cash inflows minus the depreciation that is associated
with the proposed investment. United States tax laws allow either straight-line or accelerated
depreciation.

salvage value

Straight-Line Depreciation The straight-line depreciation method of calculating annual depre-

The cash flow from the sale or

disposal of plant and equipment
at the end of a projects life.

ciation is the simplest and usually is adequate for internal planning purposes. First, subtract the
estimated salvage value from the amount of investment required at the beginning of the project
and then divide by the number of years in the assets expected economic life. Salvage value is the

Z02_KRAJ7395_10_SE_SUPF.indd 4

16/12/11 5:34 PM

0.01

0.9901
1.9704
2.9410
3.9020
4.8534
5.7955
6.7282
7.6517
8.5660
9.4713
10.3676
11.2551
12.1337
13.0034
13.8651
14.7179
15.5623
16.3983
17.2260
18.0456
18.8570
19.6604
20.4558
21.2434
22.0232
22.7952
23.5596
24.3164
25.0658
25.8077
29.4086
32.8347

Number of
Periods (n)

1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
35
40

Z02_KRAJ7395_10_SE_SUPF.indd 5

0.9804
1.9416
2.8839
3.8077
4.7135
5.6014
6.4720
7.3255
8.1622
8.9826
9.7868
10.5753
11.3484
12.1062
12.8493
13.5777
14.2919
14.9920
15.6785
16.3514
17.0112
17.6580
18.2922
18.9139
19.5235
20.1210
20.7069
21.2813
21.8444
22.3965
24.9986
27.3555

0.02
0.9709
1.9135
2.8286
3.7171
4.5797
5.4172
6.2303
7.0197
7.7861
8.5302
9.2526
9.9540
10.6350
11.2961
11.9379
12.5611
13.1661
13.7535
14.3238
14.8775
15.4150
15.9369
16.4436
16.9355
17.4131
17.8768
18.3270
18.7641
19.1885
19.6004
21.4872
23.1148

0.03
0.9434
1.8334
2.6730
3.4651
4.2124
4.9173
5.5824
6.2098
6.8017
7.3601
7.8869
8.3838
8.8527
9.2950
9.7122
10.1059
10.4773
10.8276
11.1581
11.4699
11.7641
12.0416
12.3034
12.5504
12.7834
13.0032
13.2105
13.4062
13.5907
13.7648
14.4982
15.0463

0.06
0.9259
1.7833
2.5771
3.3121
3.9927
4.6229
5.2064
5.7466
6.2469
6.7101
7.1390
7.5361
7.9038
8.2442
8.5595
8.8514
9.1216
9.3719
9.6036
9.8181
10.0168
10.2007
10.3711
10.5288
10.6748
10.8100
10.9352
11.0511
11.1584
11.2578
11.6546
11.9246

0.08
0.9091
1.7355
2.4869
3.1699
3.7908
4.3553
4.8684
5.3349
5.7590
6.1446
6.4951
6.8137
7.1034
7.3667
7.6061
7.8237
8.0216
8.2014
8.3649
8.5136
8.6487
8.7715
8.8832
8.9847
9.0770
9.1609
9.2372
9.3066
9.3696
9.4269
9.6442
9.7791

0.10
0.8929
1.6901
2.4018
3.0373
3.6048
4.1114
4.5638
4.9676
5.3282
5.6502
5.9377
6.1944
6.4235
6.6282
6.8109
6.9740
7.1196
7.2497
7.3658
7.4694
7.5620
7.6446
7.7184
7.7843
7.8431
7.8957
7.9426
7.9844
8.0218
8.0552
8.1755
8.2438

0.12
0.8772
1.6467
2.3216
2.9137
3.4331
3.8887
4.2883
4.6389
4.9464
5.2161
5.4527
5.6603
5.8424
6.0021
6.1422
6.2651
6.3729
6.4674
6.5504
6.6231
6.6870
6.7429
6.7921
6.8351
6.8729
6.9061
6.9352
6.9607
6.9830
7.0027
7.0700
7.1050

0.14
0.8621
1.6052
2.2459
2.7982
3.2743
3.6847
4.0386
4.3436
4.6065
4.8332
5.0286
5.1971
5.3423
5.4675
5.5755
5.6685
5.7487
5.8178
5.8775
5.9288
5.9731
6.0113
6.0442
6.0726
6.0971
6.1182
6.1364
6.1520
6.1656
6.1772
6.2153
6.2335

0.16
0.8475
1.5656
2.1743
2.6901
3.1272
3.4976
3.8115
4.0776
4.3030
4.4941
4.6560
4.7932
4.9095
5.0081
5.0916
5.1624
5.2223
5.2732
5.3162
5.3527
5.3837
5.4099
5.4321
5.4509
5.4669
5.4804
5.4919
5.5016
5.5098
5.5168
5.5386
5.5482

0.18

P =

j=1

0.8333
1.5278
2.1065
2.5887
2.9906
3.3255
3.6046
3.8372
4.0310
4.1925
4.3271
4.4392
4.5327
4.6106
4.6755
4.7296
4.7746
4.8122
4.8435
4.8696
4.8913
4.9094
4.9245
4.9371
4.9476
4.9563
4.9636
4.9697
4.9747
4.9789
4.9915
4.9966

0.20
0.8197
1.4915
2.0422
2.4936
2.8636
3.1669
3.4155
3.6193
3.7863
3.9232
4.0354
4.1274
4.2028
4.2646
4.3152
4.3567
4.3908
4.4187
4.4415
4.4603
4.4756
4.4882
4.4985
4.5070
4.5139
4.5196
4.5243
4.5281
4.5312
4.5338
4.5411
4.5439

0.22
0.8065
1.4568
1.9813
2.4043
2.7454
3.0205
3.2423
3.4212
3.5655
3.6819
3.7757
3.8514
3.9124
3.9616
4.0013
4.0333
4.0591
4.0799
4.0967
4.1103
4.1212
4.1300
4.1371
4.1428
4.1474
4.1511
4.1542
4.1566
4.1585
4.1601
4.1644
4.1659

0.24
0.7937
1.4235
1.9234
2.3202
2.6351
2.8850
3.0833
3.2407
3.3657
3.4648
3.5435
3.6059
3.6555
3.6949
3.7261
3.7509
3.7705
3.7861
3.7985
3.8083
3.8161
3.8223
3.8273
3.8312
3.8342
3.8367
3.8387
3.8402
3.8414
3.8424
3.8450
3.8458

0.26

0.7812
1.3916
1.8684
2.2410
2.5320
2.7594
2.9370
3.0758
3.1842
3.2689
3.3351
3.3868
3.4272
3.4587
3.4834
3.5026
3.5177
3.5294
3.5386
3.5458
3.5514
3.5558
3.5592
3.5619
3.5640
3.5656
3.5669
3.5679
3.5687
3.5693
3.5708
3.5712

0.28

0.7692
1.3609
1.8161
2.1662
2.4356
2.6427
2.8021
2.9247
3.0190
3.0915
3.1473
3.1903
3.2233
3.2487
3.2682
3.2832
3.2948
3.3037
3.3105
3.3158
3.3198
3.3230
3.3254
3.3272
3.3286
3.3297
3.3305
3.3312
3.3317
3.3321
3.3330
3.3332

0.30

Supplement F

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

n
A
A
A
j
+ g +
+
n = A a 1/(1 + r ) = A(af)
2
(1 + r)
(1 + r)
(1 + r)
j=1
= present value of a single investment
= amount of annuity to be received at the end of each period
= number of periods for which the annuity is received
= periodic interest rate

0.9524
1.8594
2.7232
3.5460
4.3295
5.0757
5.7864
6.4632
7.1078
7.7217
8.3064
8.8633
9.3936
9.8986
10.3797
10.8378
11.2741
11.6896
12.0853
12.4622
12.8212
13.1630
13.4886
13.7986
14.0939
14.3752
14.6430
14.8981
15.1411
15.3725
16.3742
17.1591

0.05

Interest Rate (r )

Financial Analysis

where P
A
n
r

0.9615
1.8861
2.7751
3.6299
4.4518
5.2421
6.0021
6.7327
7.4353
8.1109
8.7605
9.3851
9.9856
10.5631
11.1184
11.65423
12.1657
12.6593
13.1339
13.5903
14.0292
14.4511
14.8568
15.2470
15.6221
15.9828
16.3296
19.6631
16.9837
17.2920
18.6646
19.7929

0.04

Table F.2 Present Value Factors of an Annuity

F-5

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F-6

Supplement F

Financial Analysis

cash flow from the sale or disposal of plant and equipment at the end of a projects life.1 The general expression for annual depreciation is
D =

I - S
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
Modified Accelerated Cost
Recovery System (MACRS)
The only acceptable depreciation
method for tax purposes that
shortens the lives of investments,
giving firms larger early tax
deductions.

just that with what is called accelerated depreciation. Since 1986, the only acceptable accelerated
depreciation method in the United States is the Modified Accelerated Cost Recovery System
(MACRS). MACRS shortens the lives of investments, giving firms larger tax deductions. It creates
six classes of investments, each of which has a recovery period or class life. Depreciation for each
year is calculated by multiplying the assets cost by the fixed percentage in Table F.3.2 The following are examples of the first four classes:
3-year class:

specially designed tools and equipment used in research

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

33.33

20.00

14.29

10.00

44.45

32.00

24.49

18.00

14.81

19.20

17.49

14.40

7.41

11.52

12.49

11.52

11.52

8.93

9.22

5.76

8.93

7.37

8.93

6.55

4.45

6.55

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 firms 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 projects 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 unaffected, begin with the projects 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 deducted 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, depreciation in 2013 is $3,200 (or $16,000 * 0.20). The cash flow in 2018 comes from depreciations tax shield
in the first half of the year.

Year
Item

2012

2013

2014

2015

2016

2017

2018

11,000

11,000

11,000

11,000

11,000

$38,500

$38,500

$38,500

$38,500

$38,500

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

$5,300

$3,380

$5,428

$6,657

$6,657

-$922

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

Initial Information
Annual demand (salads)
Investment
Interest (discount) rate

$16,000
0.14

Cash Flows
Revenue
Expenses: Variable costs

Pretax income
Taxes (40%)

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F-8

Supplement F

Financial Analysis

Net Present Value Method

net present value (NPV)
method
The method that evaluates an
investment by calculating the
present values of all after-tax
total cash flows and then subtracting the initial investment
amount for their total.
hurdle rate
The interest rate that is the lowest desired return on an investment; the hurdle over which the
investment must pass.
internal rate of return (IRR)
The discount rate that makes the
NPV of a project 0.

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

Internal Rate of Return Method

A related technique involves calculating the internal rate of return (IRR), which is the discount
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
if the IRR exceeds the hurdle rate. The IRR is a single number that summarizes the merits of the
investment. It can be used to rank multiple projects from best to worst, so it is particularly useful
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
A method for evaluating projects
that determines how much time
will elapse before the total of
after-tax flows will equal, or pay
back, the initial investment.

Example F.2

The other commonly used method of evaluating projects is the payback method which determines how much time will elapse before the total of after-tax cash flows will equal, or pay back,
the initial investment.
Even though it is scorned by many academics, the payback method continues to be widely
used, particularly at lower management levels. It can be quickly and easily applied and gives decision 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 encourages 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 reasons, 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.

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 years total cash flow and the NPV of the project are as follows:

NPV of project

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

= ($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. Incrementing 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 following 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 period 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 benefits from technological advances, innovative product plans, and strategic capacity additions. Over
the long run, this narrow vision jeopardizes the firms competitive advantageand 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 investment 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 matrix 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 project fits operations and corporate strategy.

Learning Goals in Review

1 Explain the time value of money concept. The section Time

Value of Money, pp. 14, covers this concept, including the

future value of an investment, present value of a future amount,
future value factors, and annuities.

Demonstrate the use of the net present value, internal rate of

return, and payback methods of financial analysis. We explain

these three methods in the section Techniques of Analysis,
pp. 410. Tables F.1 and F.2 make the calculations easy, with
software such as OM Explorer or POM for Windows available

for more complex problems that recognize taxes and cash flows
over time.

Discuss the importance of combining managerial judgment

with quantitative techniques when making investment decisions. See the last section Managing by the Numbers on
p. 10 that cautions against relying just on financial analysis,
without also bring into play insight that comes from managerial
judgment.

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

OM Explorer Tutors

F.1 Present Value of a Future Amount Present Value of a Future Amount (p. 2)

Depreciation and Taxes: MACRS or Straight-Line Depreciation (p. 6);

Net Present Value (p. 8); Internal Rate of Return (p. 8); Payback
Method (pp. 89)

F.2 Present Value of an Annuity

Present Value Factors (pp. 24)

F.3 Straight-line Depreciation

Depreciation and Taxes (pp. 47)

F.4 NPV, IRR, Payback

NPV, IRR, Payback (pp. 89)

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. 47)

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:

P =

F
11 + r 2 n

3. Present Value Factors:

P = Fc

1
d
11 + r 2 n

4. Present Value of an Annuity:

P = A (af)
5. Straight-Line Depreciation:
D =

I - S
n

Key Terms
annuity 4
cash flow 4
compounding interest 2
discounting 2
discount rate 2
future value of an investment 2

hurdle rate 8
internal rate of return (IRR) 8
Modified Accelerated Cost Recovery
System (MACRS) 6
net present value (NPV) method 8
payback method 8

present value of an investment 2

salvage value 4
straight-line depreciation method 4
time value of money 1

Selected References
Brealey, Richard A., Stewart C. Meyers, and Alan J. Marcus. Fundamentals of Corporate Finance. New York: McGraw-Hill, 1995.
Brigham, Eugene F., and Louis C. Gapenski. Financial Management:
Theory and Practice, 7th ed. Orlando: Dryden, 1994.
Hayes, Robert H., and William J. Abernathy. Managing Our Way to
Economic Decline. Harvard Business Review (JulyAugust 1980),
pp. 6777.
Hodder, James E., and Henry E. Riggs. Pitfalls in Evaluating Risky
Projects. Harvard Business Review (JanuaryFebruary 1985),
pp.128135.

Z02_KRAJ7395_10_SE_SUPF.indd 11

Kieso, Donald E., and Jerry J. Weygandt. Intermediate Accounting,

4th ed. New York: John Wiley & Sons, 1983.
Luehrman, Timothy A. Whats It Worth? A General Managers
Guide to Valuation. Harvard Business Review (MayJune 1997),
pp.132142.
Ross, Stephen A., Randolph W. Westerfield, and Bradford D. Jordon.
Fundamentals of Corporate Finance, 2nd ed. Homewood, Ill.: Irwin
Professional Publication, 1993.

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