Chapter 12 – Strategy and the Analysis of Capital Investments
Chapter 12
Strategy and the Analysis of Capital Investments
Teaching Notes for Cases
12-1: Floating Investments (Source: Paul Rouse and Leigh Houghton, “Instructional Case: Floating
Investments,” Journal of Accounting Education, Vol. 20, No. 2 (2002), pp. 235-247.)
Purpose
The purpose of this case is to acquaint students with the complexities involved in reaching a decision
concerning investment in a capital project. The project contemplated is a marina, which is to be built on
purpose-bought land. Students enjoy this more unusual setting with its leisure and entertainment flavor
and are usually enthusiastic about evaluating the project.
In analyzing the issues the student should consider:
(a) The investment decision; that is, the nature and risks associated with this type of investment.
(b) The capital investment model; that is, the investments, operating cash flows, terminal value, discount
rate, taxation, and inflation effects
(c) The moving baseline concept; that is, the changing nature of the market that this investment will
serve.
(d) The risks involved in this type of project and the ways in which these risk factors can be managed.
Case Requirements
Identify the information that Jim needs to present to the Board at the next meeting, providing calculations
using the data supplied. Set out all the assumptions that need to be made and examine their
reasonableness and consequences if violated.
Include in your information set an analysis of the risks inherent in this type of investment and discuss the
ways in which management of these risk factors can be incorporated in the project.
Teaching Strategies
This case has been used in both large and small classes. In both situations the student is expected to have
read the case in advance and to have prepared an outline of an answer. In a large class (up to 250
students), students benefit by the lecturer talking through the various analysis steps. However, there is
enough challenging material in the case to provoke lively discussion on a number of the concepts. In
small classes, the case works well with the students split into groups of about six with a facilitator to
ensure that they progress successfully through the material. At the end of the group work the students
benefit by a class discussion of the concepts covered.
Concepts covered
The investment decision
Although the fundamental question to be addressed in an investment decision is whether the returns from
an investment exceed its costs, the nature and risks vary considerably from one project to another. The
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Chapter 12 – Strategy and the Analysis of Capital Investments
marina project is extremely seductive as evidenced by Jim’s enthusiasm and it is easy to forget that
similar evaluation criteria need to be applied to this project as to a more mundane project.
Three questions can be addressed:
(a) The size and risk of the investment. The capital outlay for this project is large. The nature of this
type of venture, which requires dredging of the seabed to provide sufficient draft for the boats and
the constant maintenance of sea walls and pontoons, may mean that the risk is difficult to quantify.
(b) The complexity of the venture. Will the service facilities and technological support offered by this
marina be appropriate over its lifetime or is it likely that the requirements of boat owners may
change over the life span of the marina? For example, boat owners might require access to waste
disposal systems or the ability to access computer facilities to provide weather information.
(c) The time frame for the venture. This venture is expected to run for a period of 22 years including
construction. Therefore establishment of the attributes of the after tax cash flows becomes more
critical. The variability of these cash flows over a long time period will depend on the needs of the
consumers and the level of service provided by the marina owners.
The capital investment model
There are a number of models that can be used for making capital budgeting decisions. Those not
requiring the use of discounted cash-flow techniques are payback and the accounting rate of return.
Models that use discounted cash-flow techniques are IRR and NPV. Students should be encouraged to
discuss the benefits and drawbacks of the application of each of these techniques (see Atkinson, Banker,
Kaplan, & Young, 1997; Brealey, Myers, & Marcus, 1999; Horngren, Foster, & Datar, 1999) and justify
why NPV should be chosen as the most appropriate method for use in this situation.
Assessing the capital investment model requires consideration of all of the inputs to the model.
(a) Investment in the project
The initial outlays are set out in the construction contract, but capital outlays that might be required later
in the project’s life are not covered. With an investment that is exposed to the vagaries of the weather, as
is this project, there is a possibility that significant upgrades or additional maintenance will be needed
before the end of the project life. An assessment of the project should also consider the intangible benefits
that a project of this nature may generate to the operators (in terms of reputation and profile) and berth-
holders; for example, quality of mooring, safety, maintenance and stores provision. There are also
opportunities for additional revenue streams through infrastructural development, including restaurants,
bars, and haul-out facilities. Other opportunities can arise through the encouragement of major regattas
and high profile races to be based around the marina; for example, the Americas Cup. Of course, hosting
these types of events would require additional investment.
(b) Operating cash flows
Operating cash inflows from this project come primarily from rents paid by boat owners. In establishing
an appropriate annual rental, consideration should be given to the supply of marinas in the area and the
expected demand that will be placed on this new resource. If there are other marinas available or pending,
then the pricing of the service may need to be based on a strategy of either low cost to the renter or
product differentiation.
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Chapter 12 – Strategy and the Analysis of Capital Investments
While not necessarily a public sector setting, the case provides a plausible scenario where there are no
established market prices. Information on minimum revenues forms an important part of the overall
project evaluation. In this particular case, the minimum price must pass a ‘‘reasonableness test’’ in
comparison with that charged by the local Port Authority.
Operating cash outflows may be more difficult to quantify because of the nature of the asset. Repairs and
maintenance could be high if the marina is constantly pounded by the sea. Might it be necessary to insure
against a major weather disaster (e.g. a hurricane)? If so, this would need to be factored into the
expenditure.
(c) Terminal values
Identifying and quantifying the terminal value of any investment is important. The terminal (or horizon)
value represents the cash value of the investment at the end of the period used in the capital budgeting
model. This is of particular importance in situations involving investments expected to have a long life.
While the conventional assumption is that the discounting process reduces future cash flows or values to
an extent that they can be ignored or assumed to be zero, in practice this is often not the case. For
example, Copeland, Koller, and Murrin (2000, p. 275) report that the horizon value for a company in the
tobacco industry accounts for 56% of the total company value, in the sporting goods industry it is 81%,
for the typical skin care business the figure is 100%, and for a high tech company 125%. This increase in
value can be particularly rapid when the resource forms part of a larger development (e.g. a high-class
land subdivision).
Jim has assumed that the marina itself is not expected to have any commercial value but the land it
occupies will have value. The difficulty in establishing a value for this land in 22 years time hinges on a
number of variables that are not only a reflection of the increase in inflation over a period of time but
could also represent economic conditions of the time, the desire of buyers to want land in that area, or
changes in a district scheme covering land use. It is also worth mentioning that students often overlook
demolition costs when discussing terminal values.
The marina is assumed to have zero value after 22 years. However, provided it is well maintained, there is
likely to be a substantial terminal value at this time. The instructor may wish to add some alternative
approaches to determining the terminal value (see Copeland et al., 2000 for a more in-depth discussion).
The first alternative (liquidation approach) is to set the terminal value equal to an estimate of the proceeds
from the sale of the assets of the marina, after paying off liabilities. This will normally be considerably
lower than the value of the marina as a going concern. Although the 4% tax rate could be used implying a
useful life of 25 years for the assets, this excludes $2,400,000 that was not depreciable for tax purposes.
Assuming that this latter amount had no future value, the estimated terminal value at the end of 22 years
would be $1,920,000(1.06)20 = $6,157,000. (It could be argued that this amount should be spread pro-rata
over the first three years and then adjusted for inflation.) Taxation on the depreciation recovered would
then need to be determined and the net amount discounted using 16.6%.
A second alternative (replacement-cost approach) would set the terminal value on a continuing value
basis. In this approach, the marina would be valued at replacement cost after 22 years. In the absence of
any specific price inflation, the $12 million construction costs could be indexed at the inflation rate of 6%
and discounted back using 16.6%. A shorter method would discount $9,604,185 (being the present value
of construction costs over 3 years) using the real discount rate of 10% for year 22.
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Chapter 12 – Strategy and the Analysis of Capital Investments
A third alternative, which is a variation on the second above, would be to assume that the marina will
carry on indefinitely and repeat the roll-overs three to four times. There is not much point going beyond
80 or 90 years as the discount rates are close to zero.
A fourth method, which would be applicable if we knew what the market rentals should be, would be to
use a steady state model at year 22. A simple version of this model is as follows:
PVH = (1 + g) CFH/(k − g)
where PVH is the terminal or continuing value, g is the growth rate (< k), CFH are the annual cash flows in
the horizon year, and k is the discount rate. Since the unknown factor in this case is the price, we cannot
use this formula. Further variations on this model are covered in Copeland et al. (2000) and Levin and
Olsson (2000).
(d) Discount rate
The discount rate chosen should reflect the risk of the investment taking into consideration some of the
examples mentioned above and the firm’s cost of capital. Given that the discount rate is usually nominal
and includes inflation, the cash flows should be adjusted to compensate for this factor (Carsberg & Hope,
1976). Mixing nominal with real is a technical error that is probably more commonplace than one would
imagine (e.g. Wilmington, Tap, & Die, 1985). Given this confusion, further explanation is provided below
or students can be referred to Carsberg and Hope (1976) or Zimmerman (2000).
In the absence of inflation, a rational individual will prefer a dollar today to a dollar tomorrow. The reason
for this preference is the interest that could be earned on this dollar between today and tomorrow. Let r
denote the real interest rate, which is the rate of interest that would occur if there were no inflation. Note
that this rate comprises a risk-free rate of return plus a premium for risk depending on how the dollar was
invested.
If inflation is present, then a rational individual will again prefer a dollar today not only because of the
interest that could be earned but also because of the loss in purchasing power if the dollar is received at a
future date. If inflation is i percentage per year, $1 today will need to be increased to $1(1 + i) in a year’s
time to buy the same quantity of goods. For example, if annual inflation is 5%, buying the same $1 bundle
of goods today will cost $1.05 in a year’s time. Therefore, our rational individual will require
compensation for (1) interest and (2) inflation to delay the use or consumption of the $1 for any period of
time. Assuming a period of time of one year, the nominal interest rate m is
1 + m = (1 + r) (1 + i)
the cost of capital for Floating Investments is 16.6%, calculated after taking inflation of 6% into account.
Substituting this information into the earlier equation
1.166 = (1 + r) (1.06)
and solving for r provides a real rate of return of 10%.
In general, the cost of capital or discount rates that firms use for capital budgeting purposes are derived
from the market and will incorporate an allowance for inflation. In contrast, the cash flows estimated for a
project may inadvertently not include any allowance for general price changes (i.e. inflation). Failure to
adjust these cash flows will bias the project evaluation since inflation is included in the discount rate but
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Chapter 12 – Strategy and the Analysis of Capital Investments
not in the cash flows. This is shown below where CFt denotes the annual cash flows in real terms (i.e. no
adjustment for inflation has been made) and n denotes the terminal year.
[wrong model]
The difference can be easily seen in the following where annual cash flows are adjusted for inflation.
[correct model]
The general rule is that nominal cash flows should be discounted using a nominal rate or real cash flows
should be discounted using a real rate. Mixing real with nominal will lead to erroneous results.
One question that Emma could consider is whether the risk associated with holding the land over the
period of the investment is equivalent to the risk involved in the marina development. How would
different risk factors be incorporated into the calculations?
The moving baseline concept
Frequently, capital investment decisions are based on the status quo being maintained with respect to
competitors in the same market. The moving baseline concept suggests that competitors and the market
may move concurrently with the investment being undertaken (Howell & Soucy, 1987). This moving
baseline should be then factored into the investment decision. It may be that the investor needs to proceed
with an investment that demonstrates a negative net present value in order to maintain current market
position. The cost associated with not investing is reflected in loss of market share and ultimately loss of
profits.
In this instance, it may be necessary to build the marina to ensure that the company can take advantage of
events associated with the marina; for example, the America’s cup.
Risk management
Risk tends to be managed in a capital investment decision by adjusting the cost of capital or by altering
the forecast cash flows to reflect conservative estimates. In this project, when adjusting the cost of capital
for risk, management would need to look at the expertise that this company has acquired through its
successful investments in similar types of projects. This is not a new type of venture for this company.
The risk should also be balanced against the remaining portfolio of investments that the company already
holds, i.e. is the company able to spread its risks over a wide portfolio?
Numerical analysis
The numerical analysis is set out below in three parts: part A determines the investment outlay; part B
calculates the operating cash flows net of depreciation that the rental needs to cover, and part C calculates
the minimum rental required. Workings (W) are provided after part C.
A. Non-Operating Cash flows
PV (Oct/2001)
(a) Land:
Cost – $350,000
Sale (W1) + $42,996
(b) Construction:
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Chapter 12 – Strategy and the Analysis of Capital Investments
2001 (Year 0) $1,200,000 – $1,200,000
2002 (Year 1) $4,800,000
2003 (Year 2) $4,800,000 @ 16.6% (W 2) – $ 8,404,185
2004 (Year 3) $1,200,000
(c) Tax saving on scrapping of construction in 2023 (W3) + $32,727
Net non-operating cash flows – $9,878,462
B. Operating Cash Flows
(a) Tax saving re depreciation (Annual—years 3–22):
50% × 4% × 80% × $12,000,000 = $192,000
(Tax rate x depreciation rate x depreciable cost)
PV of $192,000 (Y3-Y22) @ 16.6% (W4) +$811,308
Note: these are nominal cash flows and therefore the nominal rate is used.
(b) Rentals & maintenance (less taxes thereon):
(R – $60,000) (1 – 50%), years 3–22
PV annuity factor = 7.0360 (W5)
PV = 7.0360 (R – $60,000) (50%) = + 7.0360 (0.5 R – $30,000)
Note: these are real cash flows and therefore the real rate is used.
C. Rental Calculation
PV of Cash Inflows = PV of Cash Outflows
7.0360 × (0.50R $30,000) + $811,308 = $ 9,878,462
0.50R $30,000 = $ 1,288,680
R = $ 2,637,360 (@ Oct/2001)
R = $2,637,360 × (1.06)3 = $ 3,141,138 (@ Oct/2003)
Note: The Oct 2001 rental is inflated for three years at 6% to restate it in Oct 2003 dollars.
Calculation of boat-meters:
Type Length Midpoint Number Meters
A 12–18 15 50 750
B 8–12 10 300 3000
C 6–8 7 150 1050
4800
Annual rental per meter (year to 31 October 2004) = $3,141,138 ÷ 4,800 = $654.40 Rental for 10 meter
yacht=$6,544.00
Note: this assumes that all berths are leased. If this is not likely, the above calculations should be
revised. This could be extended to a simulation exercise using a spreadsheet as outlined in Rouse
(1992).
Workings
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Chapter 12 – Strategy and the Analysis of Capital Investments
W1 Land: est. value in year 0 = $350,000
Note: Calculation of (1.06)22 on Lotus: + A1 ^ 22 with 1.06 in Cell A1
Similarly, (1.166)-22: +B1 ^ -22 with 1.166 in Cell B1
The commands are the same in Excel
Simpler alternative:
Escalate at inflation rate (1.06)
Discount at nominal rate (1.166)
Effectively discount at real rate:
(1+r) = (1+m) ÷ (1+i) = (1.166) ÷ (1.06) = 1.10
i.e., the real rate, r = 10.0%
PV = $350 000 × (1.10)-22 = $350,000 × 0.1228 = $42,996
W2 Construction Cash Outflows:
Year Cashflow
Discount factor @
16.6%
Discounted
Cashflow
1 $4,800,000 0.8576 $4,116,638
Note: Calculation of above in Lotus: @NPV(0.166,A1..A3)
Excel: =NPV(0.166,A1:A3)
W3 Construction cost (end year 2) = $12,000,000
Tax value=80% × $12,000,000 = $9,600,000
Depreciation 20 years @ 4% per annum = 7,680,000
W4 Tax saving re depreciation remains constant at $192,000 annually (years 3 to 22); discount rate is
16.6% (nominal rate, not real rate)
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Chapter 12 – Strategy and the Analysis of Capital Investments
Note: Calculation of $1 annuity @ 16.6% for 22 years on
Lotus: @PV(1,0.166,22)
Excel: =−PV(0.166,22,1)
W5 Rentals, maintenance and taxes thereon:
Escalate at inflation rate of 6%
Discount at monetary rate of 16.6%
Effective discount rate (see W1 above) is 10%
In real terms, rentals and maintenance (and taxes thereon) are constant and can be regarded as an annuity
at 10% from year 3 to year 22.
PV factor = (8.7720 1.7360) = 7.0360
References
Atkinson, A. A., Banker, R. D., Kaplan, R. S., & Young, S. M. (1997). Management Accounting (2nd ed.).
New Jersey: Prentice Hall.
Brealey, R. A., Myers, S. C., & Marcus, A. J. (1999). Fundamentals of Corporate Finance (2nd ed.).
Boston: Irwin/McGraw-Hill.
Carsberg, B., & Hope, A. (1976). Business investment decisions under inflation. UK: The Institute of
Chartered Accountants in England and Wales.
Copeland, T., Koller, T., & Murrin, J. (2000). Valuation: measuring and managing the value of companies
(3rd ed.). John Wiley & Sons.
Horngren, C. T., Foster, G., & Datar, S. M. (1999). Cost accounting: a managerial emphasis (10th ed.).
New Jersey: Prentice Hall.
Howell, R. A., & Soucy, S. R. (1987). Capital Investment in the New Manufacturing Environment.
Management Accounting. November, 26–32.
Levin, J., & Olsson, P. (2000). Terminal value techniques in equity valuation—implications of the steady
state assumption. Working paper series in Business Administration, Stockholm School of
Economics. Available: http://netec.mcc.ac.uk/WoPEc/data/Papers/hhbhastba2000_007.html.
Rouse, P. (1992). Constructing Monte Carlo Simulations in Lotus 1–2-3. Journal of Accounting
Education, 11, 113–132.
Wilmington Tap, & Die. (1985). Harvard Case Study 9–85–124.
Case 12-2: County Line Markets—Store Remodel and New Store Investment
Case Overview
County Line Markets (CLM) needs to consider expanding or replacing 10 of its existing 67 Indiana
based-stores. The key capital investment trade-off decision facing CLM is whether to:
• Remodel or expand its existing stores now,
• replace its existing stores now with new, larger superstores,
• replace some of its existing stores now with superstores and close down others, or
• wait and replace its existing stores with superstores in the future.
This case focuses on the first two stores that are being evaluated by CLM at its Park Hills Acres and
Webster Street locations. Although the specific circumstances of each location are different, the analytical
and judgmental issues facing CLM’s management for the upgrade, expansion, or superstore rebuild are
typical of the issues present at each location. The evaluation of these two particular Park Hill area stores
will enable CLM to establish some evaluation guidelines and policies for its remaining stores.
The 10 CLM stores under evaluation are located in areas where the demographics, population, and
competitive landscape have changed dramatically since the stores were last remodeled. The Chief
Financial Officer (CFO) Ron Winston thinks that it is premature to invest substantial sums of money in
some existing locations because they are still in a state of flux and he feels it is better to wait until the
market stabilizes before committing large amounts of funds to these markets. In addition, the CFO thinks
that the Vice President of Operations Jerry Williams and the various store managers are making
‘analytical errors’ in their calculations as attempts to justify new superstores. Williams thinks that CLM
needs to invest in advance of market changes. Williams also believes that Winston is not considering
competitive developments in his analysis.
Specific Teaching Objectives
This case is designed to provide students with the following learning opportunities:
1. To formulate an investment decision and to consider alternative investment options.
2. To evaluate the relevant benefits that should be included in capital investment decisions.
3. To utilize sensitivity analysis as a tool to address the size and significance of the ‘sales erosion’ issue.
4. To consider how competitors’ actions can be incorporated into capital budgeting decisions.
5. To perform a financial analysis on an investment decision that includes multiple options.
6. To develop investment policies that can be used to evaluate other store remodel or expansion decisions.
Intended Courses and Levels
This case is intended for graduate and senior level courses in finance and accounting. This case focuses
on issues related to capital budgeting and raises not only the traditional analytic issues associated with a
capital budgeting case (i.e. cash flow determination and risk analysis), but also surfaces some key
judgmental issues frequently encountered in capital projects. In particular, this case requires students to
focus on the issues of project formulation and relevant benefit determination. Too often in capital
budgeting cases, students only learn the mechanics of evaluating projects and are not exposed to the
judgments involved in determining what investment options to consider. This case provides sufficient
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Chapter 12 – Strategy and the Analysis of Capital Investments
exposure to the judgments required when ‘sales erosion’ is a significant issue in a capital project.
Discussion Questions and Answers
Students are asked to complete the following tasks:
1. Determine the investment options that CLM should consider for the Park Hills Area.
Answer: First, students are expected to list all of the investment options that are possible in the Park
Hill Acres area. The set of investment options are listed in the following matrix:
Investment Options for CLM in Park Hill Area
Park Hill Acres Options
As
the
above matrix indicates, there are 25 possible investment combinations for CLM in the Park Hill Acres
area. There are five possible options for each store: do nothing, remodel, expand, build a superstore, or
close the store. The more extreme options are to close both stores or to build superstores in both
locations.
Second, students should then be able to eliminate some of these options as not being feasible based on
operational and/or marketplace considerations as provided in the case. In particular, students should be
able to eliminate these options using the following rationale:
•Eliminate all the options for closing the Park Hill Acres store since it is located in the least
competitive area. CLM has a ‘first movers’ opportunity to expand rather than retrench here.
•Eliminate all the “close options” for the Webster Street store with the exception of a closure if a
superstore is built at the Park Hill Acres location. There is likely to be little impact on the
sufficient room to expand at that location and there is no attractive location nearby which to
relocate. Hence, students should be able to narrow the feasible alternatives to the following:
•Do nothing at both stores
•Expand both stores (12,500 square foot expansion)
•Expand the Park Hill Acres store only
•Expand the Webster Street store only
•Build a superstore at the Park Hill Acres location
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Webster
Street
Options
Do Nothing Remodel Expansion Superstore Close
Do nothing X X X X X
Remodel X X X X X
Expand X X X X X
Superstore X X X X X
Close X X X X X