Provided by James R. Martin, Ph.D., CMA
Professor Emeritus, University of South Florida
Investment
Management Summary | Investment
Management Main Page
Sinason provides two examples to illustrate the moving baseline concept associated with investment managment.
Example 1: Equipment Replacement
|
Data for Existing Equipment |
Year X0 (Present) | Year X1 | Year X2 | Year X3 |
| Estimated average units production per hour | 90 | 87 | 84 | 83 |
| Required production to meet demand | 81 | 84 | 87 | 93 |
| Machine age in years | 2 | 3 | 4 | 5 |
| Class estimated by engineering | 3 | 3 | 4 | 5 |
| Maintenance costs estimated | $1,500 | $1,500 | $2,000 | $3,000 |
| Overtime required per week to meet demand
= (Production requirements รท Estimated production)(40 hours) |
0 | 0 | 1.43 | 4.82 |
| Overtime cost based on
($50 per hour)(Hours per week)(52 weeks) |
0 | 0 | $3,718 | $12,532 |
| Incremental cost, i.e., cost in addition to current operating costs for maintenance and overtime. | $1,500 | $1,500 | $5,718 | $15,532 |
| Data for New Equipment | Year X0 (Present) | Year X1 | Year X2 | Year X3 |
| Estimated incremental cash flows, i.e., savings compared to old equipment. | $5,000 | $10,000 | $15,000 | $25,000 |
| Cost of new equipment | $60,000 | |||
| Salvage value of old equipment | 0 | |||
| Cost of non-investment, i.e., or cost avoided if the new equipment is purchased. | $1,500 | $1,500 | $5,718 | $15,532 |
| Combined cash flow | (53,500) | 11,500 | 20,718 | 40,532 |
| Conventional Present Value Analysis | |||
|
Year |
Cash Flow | Discount Factor (8% Cost of Capital) |
Discounted Cash Flow |
| 0 | $(55,000) | 1.000 | $(55,000) |
| 1 | 10,000 | .9259 | 9,259 |
| 2 | 15,000 | .8573 | 12,859 |
| 3 | 25,000 | .7938 | 19,845 |
| NPV | $(13,037) | ||
Conclusion based on conventional analysis: Do not invest in the new equipment since the cost of non-investment is not recognized.
| Moving Baseline Present Value Analysis | |||
|
Year |
Cash Flow | Discount Factor | Discounted Cash Flow |
| 0 | $(53,500) | 1.000 | $(53,500) |
| 1 | 11,500 | .9259 | 10,648 |
| 2 | 20,718 | .8573 | 17,761 |
| 3 | 40,532 | .7938 | 32,174 |
| NPV | $7,083 | ||
Conclusion based on moving baseline analysis: Invest in the new equipment. The difference results from recognizing the cost of non-investment.
Example 2: Investment in New Technology
| Data | Year X0 (Present) | Year X1 | Year X2 | Year X3 |
| Present market share projections without the investment in the new technology. |
20% | 19.9% | 19.5% | 19.0% |
| Revenue projections without the investment in the new technology. |
$1,000,000 | $995,000 | $975,000 | $950,000 |
| Decrease in cash flow from declining; market share if investment is not made. |
0 | $5,000 | $25,000 | $50,000 |
| Cash flow from investment. | $(250,000) | $(20,000) | $80,000 | $190,000 |
| Combined cash flow. | $(250,000) | $(15,000) | $105,000 | $240,000 |
| Conventional Present Value Analysis | |||
|
Year |
Cash Flow | Discount Factor (8% Cost of Capital) |
Discounted Cash Flow |
| 0 | $(250,000) | 1.000 | $(250,000) |
| 1 | (20,000) | .9259 | (18,518) |
| 2 | 80,000 | .8573 | 68,534 |
| 3 | 190,000 | .7938 | 150,822 |
| NPV | $(49,162) | ||
Conclusion based on conventional analysis: Do not invest in the new technology since the decreases in cash flows caused by the declining market share are not recognized.
| Moving Baseline Present Value Analysis | |||
|
Year |
Cash Flow | Discount Factor (8% Cost of Capital) |
Discounted Cash Flow |
| 0 | $(250,000) | 1.000 | $(250,000) |
| 1 | (15,000) | .9259 | (13,888) |
| 2 | 105,000 | .8573 | 90,017 |
| 3 | 240,000 | .7938 | 190,512 |
| NPV | $16,641 | ||
Conclusion based on moving baseline analysis: Invest in the new technology after recognizing the decreases in cash flows caused by the declining market share if the investment is not made.
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* Sinason, D. H. 1991. A dynamic model for present value capital expenditure analysis. Journal of Cost Management (Spring): 40-45. (Summary).
Related summaries:
Cherry, K. 1993. Why aren't more investments profitable? Journal of Cost Management (Summer): 28-37. (Summary).
Engwall, R. L. 1988. Investment evaluation methodologies. Journal of Cost Management (Spring): 40-44. (Summary).
Engwall, R. L. 1988. Cost/benefit analysis. Journal of Cost Management (Fall): 64-70. (Summary).
Engwall, R. L. 1989. Investment justification issues. Journal of Cost Management (Spring): 50-53. (Summary).
Gold, B. 1976. The shaky foundations of capital budgeting. California Management Review (Winter): 51-60. (Summary).
Hayes, R. H. and W. J. Abernathy. 2007. Managing our way to economic decline. Harvard Business Review (July-August): 138-149. (This is a reprint of their 1980 article with a retrospect by Hayes on page 141). (Summary).
Heard, E. 1996. Investment justification: The cost justification charade. Journal of Cost Management (Summer): 60-65. (Summary).
Howell, R. A. and S. R. Soucy. 1987. Capital investment in the new manufacturing environment. Management Accounting (November): 26-32. (Summary).
Kite, D. 1995. Capital budgeting: Integrating environmental impact. Journal of Cost Management (Summer): 11-14. (Summary).
Lyons, B., A. Gumbus and D. E. Bellhouse. 2003. Aligning capital investment decisions with the balanced scorecard. Journal of Cost Management (March/April): 34-38. (Summary).
Martin, J. R. 1994. A controversial issues approach to enhance management accounting education. Journal of Accounting Education (Winter): 59-75. (Summary).
Martin, J. R. Not dated. Investment management. Management And Accounting Web. InvestmentManageSum
Primrose, P. L. 1992. Is anything really wrong with cost management? Journal of Cost Management (Spring): 48-57. (Summary).