Chapter 24
Capital Investment
Analysis
Financial and Managerial Accounting
8th Edition
Warren Reeve Fess
PowerPoint Presentation by Douglas Cloud
Professor Emeritus of Accounting
Pepperdine University
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Objectives
1. Explain the nature and importance of
After studying
this
capital investment
analysis.
chapter, you should
2. Evaluate capital investment proposals,
be able to:
using the following methods: average
rate of return, cash payback, net present
value, and internal rate of return.
3. List and describe factors that complicate
capital investment analysis.
4. Diagram the capital rationing process.
Nature of Capital
Investment Analysis
Capital budgeting is the process
by which management plans,
evaluates, and controls long-term
investments in fixed assets.
Nature of Capital
Investment Analysis
1. Management plans, evaluates, and
controls investments in fixed assets.
2. Capital investments involve a long-term
commitment of funds.
3. Investments must earn a reasonable rate
of return.
4. The process should include a plan for
encouraging and rewarding employees
for submitting proposals.
Methods of Evaluating
Capital Investment Proposals
Here’s a survey of business practices in a
variety of industries. It reports the capital
investment analysis methods used by large
U.S. companies.
Average rate
of return
15%
Cash payback
method
53%
Net present
value method
85%
Internal rate
of return
method
76%
0%
10% 20% 30% 40% 50% 60% 70% 80% 90%
Methods that Ignore Present Value
Average Rate of Return Method
Advantages:
 Easy to calculate
 Considers accounting income (often used to
evaluate managers)
Disadvantages:
 Ignores cash flows
 Ignores the time value of money
Average Rate of Return Method
Assumptions:
Machine cost
Expected useful life
Residual value
Expected total income
$500,000
4 years
none
$200,000
Estimated Average
Average Rate
Annual Income
of Return = Average Investment
Average Rate
$200,000 ÷ 4 years
of Return = ($500,000 + $0) / 2
= 20%
Average Rate of Return Method
Assumptions:
Proposal A Proposal B
Average annual income
Average investment
$ 30,000
$120,000
$ 36,000
$180,000
$30,000
= 25%
$120,000
Average Rate of Return Method
Assumptions:
Average annual income
Average investment
Proposal A Proposal B
$ 30,000
$120,000
$ 36,000
$180,000
$36,000
= 20%
$180,000
Methods that Ignore Present Value
Cash Payback Method
Advantages:
 Considers cash flows
 Shows when funds are available
for reinvestment
Disadvantages:
 Ignores profitability (accounting income)
 Ignores cash flows after the payback
period
Cash Payback Method
Assumptions:
Investment cost
Expected useful life
Expected annual net
cash flows (equal)
Cash
Payback
Period
$200,000
8 years
$40,000
Total Investment
=
Cash
Payback =
Period
Annual Net
Cash Inflows
$200,000 = 5 years
$40,000
Cash Payback Method
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Net Cash
Cumulative
Flow
Net Cash Flow
$ 60,000
$ 60,000
80,000
140,000
105,000
245,000
155,000
400,000
100,000
500,000
90,000
590,000
If the proposed investment is
$400,000, the payback period is at
the end of Year 4.
Present Value Methods
The time value of money concept is used in many
business decisions. This concept is an important
consideration in capital investment analysis.
Present
Value
????
= $1,000 ÷ 1.08
$$925.93
What is the present value of
$1,000 to be received one year
from today at 8% per year?
Present Value Methods
How much would have to be invested on
February 1, 2006 in order to receive $1,000
on February 1, 2009 if the interest rate
compounded annually is 12%?
Present Value Methods
Refer to the partial present
value table in Slide 18 to
answer the question.
$1,000, 3
years, 12%
compounded
annually
Calculating Present Values
Present values can be determined using present value
tables, mathematical formulas, a calculator or a computer.
Present Value of $1 with Compound Interest
Year
1
6%
0.943
10%
0.909
12%
0.893
15%
0.870
20%
0.833
2
0.890
0.826
0.797
0.756
0.694
3
0.840
0.751
0.658
0.579
4
0.792
0.683
0.712
0.636
0.572
0.482
5
0.747
0.621
0.567
0.497
0.402
6
0.705
0.564
0.507
0.432
0.335
$1,000 x .712 = $712
Present Value of an Amount
If $712 is invested on February 1, 2006
at an annual rate of 12 percent, $1,000
will accumulate by February 1, 2009.
$1,000 x .712 = $712
Present Value of an Amount
$712 x 1.12
$797 x 1.12
$893 x 1.12
$1,000
Present Value of an Annuity
An annuity is a series of equal net
cash flows at fixed time intervals.
The present value of an annuity is the
sum of these net cash flows.
Present Value of an Annuity
What would be the present value of a
$100 annuity for five periods at 12?
Calculating Present Values of Annuities
Present Value of an Annuity of $1
Year
1
6%
0.943
10%
0.909
12%
0.893
15%
0.870
20%
0.833
2
1.833
1.736
1.690
1.626
1.528
3
2.673
2.487
2.402
2.283
2.106
4
3.465
3.170
3.037
2.855
2.589
5
4.212
3.791
3.353
2.991
6
4.917
4.355
3.605
3.605
4.111
3.785
3.326
3.605 x $100 = $360.50
Net Present
Value
Method
The net present value
method analyzes capital
investment proposals by
comparing the initial
cash investment with the
present value of the net
cash flows.
Net Present Value Method
Advantage:
 Considers cash flows and the time
value of money
Disadvantage:
 Assumes that cash received can be
reinvested at the rate of return
Net Present Value Method
At the beginning of 2006, equipment with
an expected
life
of
five
years
can
be
Cash Flow
Present Value
purchased for $200,000. At the end of
five years it is anticipated that the
equipment will have no residual value.
Net Present Value Method
A net cash flow of $70,000 is expected at the end of
2006. ThisCash
net Flow
cash flow is expected
decline
Presentto
Value
$10,000 each year (except 2010) until the machine is
retired. The firm expects a minimum rate of return
of 10%. Should the equipment be purchased?
Net Present Value Method
First, we must determine which
table to use… the present value of
$1 or the present value of an annuity
of $1.
Net Present Value Method
Because there are multiple years of
net cash flows, shouldn’t we use
the present value of an annuity of
$1?
Net Present Value Method
That would be true if the net cash flows
remained constant from 2006 through
2010. Note that the net cash flows are
$70,000, $60,000, $50,000, $40,000, and
$40,000, respectively.
Net Present Value Method
So, we have to use the
present value of $1 for each
of the five years.
Net Present Value Method
$<200,000>
$70,000
$60,000
$50,000
$ 63,630
$ 49,560
$ 37,550
$ 27,320
$ 24,840
$70,000 x 0.909 (n = 1; i = 10%)
$60,000 x 0.826 (n = 2; i = 10%)
$50,000 x 0.751 (n = 3; i = 10%)
$40,000 x 0.683 (n = 4; i = 10%)
$40,000 x 0.621 (n = 5; i = 10%)
$40,000
$40,000
Net Present Value Method
$<200,000>
$ 63,630
$ 49,560
$ 37,550
$ 27,320
$ 24,840
$
2,900
$70,000
The equipment should be
net
$60,000purchased
$50,000 because
$40,000 the$40,000
present value is positive.
Net Present Value Method
When capital investment funds are limited
and the alternative proposals involve
different amounts of investment, it is useful
to prepare a ranking of the proposals using
a present value index.
Net Present Value Method
Assumptions:
Proposals
Total present value
Total investment
Net present value
A
$107,000
100,000
$ 7,000
B
$86,400
80,000
$ 6,400
C
$93,600
90,000
$ 3,600
Present value index
1.07
1.08
1.04
$86,400
÷$93,600 ÷
$107,000
The ÷
most
desirable
$80,000
$90,000
$100,000
proposal
according
to
the present value
index.
Internal Rate of Return Method
Advantages:
 Considers cash flows and the time value
of money
 Ability to compare projects of unequal
size
Disadvantages:
 Requires complex calculations
 Assumes that cash can be reinvested at
the internal rate of return
Internal Rate of Return Method
The internal rate of return method uses the net cash
flows to determine the rate of return expected from the
proposal. The following approaches may be used:
Trial and Error
Assume a rate of return and calculate the present
value. Modify the rate of return and calculate a
new present value. Continue until the present
value approximates the investment cost.
Computer Function
Use a computer function to calculate exactly
the expected rate of return.
Internal Rate of Return Method
Management is evaluating a proposal
to acquire equipment costing $97,360.
The equipment is expected to provide
annual net cash flows of $20,000 per
year for seven years.
Internal Rate of Return Method
Determine the table value using
the present value for an annuity
of $1 table.
Amount to be invested
Equal annual cash flow
$97,360
$20,000
= 4.868
Internal Rate of Return Method
Find the seven year line on the
table. Then, go across the sevenyear line until the closest amount
to 4.868 is located.
Present
PresentValue
Valueof
ofan
anAnnuity
Annuityof
of $1
$1
Year 6%
10%
12% 15%
1 0.943
0.909
0.893 0.870
2
1.833
1.736
1.690
1.626
3
2.673
2.487
2.402
2.283
4
3.465
3.170
3.037
2.855
5
4.212
3.791
3.605
3.353
6
4.917
4.355
4.111
3.785
7
5.582
4.868
4.564
4.160
Internal Rate of Return Method
Present Value of an Annuity of $1
Year 6%
1 0.943
10%
0.909
12% 15%
0.893 0.870
2
1.833
1.736
1.690
1.626
3
2.673
2.487
2.402
2.283
4
3.465
3.170
3.037
2.855
5
4.212
3.791
3.605
3.353
6
4.917
4.355
4.111
3.785
7
5.582
4.868
4.564
4.160
Internal Rate of Return Method
Move vertically to the top of the
table to determine the interest rate.
Present Value of an Annuity of $1
Year 6%
1 0.943
10%
10%
10%
0.909
12% 15%
0.893 0.870
2
1.833
1.736
1.690
1.626
3
2.673
2.487
2.402
2.283
4
3.465
3.170
3.037
2.855
5
4.212
3.791
3.605
3.353
6
4.917
4.355
4.111
3.785
7
5.582
4.868
4.564
4.160
Factors That Complicate Capital
Investment Analysis
 Income tax
 Unequal proposal lives
 Lease versus capital investment
 Uncertainty
 Changes in price levels
 Qualitative considerations
Qualitative Considerations
Improvements that increase competitiveness and
quality are difficult to quantify. The following
qualitative factors are important considerations.
1.
2.
3.
4.
5.
Improve product quality
Reduce defects and manufacturing cycle time
Increase manufacturing flexibility
Reduce inventories and need for inspection
Eliminate non-value-added activities
Capital Rationing
1. Identify potential projects.
2. Eliminate projects that do not meet minimum
cash payback or average rate of return
expectations.
3. Evaluate the remaining projects, using present
value methods.
4. Consider the qualitative benefits of all projects.
5. Rank the projects and allocate available funds.
Chapter 24
The End