Capital Investment Decisions
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Learning Objectives
Explain the meaning of capital investment decisions, and distinguish between independent and
mutually exclusive capital investment decisions.
Compute the payback period and accounting rate of return for a proposed investment, and
explain their roles in capital investment decisions.
Use net present value analysis for capital investment decisions involving independent projects.
Use the internal rate of return to assess the acceptability of independent projects.
Explain the role and value of postaudits.
Explain why net present value is better than internal rate of return for capital investment
decisions involving mutually exclusive projects.
Types of Capital Investment Decisions
Capital investment decisions are concerned with the process of planning, setting goals and
priorities, arranging financing, and using certain criteria to select long-term assets.The process
of making capital investment decisions often is referred to as capital budgeting. Two types of
capital budgeting projects will be considered: independent projects and mutually exclusive
projects.
► Independent projects are projects that, if accepted or rejected, do not affect the cash
flows of other projects.
► Mutually exclusive projects are those projects that, if accepted, preclude the
acceptance of all other competing projects.
Making Capital Investment Decisions
In general terms, a sound capital investment will earn back its original capital outlay over its life
and, at the same time, provide a reasonable return on the original investment. After making this
assessment, managers must decide on the acceptability of independent projects and compare
competing projects on the basis of their economic merits.
To make a capital investment decision, a manager must
► estimate the quantity and timing of cash flows
► assess the risk of the investment
► consider the impact of the project on the firm’s profits
Basic Capital Investment Decision Models
The basic capital investment decision models can be classified into two major categories:
► Nondiscounting models ignore the time value of money.
► Discounting models explicitly consider the time value of money.
Nondiscounting Models:
Payback Period
The payback period is a non discounting model that presents the time required for a firm to
recover its original investment.If the cash flows of a project are an equal amount each period,
payback period is computed as follows: ORIGINAL INVESTMENT/ ANNUAL CASH FLOWS
If the cash flows are unequal, the payback period is computed by adding the annual cash flows
until such time as the original investment is recovered. If a fraction of a year is needed, it is
assumed that cash flows occur evenly within each year.
Using Payback Period to Assess Risk
One way to use the payback period is to set a maximum payback period for all projects and to
reject any project that exceeds this level. Some analysts suggest that the payback period can be
used as a rough measure of risk, with the notion that the longer it takes for a project to pay for
itself, the riskier it is. Also, firms with riskier cash flows in general could require a shorter
payback period than normal. Additionally, firms with liquidity problems would be more
interested in projects with quick paybacks. Another critical concern is obsolescence. Firms with
higher risk of obsolescence such as computer manufacturers would be interested in recovering
funds rapidly.
Using the Payback Period to Choose Among Alternatives
The payback period can be used to choose among competing alternatives. Under this approach,
the investment with the shortest payback period is preferred over investments with longer
payback periods. However, this use of the payback period is less defensible because this
measure suffers from two major deficiencies:
► It ignores the cash flow performance of the investments beyond the payback period.
► It ignores the time value of money.
Nondiscounting Models: Accounting Rate of Return
The accounting rate of return (ARR) measures the return on a project in terms of income, as
opposed to using a project’s cash flow.
The accounting rate of return is computed by the following formula:
AVERAGE INCOME/ INITIAL INVESTMENT
Limitations of the Accounting Rate of Return
Unlike the payback period, the ARR does consider a project’s profitability. However, the ARR has
other potential drawbacks, including the following:
► Ignoring Time Value of Money: Like the payback period, it ignores the time value of
money.
► Dependency on Net Income: ARR is dependent upon net income, which is the financial
measure most likely to be manipulated by managers.
► Managers’ Incentive: Additionally, because bonuses to managers often are based on
accounting income or return on assets, managers may have a personal interest in
selecting investments that contribute to net income in the short-run.
Discounting Models: The Net Present Value Method
Discounting models use discounted cash flows which are future cash flows expressed in terms
of their present value.One discounting model is the net present value (NPV), which is the
difference between the present value of the cash inflows and outflows associated with a
project.
Net Present Value
NPV measures the profitability of an investment. A positive NPV indicates that the investment
increases the firm’s wealth. To use the NPV method, a required rate of return must be defined.
The required rate of return is the minimum acceptable rate of return. It also is referred to as the
discount rate, hurdle rate, and cost of capital. In theory, if future cash flows are known with
certainty, then the correct required rate of return is the firm’s cost of capital. In practice,
managers often choose a discount rate higher than the cost of capital to deal with uncertainty.
However, if the rate chosen is excessively high, it will bias the selection process toward shortterm investments. Once the NPV for a project is computed, it can be used to determine whether
or not to accept an investment.
If the NPV is greater than zero the investment is profitable and, therefore, acceptable.
► A positive NPV signals that (1) the initial investment has been recovered, (2) the
required rate of return has been recovered, and (3) a return in excess of (1) and (2) has
been received.
► If the NPV equals zero, the decision maker will find acceptance or rejection of the
investment equal.
► If the NPV is less than zero, the investment should be rejected. In this case, it is earning
less than the required rate of return.
NPV, Discount Rates, and Cash Flows
It is common to provide pessimistic and most likely cash flow scenarios to help assess a project’s
risk. As the discount rate increases, the present value of future cash flows decreases, making it
harder for a project to achieve a positive NPV.Plotting the NPV as the discount rate varies
provides good insight into the risk and economic viability of the proposed project.
Internal Rate of Return
The internal rate of return (IRR), another discounting model, is defined as the interest rate that
sets the present value of a project’s cash inflows equal to the present value of the project’s cost.
It is the interest rate that sets the project’s NPV at zero.
Once the IRR for a project is computed, it is compared with the firm’s required rate of return:
► If the IRR is greater than the required rate, the project is deemed acceptable.
► If the IRR is less than the required rate of return, the project is rejected.
► If the IRR is equal to the required rate of return, the firm is indifferent between
accepting or rejecting the investment proposal.
The IRR is the most widely used of the capital investment techniques.
Internal Rate of Return: Multiple Period
If the investment produces a series of uniform cash flows, a single discount factor from the
present value table can be used to compute the present value of the annuity.If the cash flows
are not uniform, then the IRR equation must be used.For a multiple-period setting, this equation
can be solved by trial and error or by using a business calculator or a spreadsheet program.
Post audit of Capital Projects
A key element in the capital investment process is a follow-up analysis of a capital project once
it is implemented. A post audit compares the actual benefits with the estimated benefits and
actual operating costs with estimated operating costs. It evaluates the overall outcome of the
investment and proposes corrective action if needed.
Post audit Benefits
Firms that perform post audits of capital projects experience a number of benefits, including the
following:
► Resource Allocation: By evaluating profitability, post audits ensure that resources are
used wisely.
► Positive Impact on Managers’ Behavior: If managers are held accountable for the results
of a capital investment decision, they are more likely to make such decisions in the best
interests of the firm.
► Independent Perspective: Postaudit by an independent party ensures more objective
results.
Post audit Limitations
Postaudits are costly.The assumptions driving the original analysis may often be invalidated by
changes in the actual operating environment.Accountability must be qualified to some extent by
the impossibility of foreseeing every possible eventuality.
Mutually Exclusive Projects
Up to this point, we have focused on independent projects. NPV and IRR both yield the same
decision for independent projects. However, many capital investment decisions deal with
mutually exclusive projects. For competing projects, the two methods can produce different
results. Choosing the project with the largest NPV is consistent with maximizing the wealth of
shareholders.
Net Present Value Compared with Internal Rate of Return
NPV differs from IRR in two major ways:
► The NPV method assumes that each cash inflow received is reinvested at the required
rate of return, whereas the IRR method assumes that each cash inflow is reinvested at
the computed IRR. Reinvesting at the required rate of return is more realistic and
produces more reliable results when comparing mutually exclusive projects.
► The NPV method measures profitability in absolute terms, whereas the IRR method
measures it in relative terms. NPV measures the amount by which the value of the firm
changes.
There are three steps in selecting the best project (with the largest NPV) from several competing
projects:
► Step 1: Assess the cash flow pattern for each project.
► Step 2: Compute the NPV for each project.
► Step 3: Identify the project with the greatest NPV.
Special Considerations for the Advanced Manufacturing Environment
For advanced manufacturing environments, like those using automated systems, capital
investment decisions can be more complex because they must take special considerations into
account. Great care must be exercised to assess the actual cost of an automated system
because it is easy to overlook substantial peripheral costs like software, engineering, and
training.More effort is needed to measure intangible and indirect benefits, like reduced lead
time, reliability, and customer satisfaction, in order to assess more accurately the potential
value of investments.
Present Value Concepts
An important feature of money is that it can be invested and can earn interest. A dollar today is
not the same as a dollar tomorrow. This fundamental principle is the backbone of discounting
methods.
Future value is expressed as: F = P(1 + i), where F is the future amount, P is the initial or current
outlay, and i is the interest rate.The earning of interest on interest is referred to as
compounding of interest, expressed as follows for n periods into the future:
Present Value
Often, a manager needs to compute not the future value but the amount that must be invested
now in order to yield some given future value. The amount that must be invested now to
produce the future value is known as the present value of the future amount.To compute the
present value of a future outlay, all we need to do is solve the compounding interest equation
for P:
The process of computing the present value of future cash flows is often referred to as
discounting.The interest rate used to discount the future cash flow is the discount rate. The
expression 1/(1 + i)n in the present value equation is the discount factor.
Annuities
An annuity is a series of future cash flows. If the annuity is uneven, then each future cash flow
must be discounted using individual discount rates (the present value for each cash flow is
calculated separately and then summed). For even cash flows, a single discount rate, which is
the sum of each discount rate for each cash flow, can be used.