LO 1 Nature of Capital Investment Analysis Capital investment analysis (or capital budgeting) is the process by which management plans, evaluates, and controls investments in fixed assets. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 1 Nature of Capital Investment Analysis Methods that do not use present values Average rate of return method Cash payback method Methods that use present values Net present value method Internal rate of return method © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 1 Nature of Capital Investment Analysis © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 1 Nature of Capital Investment Analysis The time value of money concept recognizes that a dollar today is worth more than a dollar tomorrow because today’s dollar can earn interest. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 2 Average Rate of Return Method The average rate of return, sometimes called the accounting rate of return, measures the average income as a percent of the average investment. The average rate of return is computed as follows: Average Rate of Return = Estimated Average Annual Income Average Investment (Initial Cost + Residual Value)/2 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 2 Average Rate of Return Method Management is evaluating the purchase of a new machine as follows: Machine cost $500,000 Residual value 0 Estimated total income from machine 200,000 Expected useful life 4 years Estimated Average Average Rate Annual Income = of Return Average Investment Average Rate $200,000/4 = of Return ($500,000 + $0)/2 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. = 20% LO 2 Average Rate of Return Method The average rate of return has the following three advantages: 1. It is easy to compute. 2. It includes the entire amount of income earned over the life of the proposal. 3. It emphasizes accounting income. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 2 Average Rate of Return Method The average rate of return has the following two disadvantages: 1. It does not directly consider the expected cash flows from the proposal. 2. It does not directly consider the timing of the expected cash flows. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. EE 25-1 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 2 Cash Payback Method The expected period of time that will pass between the date of an investment and the complete recovery in cash of the amount invested is the cash payback period. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 2 Cash Payback Method When annual net cash inflows are equal, the cash payback period is computed as follows: Cash Payback = Period Initial Cost Annual Net Cash Inflow © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 2 Cash Payback Method Cost of new machine Cash revenue from machine per year Expenses of machine per year Depreciation per year $200,000 50,000 30,000 20,000 Net cash inflow per year: Cash revenue from machine $50,000 Less cash expenses of machine: Expenses of machine $30,000 Less depreciation 20,000 10,000 Net cash inflow per year $40,000 (continued) © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 2 Cash Payback Method The time required for the net cash inflow to equal the cost of the new machine is the payback period. The estimated cash payback period for the investment in the machine is five years, as computed below. Cash Payback = Period Initial Cost Annual Net Cash Inflow Cash $200,000 Payback = $40,000 = 5 years Period © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 2 Cash Payback Method The cash payback method has the following two advantages: 1. It is simple to use and understand. 2. It analyzes cash flows. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 2 Cash Payback Method The cash payback method has the following two disadvantages: 1. It ignores cash flows occurring after the payback period. 2. It does not use present value concepts in valuing cash flows occurring in different periods. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. EE 25-2 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 3 Present Value Concepts Both the net present value and the internal rate of return methods use the following two present value concepts: Present value of an amount Present value of an annuity © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 3 Present Value of an Amount If you had $1 to invest for three years at 12%, how much would you have after one year? By the end of the second year? By the end of the third year? $1.12 x 1.12 = $1.254 $1 x 1.12 = $1.12 $1.254 x 1.12 = $1.404 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 3 Present Value of an Amount This process of interest earning interest is called compounding. The illustration below demonstrates the concept of compounding. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 3 Present Value of an Amount Using the PV of $1 Table On January 1, 2012, what is the present value of $1.404 to be received on December 31, 2014 (assuming an interest rate of 12 percent)? To determine the answer, we need to go to Exhibit 1 (next slide) and find the table value for three years at 12 percent. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 3 Present Value of an Amount 0.712 × $1.404 = $1.00 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 3 Present Value of an Amount Another way of stating this is that the present value of $1.404 to be received in three years using a compound interest rate of 12% is $1, as shown below. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 3 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 amount of cash needed today to yield a series of equal net cash flows at fixed time intervals in the future. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 3 Present Value of an Annuity The present value of a $100 annuity for five periods at 12% could be determined by using the present value factors in Exhibit 1. This is shown graphically in the next slide. Left-click your mouse on the button to go to Exhibit 1. Type “32” and press “Enter” to return to this slide. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 3 Present Value of an Annuity © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 3 Present Value of an Annuity Using the PV of an Annuity of $1 Table Using a present value of an annuity of $1 table, such as the one in Exhibit 2 (next slide), is a simpler approach. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 3 Present Value of an Annuity 3.605 × $100 = $360.50 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 3 Net Present Value Method The net present value method compares the amount to be invested with the present value of the net cash inflows. It is sometimes called the discounted cash flow method. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 3 Net Present Value Method Assume the following data for a proposed investment in new equipment: Cost of new equipment Expected useful life Minimum desired rate of return $200,000 5 years 10% Expected cash flows to be received each year: Year 1 $70,000 Year 2 60,000 Year 3 50,000 Year 4 40,000 Year 5 40,000 Total expected cash flows $260,000 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 3 Net Present Value Method Using the present value of $1 (Exhibit 1) at 10%, the present value of the net cash flow for each year is shown below. Left-click your mouse on the button to go to Exhibit 1. Type “38” and press “Enter” to return to this slide. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 3 Net Present Value Method The preceding computations are also graphically illustrated below. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 3 Net Present Value Method The net present value of $2,900 indicates that the purchase of the new equipment is expected to recover the investment and provide more than the minimum rate of return of 10%. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 3 Net Present Value Method Capital investment proposals can be ranked by using a present value index. The present value index is computed as follows: Total Present Value of Net Cash Flow Present Value Index = Amount to Be Invested © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 3 Net Present Value Method The present value index for the investment in the preceding slides is 1.0145, as computed below. Total Present Value of Net Cash Flow Present Value Index = Amount to Be Invested $202,900 = 1.0145 Present Value Index = $200,000 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 3 Net Present Value Method A company is considering three proposals. The net present value and the present value index for each proposal are as follows: Most desirable proposal © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 3 Net Present Value Method The net present value method has the following three advantages: 1. It considers the cash flows of the investment. 2. It considers the time value of money. 3. It can rank equal lived projects using the present value index. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 3 Net Present Value Method The net present value method has the following two disadvantages: 1. It has more complex computations than methods that don’t use present value. 2. It assumes the cash flows can be reinvested at the minimum desired rate of return, which may not be valid. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. EE 25-3 Left-click on the button with your mouse to go to Exhibit 2. Type “46” and press “Enter” to return to this slide. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 3 Internal Rate of Return Method The internal rate of return (IRR) method uses present value concepts to compute the rate of return from a capital investment proposal based on its expected net cash flows. This method, sometimes called the timeadjusted rate of return method, starts with the proposal’s net cash flows and works backward to estimate the proposal’s expected rate of return. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 3 Internal Rate of Return Method STEP 1: Determine the present value factor for an annuity of $1 as follows: Amount to be Invested Equal Annual Net Cash Flows $97,360 = 4.868 $20,000 (continued) © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 3 Internal Rate of Return Method STEP 2: Find the seven-year line on Exhibit 2 (the present value of an annuity of $1 at compound interest). Proceed horizontally across the table until you find the present value factor computed in Step 1 (or the closest present value factor). (continued) © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 3 Internal Rate of Return Method 3.605 (continued) © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 3 Internal Rate of Return Method STEP 3: Now that you have located 4.868 on the seven-year line, go vertically to the top of the table to determine the interest rate. (continued) © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 3 Internal Rate of Return Method 3.605 The minimum acceptable rate of return is 10%. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. (concluded) LO 3 Internal Rate of Return Method The internal rate of return method has the following three advantages: 1. It considers the cash flows of the investment. 2. It considers the time value of money. 3. It ranks proposals based upon the cash flows over their complete useful life, even if the project lives are not the same. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 3 Internal Rate of Return Method The internal rate of return method has the following two disadvantages: 1. It has complex computations, requiring a computer if the periodic cash flows are not equal (an annuity). 2. It assumes the cash received from a proposal can be reinvested at the internal rate of return, which may not be valid. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. EE 25-4 Left-click on the button with your mouse to go to Exhibit 2. Type “60” and press “Enter” to return to this slide. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 4 Factors That Complicate Capital Investment Analysis Income tax Proposals with unequal lives Leasing versus purchasing Uncertainty Changes in price levels Qualitative factors © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.