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.
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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
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LO 1
Nature of Capital Investment Analysis
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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.
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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
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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
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= 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.
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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.
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EE 25-1
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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.
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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
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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)
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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
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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.
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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.
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EE 25-2
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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
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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
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LO 3
Present Value of an Amount
 This process of interest earning interest is
called compounding. The illustration below
demonstrates the concept of
compounding.
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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.
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LO 3
Present Value of an Amount
0.712 × $1.404 = $1.00
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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.
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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.
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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.
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LO 3
Present Value of an Annuity
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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.
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LO 3
Present Value of an Annuity
3.605 × $100 = $360.50
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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.
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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
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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.
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LO 3
Net Present Value Method
The preceding computations are also graphically
illustrated below.
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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%.
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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
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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
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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
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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.
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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.
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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.
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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.
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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)
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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)
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LO 3
Internal Rate of Return Method
3.605
(continued)
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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)
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LO 3
Internal Rate of Return Method
3.605
The minimum acceptable
rate of return is 10%.
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(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.
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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.
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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.
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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
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