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Capital
Investment
Analysis
1
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10-1
Objective 1
Explain the nature
and importance of
capital investment
analysis.
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Capital Investment Analysis
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10-1
Capital investment analysis
(or capital budgeting) is the
process by which
management plans,
evaluates, and controls
investments in fixed assets.
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Objective 2
Evaluate capital investment
proposals, using the
following methods: average
rate of return, cash payback,
net present value, and
internal rate of return.
10-2
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Methods of Evaluating Capital
Investment Proposals
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10-2
Methods that ignore present values:
 The average rate of return method
 The cash payback method
Methods that use present values:
 The net present value method
 The internal rate of return method
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Percentage of Respondents Reporting
the Use of the Method as “Always” or
“Often”
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Average rate of
return
Cash payback
method
Net present
value method
Internal rate of
return method
10-2
15%
53%
85%
76%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90%
Source: Patricia A. Ryan and Glenn P. Ryan. “Capital Budgeting Practices of the Fortune
1,000. How Have Things Changed? Journal of Business and Management (Winter 2002).
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Average Rate of Return Method
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10-2
Advantages:
 Easy to calculate
 Considers accounting income (often
used to evaluate managers)
Disadvantages:
 Ignores cash flows
 Ignores the time value of money
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Purchase of Machine Example
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10-2
Assumptions:
Machine cost
Expected useful life
Residual value
Expected total income
Average rate
=
of return
Average rate
=
of return
$500,000
4 years
none
$200,000
Estimated Average
Annual Income
Average Investment
$200,000/4
= 20%
($500,000 + $0)/2
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10-2
Proposal A Proposal B
Estimated average
annual income
Average investment
Average rate of return
$ 30,000
$120,000
$ 36,000
$180,000
25%
$30,000
$120,000
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12
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10-2
Proposal A Proposal B
Estimated average
annual income
Average investment
Average rate of return
$ 30,000
$120,000
25%
Proposal A would be
preferred over
Proposal B.
$ 36,000
$180,000
20%
$360,000
$180,000
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10-2
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Example Exercise 10-1
Determine the average rate of return for a project that is
estimated to yield total income of $273,600 over three
years, cost $690,000, and has a $70,000 residual value.
Follow My Example 10-1
Est. average annual income: $91,200 ($273,600/3 years)
Average investment: $380,000 ($690,000 + $70,000)/2
Average rate of return: 24% ($91,200/$380,000)
For Practice: PE 10-1A, PE 10-1B
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Cash Payback Method
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10-2
The expected period of time that
will pass between the date of an
investment and the complete
recovery in cash (or equivalent)
of the amount invested is the
cash payback period.
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10-2
The excess of cash flowing in
from revenue over the cash
flowing out for expenses is
termed net cash flow.
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Assumptions:
Investment cost
Expected annual net
cash flow (equal)
10-2
$200,000
$40,000
Cash
payback =
period
Total Investment
Annual Net
Cash Flow
Cash
payback =
period
$200,000
= 5 years
$40,000
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17
Advantages and Disadvantages of the
Cash Payback Method
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10-2
Advantages:
 Considers cash flows
 Shows when funds are available for
reinvestment
Disadvantages:
 Ignores profitability (accounting income)
 Ignores cash flows after the payback
period
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10-2
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Example Exercise 10-2
A project has estimated annual net cash flows
of $30,000. It is estimated to cost $105,000.
Determine the cash payback period.
Follow My Example 10-2
3.5 years ($105,000/$30,000)
For Practice: PE 10-2A, PE 10-2B
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21
Present Value Concepts
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10-2
Present value concepts can be
divided into:
 the present value of an
amount and
 the present value of an
annuity.
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Present Value of an Amount
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10-2
On January 1, 2008, you
invest $1 in an account that
earns 12% interest
compounded annually.
Interest earning interest is
called compounding.
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Present Value Concepts
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$1.00
$1.00
$1.00 x 1.12
$1.12 x 1.12
$1.12
10-2
$1.254 x 1.12
$1.254
$1.404
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10-2
Assume that today is January 1, 2008 and
the current interest rate is 12 percent.
What is the present value of $1,404 to be
received on January 1, 2011? To
determine the answer, we need to go to
Exhibit 1 and find the table value for three
years at 12 percent.
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Partial Present Value
of $1 Table
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10-2
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
Left click the mouse for solution.
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10-2
Table x Amount to be
received on
Present value =
value January 1, 2011
Present value = 0.712 x $1,404
Present value = $1,000.00 (rounded)
Summary: If the interest rate is 12%,
then $1,404 in three years is worth
$1,000 today.
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Present Value of an Annuity
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10-2
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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Net Present Value Method
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10-2
The net present value method (also
called the discounted cash flow
method) analyzes capital
investment proposals by comparing
the initial cash investment with the
present value of the net cash flows.
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Equipment Example
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10-2
At the beginning of 2008,
equipment with an expected life of
five years can be purchased for
$200,000. At the end of five years
it is anticipated that the equipment
will have no residual value.
(Continued)
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Equipment Example
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10-2
A net cash flow of $70,000 is
expected at the end of 2008. This
net cash flow is expected to decline
$10,000 each year (except 2012)
until the machine is retired. The
firm expects a minimum rate of
return of 10%. Should the
equipment be purchased?
(Continued)
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10-2
Equipment Example
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$(200,000)
$70,000
$60,000
$50,000
$40,000
$40,000
$ 63,630
$70,000 x 0.909 (n = 1; i =10%)
(Continued)
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10-2
Equipment Example
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$(200,000)
$70,000
$60,000
$50,000
$40,000
$40,000
$ 63,630
$ 49,560
$60,000 x 0.826 (n = 2; i = 10%)
(Continued)
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10-2
Equipment Example
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$(200,000)
$70,000
$60,000
$50,000
$40,000
$40,000
$ 63,630
$ 49,560
$ 37,550
$50,000 x 0.751 (n = 3; i = 10%)
(Continued)
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10-2
Equipment Example
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$(200,000)
$
$
$
$
63,630
49,560
37,550
27,320
$70,000
$60,000
$50,000
$40,000
$40,000
$40,000 x 0.683 (n = 4; i =10%)
(Continued)
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10-2
Equipment Example
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$(200,000)
$
$
$
$
$
63,630
49,560
37,550
27,320
24,840
$70,000
$60,000
$50,000
$40,000
$40,000
$40,000 x 0.621 (n = 5; i = 10%)
(Continued)
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10-2
Equipment Example
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$(200,000)
$
$
$
$
$
$
$70,000
$60,000
63,630
49,560
37,550
27,320
24,840
2,900 Net present value
$50,000
$40,000
$40,000
The equipment should be
purchased because the net
present value is positive.
Total present value of the net cash flow is $202,900
(Concluded)
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Present Value Index
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10-2
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 by using a
present value index.
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Present value index =
Present value index =
10-2
Total present value of
net cash flow
Amount to be invested
$202,900*
$200,000
= 1.0145
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Ranking Various Proposals Using a
Present Value Index
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10-2
Proposal A Proposal B Proposal C
Total present value of
net cash flow
$107,000
Amount to be invested 100,000
Net present value
$ 7,000
Present value index
$86,400
80,000
$ 6,400
$86,400
90,000
$ 3,600
1.07
$107,000
$100,000
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40
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10-2
Proposal A Proposal B Proposal C
Total present value of
net cash flow
$107,000
Amount to be invested 100,000
Net present value
$ 7,000
Present value index
1.07
$86,400
80,000
$ 6,400
$86,400
90,000
$ 3,600
1.08
$86,400
$80,000
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10-2
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Proposal A Proposal B Proposal C
Total present value of
net cash flow
$107,000
Amount to be invested 100,000
Net present value
$ 7,000
Present value index
1.07
$86,400
80,000
$ 6,400
1.08
$86,400
90,000
$ 3,600
0.96
$86,400
$90,000
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42
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10-2
Proposal A Proposal B Proposal C
Total present value of
net cash flow
$107,000
Amount to be invested 100,000
Net present value
$ 7,000
Present value index
1.07
$86,400
80,000
$ 6,400
$86,400
90,000
$ 3,600
1.08
Proposal B has the best present value
index. Management should consider
the possible use of the $20,000
difference between Proposal A and
Proposal B before making a decision.
0.96
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10-2
A proposal is made to acquire $200,000
of equipment with an expected useful
life of five years (no residual value) and
a minimum desired rate of return of
10%. The new equipment is expected
to generate a net cash inflow of
$50,000 each year. Should the firm
acquire the equipment?
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10-2
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Present Value
Equal Annual x Table Value
of an Annuity =
from Exhibit 2
Cash Flows
of $1
Present Value
Table Value
x
of an Annuity =
$50,000
from Exhibit 2
of $1
Refer to Exhibit 2
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Partial Present Value of an
Annuity Table
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10-2
Present Value of an Annuity of $1 at Compound Interest
Year 6%
1 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
3.605
3.353
2.991
6
4.917
3.791
3.791
4.355
4.111
3.785
3.326
7
5.582
4.868
4.564
4.160
3.605
8
6.210
5.335
4.968
4.487
3.837
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10-2
Present Value
of an Annuity = $50,000 x 3.791
of $1
$189,550
= $50,000 x 3.791
Present Value Index =
$189,550
= 0.948
$200,000
The proposal should be rejected because the
present value index is less than one.
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Advantage and Disadvantage of Net
Present Value Method
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10-2
Advantage:
 Considers cash flows and the time
value of money
Disadvantage:
 Assumes that cash received can be
reinvested at the rate of return
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10-2
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Example Exercise 10-3
A project has estimated annual net cash flows of
$50,000 for seven years and is estimated to cost
$240,000. Assume a minimum acceptable rate of
return of 12%. Using Exhibit 2, determine the (a) net
present value of the project and (b) the present value
index, rounded to two decimal places.
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10-2
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Follow My Example 10-3
(a) ($11,800) [($50,000 x 4.564) – $240,000]
(b) 0.95
($228,200/$240,000)
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For Practice: PE 10-3A, PE 10-3B
Internal Rate of Return Method
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10-2
The internal rate of return (IRR) method
(sometimes called the time-adjusted rate
of return method) uses present value
concepts to compute the rate of return
from the net cash flows expected from
capital investment proposals.
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10-3
Objective 3
List and describe
factors that
complicate capital
investment analysis.
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Factors that Complicate Capital
Investment Analysis
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





10-3
Income tax
Unequal proposal lives
Lease versus capital investment
Uncertainty
Changes in price levels
Qualitative considerations
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Capital Rationing
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10-4
Capital rationing is the
process by which
management allocates funds
among competing capital
investment proposals.
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