19
Capital Investment
19-1
Payback and Accounting Rate of
Return: Nondiscounting
Methods
2
Payback Period: the time required for a firm to recover its
original investment.
When the cash flows of a project are assumed to be
even, the following formula can be used to compute the
project’s payback period:
Payback period = original investment/annual cash
flow
If the cash flows are uneven, the payback period is
computed by adding the annual cash flows until such time
as the original investment is recovered.
19-2
Payback and Accounting Rate of
Return: Nondiscounting
Methods
2
• The payback period provides information to
managers that can be used as follows:
• To help control the risks associated with the
uncertainty of future cash flows.
• To help minimize the impact of an investment on a
firm’s liquidity problems.
• To help control the risk of obsolescence.
• To help control the effect of the investment on
performance measures.
19-3
Payback and Accounting Rate of
Return: Nondiscounting
Methods
2
Accounting Rate of Return (ARR)
Measures the return on a project in terms of income, as opposed
to using a project’s cash flow
Accounting rate of return = Average income /Original
investment
Where:
Average income = average annual net cash
flows less average depreciation
Original investment (or average investment) =
(I+S)/2 (I is the original investment and S is the
salvage value). Assume that the investment is
uniformly consumed.
The major deficiency of the accounting rate of return is that it
ignores the time value of money.
19-4
The Net Present Value Method
3
• Net Present value is the difference between the
present value of the cash inflows and outflows
associated with a project:
NPV = P - 1
Where:
P = the present value of the
project’s future cash inflows
I = the present value of the project’s
cost (usually the initial outlay)
NPV measures the profitability of an investment. If the NPV is
positive, it measures the increase in wealth
19-5
The Net Present Value Method
3
Decision Criteria for NPV
If the NPV is positive, it signals that
1) The initial investment has been recovered
2) The required rate of return has been recovered
3) A return in excess of (1) and (2) has been received
Reinvestment Assumption: The NVP model assumes
that all cash flows generated by a project are
immediately reinvested to earn the required rate of
return throughout the life of the project.
19-6
Internal Rate of Return
4
The internal rate of return (IRR) is 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.
19-7
Internal Rate of Return
4
Decision Criteria:
If the IRR>Cost of Capital, the project should be
accepted.
If the IRR = Cost of Capital, acceptance or rejection is
equal.
If the IRR < Cost of Capital, the project should be
rejected.
19-8
NPV versus ITT: Mutually
Exclusive Projects
5
There are two major differences between net present
value and the internal rate of return:
• NPV assumes cash inflows are reinvested at the
required rate of return, whereas the IRR method
assumes that the inflows are reinvested at the
internal rate of return.
• NPV measures the profitability of a project in
absolute dollars, whereas the IRR methods
measures it as a percentage.
19-9
Computing After-Tax
Cash Flows
•
6
To analyze tax effects, cash flows are usually
broken into three categories:
1. The initial cash outflows needed to acquire the
assets of the project
2. The cash flows produced over the life of the
project (operating cash flows)
3. The cash flows from the final disposal of the
project
19-10
Computing After-Tax Cash Flows 6
MACRS Depreciation
The taxpayer can use either the straight-line or the modified
accelerated cost recovery system (MACRS) to compute annual
depreciation with a half year convention
The tax laws classify most assets into the following three
classes (class = allowable years for depreciation):
Class 3: most small tools
Class 5: cars, light trucks, computer equipment
Class 7: machinery, office equipment
19-11
Capital Investment: Advanced
Technology and Environmental
Considerations
7
How Estimates of Operating Cash Flows Differ
A company is evaluating a potential investment in a flexible manufacturing
system (FMS). The choice is to continue producing with its traditional
equipment, expected to last 10 years, or to switch to the new system, which
is also expected to have useful life of 10 years. The company’s discount rate
is 12 percent.
Present value ($4,000,000 * 5.65)
Investment
Net Present Value
$22,600,000
18,000,000
$ 4,600,000
19-12