C Learning Objectives Power Notes 1.Nature of Capital Investment Analysis 2.Methods of Evaluating Capital Investment Proposals 3.Factors That Complicate Capital Investment Analysis 4.Capital Rationing Chapter 24 C24 Capital Investment Analysis Capital Investment Analysis

C Nature of Capital Investment Decisions Average Rate of Return; Cash Payback The Time Value of Money Present Value Analysis Other Considerations Slide # Power Note Topics Note: To select a topic, type the slide # and press Enter. Power Notes Chapter 24 Capital Investment Analysis Capital Investment Analysis

C Nature of Capital Investment Decisions 1.Management plans, evaluates, and controls investments in fixed assets. 2.Capital investments involve a long-term commitment of funds. 3.Investments must earn a reasonable rate of return. 4.Should include a plan for encouraging and rewarding employees for submitting proposals.

C Methods of Evaluating Capital Investments Average rate of return method Cash payback method Net present value method Internal rate of return method Methods that do not use present values Methods that do not use present values Methods that use present values Methods that use present values

C Easy to calculate Considers accounting income (often used to evaluate managers) Average Rate of Return Cash Payback Advantages: Ignores cash flows Ignores the time value of money Disadvantages: Considers cash flows Shows when funds are available for reinvestment Advantages:Disadvantages: Ignores profitability (accounting income) Ignores cash flows after the payback period

C Considers cash flows and the time value of money Net Present Value Internal Rate of Return Advantages: Assumes that cash received can be reinvested at the rate of return Disadvantages: Considers cash flows and the time value of money Ability to compare projects of unequal size Advantages:Disadvantages: Requires complex calculations Assumes that cash can be reinvested at the internal rate of return

C Average Rate of Return Method Machine cost$500,000 Expected useful life4 years Residual valuenone Expected total income$200,000 Assumptions: Assumptions: Average Rate of Return Estimated Average Annual Income Average Investment =

C Average Rate of Return Method Machine cost$500,000 Expected useful life4 years Residual valuenone Expected total income$200,000 Assumptions: Assumptions: Average Rate of Return Estimated Average Annual Income Average Investment = = $200,000 / 4 yrs. Average Rate of Return = ($500,000 + $0) / 2 20%

C Average Rate of Return Method Average annual income$30,000$36,000 Average investment$120,000$180,000 Average rate of return Assumptions: Assumptions: Average Rate of Return Estimated Average Annual Income Average Investment = Proposal AProposal B What is the average rate of return for each proposal?

C Average Rate of Return Method Average annual income$30,000$36,000 Average investment$120,000$180,000 Average rate of return25%20% Assumptions: Assumptions: Proposal AProposal B This method emphasizes accounting income which is commonly used in evaluating management performance.

C Cash Payback Method Investment cost$200,000 Expected useful life8 years Expected annual net cash flows (equal)$40,000 Assumptions: Assumptions: Cash Payback Period Total Investment Annual Net Cash Inflows = What is the cash payback period?

C Cash Payback Method Investment cost$200,000 Expected useful life8 years Expected annual net cash flows (equal)$40,000 Assumptions: Assumptions: = $200,000 Cash Payback Period = $40,000 5 years Cash Payback Period Total Investment Annual Net Cash Inflows =

C Year 1$ 60,000$ 60,000 Year 280,000140,000 Year 3105,000245,000 Year 4155,000400,000 Year 5100,000500,000 Year 690,000590,000 Assumptions: Assumptions: Net CashCumulative FlowNet Cash Flow Cash Payback Method If the proposed investment is $400,000, what is the payback period?

C Year 1$ 60,000$ 60,000 Year 280,000140,000 Year 3105,000245,000 Year 4155,000400,000 Year 5100,000500,000 Year 690,000590,000 Assumptions: Assumptions: Cash Payback Method If the proposed investment is $450,000, what is the payback period? Net CashCumulative FlowNet Cash Flow

C The Time Value of Money – Future Value The time value of money concept is used in many business decisions. This concept is an important consideration in capital investment analysis. Present Value Future Value $1,000 $ ???? What is the future value of $1,000 invested today (present value) at 8% per year?

C The Time Value of Money – Future Value The time value of money concept is used in many business decisions. This concept is an important consideration in capital investment analysis. Present Value Future Value $1,000 = $1,000 + ($1,000 x 8%) = $1,000 x 108% or 1.08 What is the future value of $1,000 invested today (present value) at 8% per year? $1,080

C The Time Value of Money – Present Value The time value of money concept is used in many business decisions. This concept is an important consideration in capital investment analysis. Present Value Future Value $ ???? What is the present value of $1,000 to be received one year from today at 8% per year? $1,000

C The Time Value of Money – Present Value The time value of money concept is used in many business decisions. This concept is an important consideration in capital investment analysis. Present Value Future Value $ = $1,000 / 108% or 1.08 What is the present value of $1,000 to be received one year from today at 8% per year? $1,000

C Calculating Present Values Present values can be determined using present value tables, mathematical formulas, calculators or computers. Present Value of $1 with Compound Interest =$1.0000/ 1.06 Calculator PV Table Period 6% One dollar at the end of one period at 6% per period is equal to $.9434 today (present value).

C Calculating Present Values Present values can be determined using present value tables, mathematical formulas, calculators or computers. Present Value of $1 with Compound Interest PV Table Period 6% One dollar at the end of two periods at 6% per period is equal to $.8900 today (present value). To use the value from the prior period as the starting point, don’t clear your calculator =$1.0000/ 1.06 $ =$.9434/ 1.06 Calculator

C Calculating Present Values Present values can be determined using present value tables, mathematical formulas, calculators or computers. Present Value of $1 with Compound Interest PV Table Period 6% One dollar at the end of three periods at 6% per period is equal to $.8396 today (present value) =$1.0000/ =$.9434/ 1.06 $ = $.8900/ 1.06 Calculator

C Calculating Present Values Present values can be determined using present value tables, mathematical formulas, calculators or computers. Present Value of $1 with Compound Interest =$1.0000/ =$.9434/ = $.8900/ = $.8396/ = $.7921/ = $.7432/ 1.06 PV Table Period 6% When using a calculator, learn to use constant division. You will then enter $1 and 1.06 the first time, pressing only the equal (=) key for each successive answer. Calculator

C Calculating Present Values of Annuities Present Value of $1 — Annuity of 1$ PV TableAnnuity Period 6% 6% Calculation Sum of Periods = Period = Periods 1– = Periods 1– = Periods 1– = Periods 1– The PV of an annuity of $1 to be received each year for two years is $ This is the sum of the PV of the two amounts for periods 1 and 2. Annuities represent a series of equal amounts to be paid or received in the future over equal periods.

C Calculating Present Values of Annuities Present Value of $1 — Annuity of 1$ PV TableAnnuity Period 6% 6% Calculation Sum of Periods = Period = Periods 1– = Periods 1– = Periods 1– = Periods 1– The PV of an annuity of $1 to be received each year for three years is $ This is the sum of the PV of the three amounts for periods 1–3. Annuities represent a series of equal amounts to be paid or received in the future over equal periods.

C Calculating Present Values of Annuities Annuities represent a series of equal amounts to be paid or received in the future over equal periods. Present Value of $1 — Annuity of 1$ PV TableAnnuity Period 6% 6% Calculation Sum of Periods = Period = Periods 1– = Periods 1– = Periods 1– = Periods 1– Total

C =$ 63, = 49, = 37, = 27, = 24, $202, , $ 2, Year 1$70,000 / 1.10(1 time)= Year 260,000 / 1.10(2 times)= Year 350,000 / 1.10(3 times)= Year 440,000 / 1.10(4 times)= Year 540,000 / 1.10(5 times)= Total present value Less investment Net present value Present value index Assumptions: Assumptions: Cash FlowPresent Value Present Value Method Investment$200,000 Useful life5 years Residual valuenone Minimum rate of return10%

C Total present value$107,000$86,400$93,600 Total investment100,00080,00090,000 Net present value$ 7,000$ 6,400$ 3,600 Present value index Assumptions: Assumptions: Proposals ABC What is the meaning of an index over 1.0? Present Value Method

C Internal Rate of Return Method Assume a rate of return and calculate the present value. Modify the rate of return and calculate a new present value. Continue until the present value approximates the investment cost. Use a computer function to calculate exactly the expected rate of return. The internal rate of return method uses the net cash flows to determine the rate of return expected from the proposal. The following approaches may be used: Trial and Error Trial and Error Computer Function Computer Function

C Qualitative Considerations 1.Improve product quality? 2.Reduce defects and manufacturing cycle time? 3.Increase manufacturing flexibility? 4.Reduce inventories and need for inspection? 5.Eliminate non-value-added activities? Improvements that increase competitiveness and quality are difficult to quantify. The following qualitative factors are important considerations.

C The Capital Rationing Process 1.Identify potential projects. 2.Eliminate projects that do not meet minimum cash payback or average rate of return expectations. 3.Evaluate the remaining projects, using present value methods. 4.Consider the qualitative benefits of all projects. 5.Rank the projects and allocate available funds.

C Note: To see the topic slide, type 2 and press Enter. This is the last slide in Chapter 24. Power Notes Chapter 24 Capital Investment Analysis Capital Investment Analysis