Capital Investment Analysis Chapter 25 Capital Investment Analysis Accounting, 21st Edition Warren Reeve Fess © Copyright 2004 South-Western, a division of Thomson Learning. All rights reserved. Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc. PowerPoint Presentation by Douglas Cloud Professor Emeritus of Accounting Pepperdine University

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After studying this chapter, you should be able to: Objectives 1. Explain the nature and importance of capital investment analysis. 2. Evaluate capital investment proposals, using the following methods: average rate of return, cash payback, net present value, and internal rate of return. 3. List and describe factors that complicate capital investment analysis. 4. Diagram the capital rationing process. After studying this chapter, you should be able to:

Nature of Capital Investment Analysis Capital budgeting is the process by which management plans, evaluates, and controls long-term investments in fixed assets.

Nature of Capital Investment Analysis 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. The process should include a plan for encouraging and rewarding employees for submitting proposals.

Methods of Evaluating Capital Investment Proposals Here’s a survey of business practices in a variety of industries. It reports the capital investment analysis methods used by large U.S. companies.

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% Average rate of return 15% Cash payback method Net present value method Internal rate of return method 15% 53% 85% 76% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

Average Rate of Return Method Methods that Ignore Present Value Average Rate of Return Method Advantages: Easy to calculate Considers accounting income (often used to evaluate managers) Disadvantages: Ignores cash flows Ignores the time value of money

Average Rate of Return Method Assumptions: Machine cost $500,000 Expected useful life 4 years Residual value none Expected total income $200,000 Estimated Average Annual Income Average Rate of Return = Average Investment Average Rate of Return = $200,000 ÷ 4 years ($500,000 + $0) / 2 20%

Average Rate of Return Method Assumptions: Proposal A Proposal B Average annual income $ 30,000 $ 36,000 Average investment $120,000 $180,000 $30,000 $120,000 = 25%

Average Rate of Return Method Assumptions: Proposal A Proposal B Average annual income $ 30,000 $ 36,000 Average investment $120,000 $180,000 $36,000 $180,000 = 20%

Methods that Ignore Present Value Cash Payback Method Advantages: Considers cash flows Shows when funds are available for reinvestment Disadvantages: Ignores profitability (accounting income) Ignores cash flows after the payback period

Cash Payback Method Assumptions: Investment cost $200,000 Expected useful life 8 years Expected annual net cash flows (equal) $40,000 Cash Payback Period Total Investment Annual Net Cash Inflows = Cash Payback Period $200,000 = $40,000 = 5 years

Cash Payback Method Net Cash Cumulative Flow Net Cash Flow Year 1 $ 60,000 $ 60,000 Year 2 80,000 140,000 Year 3 105,000 245,000 Year 4 155,000 400,000 Year 5 100,000 500,000 Year 6 90,000 590,000 If the proposed investment is $400,000, the payback period is at the end of Year 4.

Present Value Methods The time value of money concept is used in many business decisions. This concept is an important consideration in capital investment analysis. Present Value $ 925.93 = $1,000 ÷ 1.08 $ ???? What is the present value of $1,000 to be received one year from today at 8% per year?

Present Value Methods How much would have to be invested on February 1, 2006, in order to receive $1,000 on February 1, 2009, if the interest rate compounded annually is 12%?

$1,000, 3 years, 12% compounded annually Present Value Methods Refer to the partial present value table in Slide 18 to answer the question. $1,000, 3 years, 12% compounded annually

Calculating Present Values Present Value of $1 with Compound Interest Present values can be determined using present value tables, mathematical formulas, a calculator or a computer. Present Value of $1 with Compound Interest Year 6% 10% 12% 15% 20% 1 0.943 0.909 0.893 0.870 0.833 2 0.890 0.826 0.797 0.756 0.694 3 0.840 0.751 0.712 0.658 0.579 4 0.792 0.683 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 0.712 $1,000 x .712 = $712

Present Value of an Amount If $712 is invested on February 1, 2006, at an annual rate of 12 percent, $1,000 will accumulate by February 1, 2009. $1,000 x .712 = $712

Present Value of an Amount $712 x 1.12 $797 x 1.12 $893 x 1.12 $1,000 Feb. 1 2009 Feb. 1 2006 Feb. 1 2007 Feb. 1 2008

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 sum of these net cash flows.

Present Value of an Annuity What would be the present value of a $100 annuity for five periods at 12?

Calculating Present Values of Annuities Present Value of an Annuity of $1 Year 6% 10% 12% 15% 20% 1 0.943 0.909 0.893 0.870 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 3.791 3.605 3.353 2.991 6 4.917 4.355 4.111 3.785 3.326 3.605 3.605 x $100 = $360.50

Net Present Value Method The net present value method analyzes capital investment proposals by comparing the initial cash investment with the present value of the net cash flows. Net Present Value Method

Net Present Value Method Advantage: Considers cash flows and the time value of money Disadvantage: Assumes that cash received can be reinvested at the rate of return

Net Present Value Method At the beginning of 2006, 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. Cash Flow Present Value

Net Present Value Method A net cash flow of $70,000 is expected at the end of 2006. This net cash flow is expected to decline $10,000 each year (except 2010) until the machine is retired. The firm expects a minimum rate of return of 10%. Should the equipment be purchased? Cash Flow Present Value

Net Present Value Method First, we must determine which table to use… the present value of $1 or the present value of an annuity of $1.

Net Present Value Method Because there are multiple years of net cash flows, shouldn’t we use the present value of an annuity of $1?

Net Present Value Method That would be true if the net cash flows remained constant from 2006 through 2010. Note that the net cash flows are $70,000, $60,000, $50,000, $40,000, and $40,000, respectively.

Net Present Value Method So, we have to use the present value of $1 for each of the five years.

Net Present Value Method Jan. 1 2006 Dec. 31 2007 2008 2009 2010 $<200,000> $70,000 $60,000 $50,000 $40,000 $40,000 $ 63,630 $70,000 x 0.909 (n = 1; i = 10%) $ 49,560 $60,000 x 0.826 (n = 2; i = 10%) $ 37,550 $50,000 x 0.751 (n = 3; i = 10%) $ 27,320 $40,000 x 0.683 (n = 4; i = 10%) $ 24,840 $40,000 x 0.621 (n = 5; i = 10%)

Net Present Value Method Jan. 1 2006 Dec. 31 2007 2008 2009 2010 The equipment should be purchased because the net present value is positive. $<200,000> $70,000 $60,000 $50,000 $40,000 $40,000 $ 63,630 $ 49,560 $ 37,550 $ 27,320 $ 24,840 $ 2,900

Net Present Value Method 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 using a present value index.

Net Present Value Method Proposals A B C Assumptions: Total present value $107,000 $86,400 $93,600 Total investment 100,000 80,000 90,000 Net present value $ 7,000 $ 6,400 $ 3,600 Present value index 1.07 1.08 1.04 $107,000 ÷ $100,000 The most desirable proposal according to the present value index. $86,400 ÷ $80,000 $93,600 ÷ $90,000

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

Internal Rate of Return Method 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 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. Computer Function Use a computer function to calculate exactly the expected rate of return.

Internal Rate of Return Method Management is evaluating a proposal to acquire equipment costing $97,360. The equipment is expected to provide annual net cash flows of $20,000 per year for seven years.

Internal Rate of Return Method Determine the table value using the present value for an annuity of $1 table. Step 1: Amount to be invested Equal annual cash flow $97,360 $20,000 = 4.868

Present Value of an Annuity of $1 Internal Rate of Return Method Step 2: Find the seven year line on the table. Then, go across the seven-year line until the closest amount to 4.868 is located. Present Value of an Annuity of $1 1 0.943 0.909 0.893 0.870 2 1.833 1.736 1.690 1.626 3 2.673 2.487 2.402 2.283 4 3.465 3.170 3.037 2.855 5 4.212 3.791 3.605 3.353 6 4.917 4.355 4.111 3.785 7 5.582 4.868 4.564 4.160 Year 6% 10% 12% 15%

Present Value of an Annuity of $1 Internal Rate of Return Method Present Value of an Annuity of $1 Year 6% 10% 12% 15% 1 0.943 0.909 0.893 0.870 2 1.833 1.736 1.690 1.626 3 2.673 2.487 2.402 2.283 4 3.465 3.170 3.037 2.855 5 4.212 3.791 3.605 3.353 6 4.917 4.355 4.111 3.785 7 5.582 4.868 4.564 4.160 4.868

Present Value of an Annuity of $1 Internal Rate of Return Method Step 3: Move vertically to the top of the table to determine the interest rate. Present Value of an Annuity of $1 Year 6% 10% 12% 15% 10% 1 0.943 0.909 0.893 0.870 2 1.833 1.736 1.690 1.626 3 2.673 2.487 2.402 2.283 4 3.465 3.170 3.037 2.855 5 4.212 3.791 3.605 3.353 6 4.917 4.355 4.111 3.785 7 5.582 4.868 4.564 4.160 10% 4.868

Factors That Complicate Capital Investment Analysis Income tax Unequal proposal lives Lease versus capital investment Uncertainty Changes in price levels Qualitative considerations

Qualitative Considerations Improvements that increase competitiveness and quality are difficult to quantify. The following qualitative factors are important 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

Capital Rationing 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.

Chapter 25 The End