Financial and Managerial Accounting Wild, Shaw, and Chiappetta Fifth Edition McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. 1

Capital Budgeting & Investment Analysis Chapter 24 Capital Budgeting & Investment Analysis 24-2

Conceptual Learning Objectives C1: Describe the selection of a hurdle rate for an investment. 24-3

Analytical Learning Objectives A1: Analyze a capital investment project using break-even time. 24-4

Procedural Learning Objectives P1: Compute payback period and describe its use. P2: Compute accounting rate of return and explain its use. P3: Compute net present value and describe its use. P4: Compute internal rate of return and explain its use. 24-5

Capital Budgeting Large amounts of money are usually involved. Outcome is uncertain. Large amounts of money are usually involved. Investment involves a long-term commitment. Decision may be difficult or impossible to reverse. Capital budgeting: Analyzing alternative long- term investments and deciding which assets to acquire or sell. 24-6

Payback Period P1 The payback period of an investment is the time expected to recover the initial investment amount. Payback period = Cost of investment Annual net cash flow Click to add notes Net cash flow = Cash inflows – Cash outflows. Managers prefer investing in projects with shorter payback periods. 24-7

Using the Payback Period Ignores the time value of money. Unacceptable for projects with long lives where time value of money effects are major. Ignores cash flows after the payback period. 24-8

Accounting Rate of Return (Return on Average Investments) P2 The accounting rate of return focuses on annual income instead of cash flows. Accounting Annual after-tax net income rate of return Annual average investment = Beginning book value + Ending book value 2 24-9

Net Present Value Decision Rule When an asset’s expected cash flows are discounted at the required rate and yield a positive net present value, then the asset should be acquired. Accept project If >0$ Present value of net cash flows ($) Amount invested ($) Net present value ($) Reject project If < 0$ 24-10

Using Net Present Value C1 General decision rule . . . 24-11

Internal Rate of Return (IRR) P4 The interest rate that makes . . . Present value of cash inflows Present value of cash outflows =  The net present value equal zero. 24-12

Internal Rate of Return (IRR) (Exhibit 24.9) P4 1. Determine the present value factor. $12,000 ÷ $5,000 per year = 2.4000 2. Using present value of annuity table . . . IRR is approximately 12%. IRR is the interest rate of the column in which the present value factor is found. 24-13

Using Internal Rate of Return P4 Compare the internal rate of return on a project to a predetermined hurdle rate, which is a minimum acceptable rate of return. To be acceptable, a project’s rate of return cannot be less than the hurdle rate. If >0% Accept project Internal rate of return (%) Hurdle rate (%) Reject project If < 0% 24-14

Comparing Methods C1 24-15

Break-Even Time A1 Break-even time incorporates time value of money into the payback period method of evaluating capital investments. 24-16

End of Chapter 24 24-17