ACCOUNTING FUNDAMENTALS FOR MANAGERS University of Management and Technology 1901 North Fort Myer Drive Arlington, VA 22209 Voice: (703) 516-0035 Fax: (703) 516-0985 Website: www.umtweb.edu

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Capital Investment Analysis Chapter 15 Capital Investment Analysis

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

Learning Objectives Diagram the capital rationing process.

1 Explain the nature and importance of capital investment analysis. Learning Objective 1 Explain the nature and importance of capital investment analysis.

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.

Learning Objective 2 Evaluate capital investment proposals using the following methods: average rate of return, cash payback, net present value, and internal rate of return.

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

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

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

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 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 yrs. = = 20% ($500,000 + $0) / 2

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

Average Rate of Return Method Assumptions: Proposal A Proposal B Average annual income $30,000 $36,000 Average investment $120,000 $180,000 Average rate of return 25% 20% This method emphasizes accounting income which is commonly used in evaluating management performance.

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 What is the cash 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 = = 5 years $40,000

Cash Payback Method Assumptions: 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, what is the payback period?

Cash Payback Method Assumptions: 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 $450,000, what is the payback period?

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 $1,000 What is the future value of $1,000 invested today (present value) at 8% per year? Future Value $ ????

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 $1,000 What is the future value of $1,000 invested today (present value) at 8% per year? Future Value = $1,000 + ($1,000 x 8%) = $1,000 x 108% or 1.08 $1,080

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 $ ???? What is the present value of $1,000 to be received one year from today at 8% per year? Future Value $1,000

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 $ 925.93 = $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? Future Value $1,000

Calculating Present Values Present Value of $1 with Compound Interest 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% Calculator 1 .9434 = $1.0000 / 1.06 One dollar at the end of one period at 6% per period is equal to $.9434 today (present value).

Calculating Present Values Present Value of $1 with Compound Interest 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% Calculator 1 .9434 = $1.0000 / 1.06 2 .8900 = $ .9434 / 1.06 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.

Calculating Present Values Present Value of $1 with Compound Interest 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% Calculator 1 .9434 = $1.0000 / 1.06 2 .8900 = $ .9434 / 1.06 3 .8396 = $ .8900 / 1.06 One dollar at the end of three periods at 6% per period is equal to $.8396 today (present value).

Calculating Present Values Present Value of $1 with Compound Interest 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% Calculator 1 .9434 = $1.0000 / 1.06 2 .8900 = $ .9434 / 1.06 3 .8396 = $ .8900 / 1.06 4 .7921 = $ .8396 / 1.06 5 .7432 = $ .7921 / 1.06 6 .7050 = $ .7432 / 1.06 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.

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 Table Annuity Period 6% 6% Calculation Sum of Periods 1 .9434 .9434 = Period 1 2 .8900 1.8334 = Periods 1–2 3 .8396 2.6730 = Periods 1–3 4 .7921 3.4651 = Periods 1–4 5 .7432 4.2124 = Periods 1–5 4.2124 The PV of an annuity of $1 to be received each year for two years is $1.8334. This is the sum of the PV of the two amounts for periods 1 and 2.

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 Table Annuity Period 6% 6% Calculation Sum of Periods 1 .9434 .9434 = Period 1 2 .8900 1.8334 = Periods 1–2 3 .8396 2.6730 = Periods 1–3 4 .7921 3.4651 = Periods 1–4 5 .7432 4.2124 = Periods 1–5 4.2124 The PV of an annuity of $1 to be received each year for three years is $2.6730. This is the sum of the PV of the three amounts for periods 1–3.

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 Table Annuity Period 6% 6% Calculation Sum of Periods 1 .9434 .9434 = Period 1 2 .8900 1.8334 = Periods 1–2 3 .8396 2.6730 = Periods 1–3 4 .7921 3.4651 = Periods 1–4 5 .7473 4.2124 = Periods 1–5 4.2124 Total

Net Present Value Method Investment $200,000 Useful life 5 years Residual value none Minimum rate of return 10% Assumptions: Cash Flow Present Value Year 1 $70,000 / 1.10 (1 time) = Year 2 60,000 / 1.10 (2 times) = Year 3 50,000 / 1.10 (3 times) = Year 4 40,000 / 1.10 (4 times) = Year 5 40,000 / 1.10 (5 times) = Total present value Less investment Net present value Present value index = $ 63,636.36 = 49,586.78 = 37,565.74 = 27,320.54 = 24,836.85 $202,946.27 200,000.00 $ 2,946.27 1.015

Net Present Value Method Assumptions: Proposals A B C 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 What is the meaning of an index over 1.0?

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. Use a computer function to calculate exactly the expected rate of return. Computer Function

Learning Objective 3 List and describe factors that complicate capital investment analysis.

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?

Learning Objective 4 Diagram the capital rationing process.

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.