Capital Investment Analysis ACG 2071 Module 12 Chapter 25 Fall 2007

Capital Budgeting Is the process by which management plans, evaluates, and controls investments in fixed assets Involves long term commitment of funds Must earn a reasonable rate of return

Methods Methods – not using present value Average rate return Cash payback period Present Value Methods Net present value method Present value index Internal rate of return

Methods – not using PV Used to screen proposals Minimum standards are set for accepting or not

Average rate of return ARR = Average annual income Average investment Where Average investment is one half of the original cost

Example 1: Suppose that the company is considering the purchase of a machine at a cost of $500,000. The machine is expected to have a useful life of 4 years, with no residual value and to yield total income of $200,000. Compute the average rate of return.

Average of Rate of Return Average Rate of Return = Average annual income Average investment Average annual income = $200,000/4 = $50,000 Average investment = $500,000/2 = $250,000 ARR = 50,000/250,000 = 20%

Example 2: Suppose a corporation has an investment with a cost of $400,000 and average annual income of $20,000 what is the ARR?

Cash Payback Period Looks for project with the shortest period to recover the original investment Net cash Flow = excess cash flow from revenues – expenses Cash payback period = number of years to recover cash invested

Cash Payback Period EVEN cash flows formula: Original investment Net cash flow = number of years to payback investment

Example 3: Suppose that the company is considering the purchase of a machine at a cost of $400,000. The machine is expected to have net cash flow if $100,000. What is the cash payback period? Original investment = $400,000 = 4 years Net cash flow $100,000

Example 4: Suppose machine with cost of $500,000 and net cash flow of $75,000 per year. What is the payback period?

Uneven Cash Flows: Uneven cash flows Cost is $300,000 then subtract the flows YearCash Flows 1$60, , , , , ,000

Example: YearCash FlowsBalance at end of year 1$60,000$300,000 - $60,000 = $240, ,000$240,000 - $80,000 = $160, ,000$160,000 - $105,000 = $55, ,000$55,000 - $155,000 = end 5100, ,000

Present value methods Investment in fixed assets may be reviewed as acquiring a series of net cash flows over a period of time Time is an important factor in determining the value of an investment

Present value of $1 It allows you to compare monies received today to monies received at a future date Due to the fact that money has a value - interest The quicker that you receive the money the more it is worth

Net Present Value Method Analyze capital investment proposals by comparing the initial cash investment with the present value of the net cash flows Called discounted cash flow method Rate is set my management If Net present value > original investment then go ahead with project

Discounted Cash Flow Method Total present value of net cash flow = Net cash flow x PV of Annuity Then: Net cash flow X PV of Annuity LESS original investment > 0 then take the project

Present Value of an Annuity Year6%10%12%15%20%

Present value tables Year6%10%12%15%20%

Example 5: Suppose that a proposal to acquire $200,000 of equipment with an expected useful life of five years and a minimum desired rate of return of 10%. The net cash flow is $70,000. Should we accept the project?

Example 5: cash flow x PV of Annuity $70,000 x = $221,900 Net cash flow $221,900 Original investment $200,000 Discounted cash flow 21,900 Since positive accept the proposal

Example 6: Same as 5 but uneven cash flows YearCash Flows 1$70, , , ,000 6 NPV $70,000 * = 62,510 $60,000 * = 47,820 40,000 * = 28,480 40,000*.636 = $25,440 20,000 * = 11,340 20,000 * = 10,140 TOTAL $185,730

Example Add the Net present values = $185,730 Cost of project is $350,000 Since project is more expensive than return Decline the deal

Example 7: Cost of project $200,000 for 4 years Cash flows are $90,000 $60,000 $50,000 $40,000 Rate is 10%

Example 7: Cost is $200,000 NPV is $212,760 Difference is positive Keep the deal YearCash Flow NPV 1$90,000$81,810 2$80,00066,080 3$50,00037,550 4$40,00027,320 Total212,760

Present value index = total present value of net cash flow/amount to be invested Select highest index among the projects ProposalABC PV cash flows$107,000$86,400$93,600 Original Investment100,00080,00090,000 NPV7,0006,4003,600 Index

Internal Rate of Return Uses present value concepts to compute the rate of return from the net cash flows PV of Cash Flows = Annual cash flows X PV factor NPV = PV cash flows – cost of investment If NPV > 0 then accept the proposal

Factors complicating capital investment analysis Income tax Unequal proposal lives Lease versus capital investment Uncertainty Inflation Qualitative consideration