Capital Investment Decisions Management Accounting: The Cornerstone for Business Decisions Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

Learning Objectives 1.Explain what a capital investment decision is and distinguish between independent and mutually exclusive capital investment decisions. 2.Compute the payback period and accounting rate of return for a proposed investment and explain their roles in capital investment decisions. 3.Use net present value analysis for capital investment decisions involving independent projects.

Learning Objectives 4.Use the internal rate of return to assess the acceptability of independent projects. 5.Explain the role and value of post audits. 6.Explain why NPV is better than IRR for capital investments decisions involving mutually exclusive projects.

How to calculate payback. Payback period = original investment / annual cash flow Suppose that an new car wash facility requires an investment of $120,000 and has either: a.Even cash flows of $40,000 per year or b. The following annual cash flows $20,000, $40,000, $40,000, $50,000, and $30,000 REQUIRED: Calculate the payback period for each case. Calculation: 13-1

b. How to calculate payback. 13-1

List Four Ways Payback Can be Used by Managers

How to calculate the accounting rate of return (ARR). ARR = Average Income / Initial Investment Assume that an investment requires an investment requires an initial outlay of $140,000. The life of the investment is 5 years with following income stream: $30,000, $40,000, $40,000 $50,000, and $40,000. REQUIRED: Calculate the accounting rate of return. Calculation: 13-2

How to assess cash flows and calculate NPV. A market study revealed expected annual revenues of $320,000 for the new cordless headset. Equipment to produce the cordless headset would cost $350,000. After five years, the equipment can be sold for $50,000. In addition, to the equipment, working capital is expected to increase $40,000 because of increases in inventories and receivables. The firm expects to recover the investment in working capital at the end of the project’s life. Annual cash operating expenses are estimated at $175,000. The required rate of return is 12%. REQUIRED: Estimate the annual cash flows and calculate the NPV. 13-3

Step 1. Cash- Flow Identification YearItemCash Flow 0Equipment Working capital Total 1-4Revenues Operating expenses Total 5Revenues Operating expenses Salvage value Recovery of working capital Total How to assess cash flows and calculate NPV. 13-3

Step 2A NPV Analysis Year Cash FlowDiscount FactorPresent Value Net Present Value How to assess cash flows and calculate NPV. 13-3

Step 2B NPV Analysis YearCash FlowDiscount FactorPresent Value Net Present Value How to assess cash flows and calculate NPV. 13-3

How to calculate IRR with Uniform Cash flows. Assume that a hospital has the opportunity to invest $160,000 in a blood analyzer that will produce a net cash flow of $57,184 in each of the next four years. REQUIRED: Calculate the IRR for the blood analyzer. Calculation: 13-4

Multiple Period Settings With Uneven Cash Flows The simple truth is performing IRR is one of the easiest tasks there is in Excel. It is a matter of listing outflows in a column as negative amounts and then in the same column inflows as positive amounts. Simply follow the directions in the Excel drop down box and it will take less than a couple of seconds to get a precise answer.

Define and Describe a Post Audit

What are the benefits of a post audit?

Compare NPV to IRR

How to calculate NPV & IRR for mutually exclusive projects. Consider two pollution prevention projects. Design Papa and Oscar. Both have a project life of 7 years. Design Papa requires an outlay of $140,000 and has a net after-tax inflow of $40,000 (revenues of $180,000 minus costs of $140,000). Design Oscar, with an initial outlay of $300,000 has a net annual cash inflow of $50,000 ($240,000 - $190,000). The after-tax cash flows are summarized as follows: 13-5

Cash Flow Pattern YearDesign PapaDesign Oscar 0$(240,000)$(300,000) 140,00050, ,00050, ,00050, ,00050, ,00050, ,00050, ,00050,000 The cost of capital for the company is 12%. REQUIRED: Calculate the NPV & the IRR for each. How to calculate NPV & IRR for mutually exclusive projects. 13-5

Calculation:Design Papa: NPV Analysis How to calculate NPV & IRR for mutually exclusive projects. 13-5

Design Oscar: NPV Analysis How to calculate NPV & IRR for mutually exclusive projects. 13-5