1. 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

2. Some of the action has been automated, so click the mouse when you see this lightning bolt in the lower right-hand corner of the screen. You can point and click anywhere on the screen.

3. 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:

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

5. 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.

6. 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.

7. 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% % 20% 30% 40% 50% 60% 70% 80% 90%

8. 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

9. 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%

10. 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%

11. 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%

12. 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

13. 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

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

15. 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 $
= $1,000 ÷ 1.08
$ ????
What is the present value of $1,000 to be received one year from today at 8% per year?

16. 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%?

17. $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

18. 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 % % % % %
0.712
$1,000 x .712 = $712

19. 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

20. 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

21. 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.

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

23. Calculating Present Values of Annuities
Present Value of an Annuity of $1
Year % % % % %
3.605
3.605 x $100 = $360.50

24. 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

25. 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

26. 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

27. Net Present Value Method
A net cash flow of $70,000 is expected at the end of 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

28. 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.

29. 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?

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

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

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

33. 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, $60, $50, $40, $40,000
$ 63,630
$ 49,560
$ 37,550
$ 27,320
$ 24,840
$ ,900

34. 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.

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

36. 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

37. 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.

38. 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.

39. 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

40. 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 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% % % %

41. Present Value of an Annuity of $1
Internal Rate of Return Method
Present Value of an Annuity of $1
Year 6% % % %
4.868

42. 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%
10%
4.868

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

44. 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

45. 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.

46. Chapter 25
The End