1. Capital Investment Analysis
Principles of Financial and Managerial Accounting
11e
Principles of Managerial Accounting
11e
Chapter 25
Principles of Financial and Managerial Accounting
Using excel for Success
Student Version
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Prepared by: C. Douglas Cloud
Professor Emeritus of Accounting
Pepperdine University
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Reeve Warren Duchac

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

3. Nature of Capital Investment Analysis
LO 1
Nature of Capital Investment Analysis
Capital investment analysis (or capital budgeting) is the process by which management plans, evaluates, and controls investments in fixed assets.
The time value of money concept recognizes that a dollar today is worth more than a dollar tomorrow because today’s dollar can earn interest.

4. Learning Objective 2
Evaluate capital investment proposals using the average rate of return and cash payback methods.

5. Average Rate of Return Method
LO 2
Average Rate of Return Method
The average rate of return, sometimes called the accounting rate of return, measures the average income as a percent of the average investment. The average rate of return is computed as follows:
Average Rate
of Return
Estimated Average
Annual Income
Average Investment =
(Initial Cost + Residual Value)/2

6. Average Rate of Return Method
LO 2
Average Rate of Return Method
Management is evaluating the purchase of a new machine as follows:
Machine cost $500,000
Residual value 0
Estimated total income from machine 200,000
Expected useful life 4 years
Average Rate
of Return
Estimated Average
Annual Income
Average Investment =
Average Rate
of Return
$200,000/4
($500,000 + $0)/2 =
= 20%

7. Average Rate of Return Method
LO 2
Average Rate of Return Method
The average rate of return of 20% should be compared to the minimum rate of return required by management. If the average rate of return equals or exceeds the minimum rate, the machine should be purchased or considered for further analysis.

8. Average Rate of Return Method
LO 2
Average Rate of Return Method
The average rate of return has the following three advantages:
It is easy to compute.
It includes the entire amount of income earned over the life of the proposal.
It emphasizes accounting income.

9. Average Rate of Return Method
LO 2
Average Rate of Return Method
The average rate of return has the following two disadvantages:
It does not directly consider the expected cash flows from the proposal.
It does not directly consider the timing of the expected cash flows.

10. LO 2
Cash Payback Method
The expected period of time that will pass between the date of an investment and the complete recovery in cash of the amount invested is the cash payback period.
When annual net cash inflows are equal, the cash payback period is computed as follows:
Cash
Payback Period
Initial Cost
Annual Net
Cash Inflow =

11. Cash Payback Method LO 2 Cost of new machine $200,000
Cash revenue from machine per year 50,000
Expenses of machine per year 30,000
Depreciation per year 20,000
Net cash inflow per year:
Cash revenue from machine $50,000
Less cash expenses of machine:
Expenses of machine $30,000
Less depreciation 20, ,000
Net cash inflow per year $40,000
(continued)

12. LO 2
Cash Payback Method
The time required for the net cash inflow to equal the cost of the new machine is the payback period. The estimated cash payback period for the investment in the machine is five years, as computed below.
Cash
Payback Period
Initial Cost
Annual Net
Cash Inflow =
= 5 years
Cash
Payback Period
$200,000
$40,000 =

13. LO 2
Cash Payback Method
The cash payback method has the following two advantages:
It is simple to use and understand.
It analyzes cash flows.
The cash payback method has the following two disadvantages:
It ignores cash flows occurring after the payback period.
It does not use present value concepts in valuing cash flows occurring in different periods.

14. Learning Objective 3
Evaluate capital investment proposals using the net present value and internal rate of return methods.

15. Present Value Concepts
LO 3
Present Value Concepts
Both the net present value and the internal rate of return methods use the following two present value concepts:
Present value of an amount
Present value of an annuity

16. Present Value of an Amount
LO 3
Present Value of an Amount
Using the PV of $1 Table
On January 1, 2012, what is the present value of $1.404 to be received on December 31, 2014 (assuming an interest rate of 12 percent)? To determine the answer, we need to go to Exhibit 1 (in your textbook) and find the table value for three years at 12 percent.

17. Present Value of an Annuity
LO 3
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 amount of cash needed today to yield a series of equal net cash flows at fixed time intervals in the future.

18. Present Value of an Annuity
LO 3
Present Value of an Annuity
The present value of a $100 annuity for five periods at 12% could be determined by using the present value factors in Exhibit 1. This is shown below.

19. Net Present Value Method
LO 3
Net Present Value Method
Assume the following data for a proposed investment in new equipment:
Cost of new equipment $200,000
Expected useful life 5 years
Minimum desired rate of return 10%
Expected cash flows to be received each year:
Year 1 $70,000
Year 2 60,000
Year 3 50,000
Year 4 40,000
Year ,000
Total expected cash flows $260,000

20. Net Present Value Method
LO 3
Net Present Value Method
Using the present value of $1 (Exhibit 1) at 10%, the present value of the net cash flow for each year is shown below.

21. Net Present Value Method
LO 3
Net Present Value Method
The net present value of $2,900 indicates that the purchase of the new equipment is expected to recover the investment and provide more than the minimum rate of return of 10%.

22. Total Present Value of Net Cash Flow
Net Present Value Method
Capital investment proposals can be ranked by using a present value index. The present value index is computed as follows:
Total Present Value of Net Cash Flow
Amount to Be Invested
Present Value Index =

23. Total Present Value of Net Cash Flow
Net Present Value Method
The present value index for the investment in the preceding slides is , as computed below.
Total Present Value of Net Cash Flow
Amount to Be Invested
Present Value Index =
Present Value Index =
$202,900
$200,000 =

24. Net Present Value Method
LO 3
Net Present Value Method
A company is considering three proposals. The net present value and the present value index for each proposal are as follows:
Most desirable proposal

25. Net Present Value Method
LO 3
Net Present Value Method
The net present value method has the following three advantages:
It considers the cash flows of the investment.
It considers the time value of money.
It can rank equal lived projects using the present value index.

26. Net Present Value Method
LO 3
Net Present Value Method
The net present value method has the following two disadvantages:
It has more complex computations than methods that don’t use present value.
It assumes the cash flows can be reinvested at the minimum desired rate of return, which may not be valid.

27. Internal Rate of Return Method
LO 3
Internal Rate of Return Method
The internal rate of return (IRR) method uses present value concepts to compute the rate of return from a capital investment proposal based on its expected net cash flows.
This method, sometimes called the time-adjusted rate of return method, starts with the proposal’s net cash flows and works backward to estimate the proposal’s expected rate of return.

28. Internal Rate of Return Method
LO 3
Internal Rate of Return Method
Management is evaluating the following proposal to purchase new equipment:
Cost of new equipment………………… $33,530
Yearly expected cash flows to be
received…………………………………. 10,000
Expected life……………………………… 5 years
Minimum desired rate of return……….. 12%

29. Internal Rate of Return Method
LO 3
Internal Rate of Return Method
The present value of the net cash flows, using the present value of an annuity table (Exhibit 2), is $2,520, as shown below in Exhibit 3.

30. Equal Annual Net Cash Flows
Internal Rate of Return Method
STEP 1: Determine the present value factor for an annuity of $1 as follows:
Amount to be Invested
Equal Annual Net Cash Flows
$97,360
$20,000
= 4.868
(continued)

31. Internal Rate of Return Method
LO 3
Internal Rate of Return Method
STEP 2: Find the seven-year line on Exhibit 2 (the present value of an annuity of $1 at compound interest). Proceed horizontally across the table until you find the present value factor computed in Step 1 (or the closest present value factor).
(continued)

32. Internal Rate of Return Method
LO 3
Internal Rate of Return Method
STEP 3: Now that you have located on the seven-year line, go vertically to the top of the table to determine the interest rate.
(concluded)

33. Internal Rate of Return Method
LO 3
Internal Rate of Return Method
The internal rate of return method has the following three advantages:
It considers the cash flows of the investment.
It considers the time value of money.
It ranks proposals based upon the cash flows over their complete useful life, even if the project lives are not the same.

34. Internal Rate of Return Method
LO 3
Internal Rate of Return Method
The internal rate of return method has the following two disadvantages:
It has complex computations, requiring a computer if the periodic cash flows are not equal (an annuity).
It assumes the cash received from a proposal can be reinvested at the internal rate of return, which may not be valid.

35. List and describe factors that complicate capital investment analysis.
Learning Objective 4
List and describe factors that complicate capital investment analysis.

36. Unequal Proposal Lives
LO 4
Unequal Proposal Lives
Assume that a company is considering purchasing a new truck or a new computer network. The data for each proposal are shown below.

37. Unequal Proposal Lives
LO 4
Unequal Proposal Lives
(continued)

38. Unequal Proposal Lives
LO 4
Unequal Proposal Lives

39. Changes in Price Levels
LO 4
Changes in Price Levels
General price levels often increase in a rapidly growing economy, which is called inflation.
Price levels may change for foreign investments. This occurs as currency exchange rates change.
Currency exchange rates are the rates at which currency in another country can be exchanged for U.S. dollars.

40. Diagram the capital rationing process.
Learning Objective 5
Diagram the capital rationing process.

41. LO 5
Capital Rationing
Capital rationing is the process by which management allocates funds among competing capital investment proposals.

42. Capital Investment Analysis
The End