1. Power Notes Chapter M9 Capital Investment Analysis Learning Objectives
1. Nature of Capital Investment Analysis
2. Methods of Evaluating Capital Investment Proposals
3. Factors That Complicate Capital Investment Analysis
4. Capital Rationing C9

2. Power Notes Chapter M9 Capital Investment Analysis
Slide # Power Note Topics 3 7 15 26 29
Nature of Capital Investment Decisions
Average Rate of Return; Cash Payback
The Time Value of Money
Present Value Analysis
Other Considerations
Note: To select a topic, type the slide # and press Enter.

3. 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.

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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?

10. 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.

11. 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?

12. 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

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

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

15. 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
$ ????

16. 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

17. 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

18. 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 $
= $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

19. 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 %
Calculator
= $ / 1.06
One dollar at the end of one period at 6% per period is equal to $.9434 today (present value).

20. 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 %
Calculator
= $ / 1.06
= $ / 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.

21. 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 %
Calculator
= $ / 1.06
= $ / 1.06
= $ / 1.06
One dollar at the end of three periods at 6% per period is equal to $.8396 today (present value).

22. 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 %
Calculator
= $ / 1.06
= $ / 1.06
= $ / 1.06
= $ / 1.06
= $ / 1.06
= $ / 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.

23. 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%
Calculation
Sum of Periods
= Period 1
= Periods 1–2
= Periods 1–3
= Periods 1–4
= Periods 1–5
4.2124
The PV of an annuity of $1 to be received each year for two years is $ This is the sum of the PV of the two amounts for periods 1 and 2.

24. 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%
Calculation
Sum of Periods
= Period 1
= Periods 1–2
= Periods 1–3
= Periods 1–4
= Periods 1–5
4.2124
The PV of an annuity of $1 to be received each year for three years is $ This is the sum of the PV of the three amounts for periods 1–3.

25. 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%
Calculation
Sum of Periods
= Period 1
= Periods 1–2
= Periods 1–3
= Periods 1–4
= Periods 1–5
4.2124
Total

26. 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

27. 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
What is the meaning of an index over 1.0?

28. 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

29. 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?

30. 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.

31. Power Notes This is the last slide in Chapter M9. Chapter M9
Capital Investment Analysis
This is the last slide in Chapter M9.
Note: To see the topic slide, type 2 and press Enter.