1. Capital Investment Analysis10
Capital Investment Analysis

2. Explain the nature and importance of capital investment analysis.
10-1
Objective 1
Explain the nature and importance of capital investment analysis.

3. Capital Investment Analysis
10-1
Capital investment analysis (or capital budgeting) is the process by which management plans, evaluates, and controls investments in fixed assets.

4. 10-2
Objective 2
Evaluate capital investment proposals, using the following methods: average rate of return, cash payback, net present value, and internal rate of return.

5. Methods that ignore present values: The average rate of return method
Methods of Evaluating Capital Investment Proposals
10-2
Methods that ignore present values:
The average rate of return method
The cash payback method
Methods that use present values:
The net present value method
The internal rate of return method

6. Percentage of Respondents Reporting the Use of the Method as “Always” or “Often”
10-2
Average rate of return
Cash payback method
Net present value method
Internal rate of return method
15%
53%
85%
76%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 9
Source: Patricia A. Ryan and Glenn P. Ryan. “Capital Budgeting Practices of the Fortune 1,000. How Have Things Changed? Journal of Business and Management (Winter 2002).

7. Considers accounting income (often used to evaluate managers)
Average Rate of Return Method
10-2
Advantages:
Easy to calculate
Considers accounting income (often used to evaluate managers)
Disadvantages:
Ignores cash flows
Ignores the time value of money

8. Expected useful life 4 years Residual value none
Purchase of Machine Example
10-2
Assumptions:
Machine cost $500,000
Expected useful life 4 years
Residual value none
Expected total income $200,000
Average rate
of return
Estimated Average
Annual Income
Average Investment =
Average rate
of return
$200,000/4
($500,000 + $0)/2 =
= 20% 11

9. Estimated average annual income $ 30,000 $ 36,000
10-2
Proposal A Proposal B
Estimated average annual income $ 30,000 $ 36,000
Average investment $120,000 $180,000
25%
Average rate of return
$30,000
$120,000 12

10. Proposal A would be preferred over Proposal B.
10-2
Proposal A Proposal B
Estimated average annual income $ 30,000 $ 36,000
Average investment $120,000 $180,000
25%
Average rate of return
20%
Proposal A would be preferred over Proposal B.
$360,000
$180,000 13

11. Est. average annual income: $91,200 ($273,600/3 years)
10-2
Example Exercise 10-1
Determine the average rate of return for a project that is estimated to yield total income of $273,600 over three years, cost $690,000, and has a $70,000 residual value.
Follow My Example 10-1
Est. average annual income: $91,200 ($273,600/3 years)
Average investment: $380,000 ($690, $70,000)/2
Average rate of return: 24% ($91,200/$380,000) 14
For Practice: PE 10-1A, PE 10-1B

12. Cash Payback Method
10-2
The expected period of time that will pass between the date of an investment and the complete recovery in cash (or equivalent) of the amount invested is the cash payback period.

13. 10-2
The excess of cash flowing in from revenue over the cash flowing out for expenses is termed net cash flow.

14. Assumptions: Investment cost $200,000 Expected annual net
10-2
Assumptions:
Investment cost $200,000
Expected annual net
cash flow (equal) $40,000
Cash
payback period
Total Investment
Annual Net
Cash Flow =
= 5 years
Cash
payback period
$200,000
$40,000 = 17

15. Shows when funds are available for reinvestment
Advantages and Disadvantages of the Cash Payback Method
10-2
Advantages:
Considers cash flows
Shows when funds are available for reinvestment
Disadvantages:
Ignores profitability (accounting income)
Ignores cash flows after the payback period

16. 10-2
Example Exercise 10-2
A project has estimated annual net cash flows of $30,000. It is estimated to cost $105,000. Determine the cash payback period.
Follow My Example 10-2
3.5 years ($105,000/$30,000) 21
For Practice: PE 10-2A, PE 10-2B

17. Present value concepts can be divided into:
Present Value Concepts
10-2
Present value concepts can be divided into:
the present value of an amount and
the present value of an annuity.

18. Present Value of an Amount
10-2
On January 1, 2008, you invest $1 in an account that earns 12% interest compounded annually. Interest earning interest is called compounding.

19. $1.12 $1.254 $1.404 Present Value Concepts 10-2 Jan. 1 2008 Jan. 1
Present Value Concepts
10-2
$1.00 x 1.12
$1.12 x 1.12
$1.254 x 1.12
Jan. 1
2008
$1.00
$1.12
$1.254
$1.404
Jan. 1
2009
2010
2011 24

20. 10-2
Assume that today is January 1, 2008 and the current interest rate is 12 percent. What is the present value of $1,404 to be received on January 1, 2011? To determine the answer, we need to go to Exhibit 1 and find the table value for three years at 12 percent.

21. Present Value of $1 with Compound Interest
Partial Present Value of $1 Table
10-2
Present Value of $1 with Compound Interest
Year % % % % %
0.712 26
Left click the mouse for solution.

22. Amount to be received on January 1, 2011
10-2
Amount to be received on January 1, 2011
Table value x
Present value =
Present value =
x $1,404
Present value =
$1, (rounded)
Summary: If the interest rate is 12%, then $1,404 in three years is worth $1,000 today. 27

23. Present Value of an Annuity
10-2
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.

24. Net Present Value Method
10-2
The net present value method (also called the discounted cash flow method) analyzes capital investment proposals by comparing the initial cash investment with the present value of the net cash flows.

25. Equipment Example
10-2
At the beginning of 2008, 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.
(Continued)

26. Equipment Example
10-2
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 2012) until the machine is retired. The firm expects a minimum rate of return of 10%. Should the equipment be purchased?
(Continued)

27. (Continued) Equipment Example 10-2 $70,000 x 0.909 (n = 1; i =10%)
Equipment Example
10-2
Jan. 1
2008
Dec. 31
2009
2010
2011
2012
$(200,000) $70, $60, $50, $40, $40,000
$ 63,630
$70,000 x (n = 1; i =10%)
(Continued) 32

28. (Continued) Equipment Example 10-2 $60,000 x 0.826 (n = 2; i = 10%)
Equipment Example
10-2
Jan. 1
2008
Dec. 31
2009
2010
2011
2012
$(200,000) $70, $60, $50, $40, $40,000
$ 63,630
$ 49,560
$60,000 x (n = 2; i = 10%)
(Continued) 33

29. (Continued) Equipment Example 10-2 $50,000 x 0.751 (n = 3; i = 10%)
Equipment Example
10-2
Jan. 1
2008
Dec. 31
2009
2010
2011
2012
$(200,000) $70, $60, $50, $40, $40,000
$ 63,630
$ 49,560
$ 37,550
$50,000 x (n = 3; i = 10%)
(Continued) 34

30. (Continued) Equipment Example 10-2 $40,000 x 0.683 (n = 4; i =10%)
Equipment Example
10-2
Jan. 1
2008
Dec. 31
2009
2010
2011
2012
$(200,000) $70, $60, $50, $40, $40,000
$ 63,630
$ 49,560
$40,000 x (n = 4; i =10%)
$ 37,550
$ 27,320
(Continued) 35

31. (Continued) Equipment Example 10-2 $40,000 x 0.621 (n = 5; i = 10%)
Equipment Example
10-2
Jan. 1
2008
Dec. 31
2009
2010
2011
2012
$(200,000) $70, $60, $50, $40, $40,000
$ 63,630
$ 49,560
$ 37,550
$40,000 x (n = 5; i = 10%)
$ 27,320
$ 24,840
(Continued) 36

32. Total present value of the net cash flow is $202,900
Equipment Example
10-2
Jan. 1
2008
Dec. 31
2009
2010
2011
2012
$(200,000) $70, $60, $50, $40, $40,000
$ 63,630
The equipment should be purchased because the net present value is positive.
$ 49,560
$ 37,550
$ 27,320
$ 24,840
$ 2,900
Net present value 37
Total present value of the net cash flow is $202,900
(Concluded)

33. Present Value Index
10-2
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 by using a present value index.

34. Total present value of net cash flow
10-2
Total present value of net cash flow
Present value index =
Amount to be invested
Present value index =
$202,900*
$200,000 = 39

35. Ranking Various Proposals Using a Present Value Index
10-2
Proposal A Proposal B Proposal C
Total present value of net cash flow $107,000 $86,400 $86,400
Amount to be invested 100, , ,000
Net present value $ 7,000 $ 6,400 $ 3,600
Present value index
1.07
$107,000 $100,000 40

36. 10-2
Proposal A Proposal B Proposal C
Total present value of net cash flow $107,000 $86,400 $86,400
Amount to be invested 100, , ,000
Net present value $ 7,000 $ 6,400 $ 3,600
Present value index
1.07
1.08
$86,400 $80,000 41

37. 10-2
Proposal A Proposal B Proposal C
Total present value of net cash flow $107,000 $86,400 $86,400
Amount to be invested 100, , ,000
Net present value $ 7,000 $ 6,400 $ 3,600
Present value index
1.07
1.08
0.96
$86,400 $90,000 42

38. Total present value of net cash flow $107,000 $86,400 $86,400
10-2
Total present value of net cash flow $107,000 $86,400 $86,400
Amount to be invested 100, , ,000
Net present value $ 7,000 $ 6,400 $ 3,600
Present value index
1.07
1.08
Proposal A Proposal B Proposal C
0.96
Proposal B has the best present value index. Management should consider the possible use of the $20,000 difference between Proposal A and Proposal B before making a decision. 43

39. 10-2
A proposal is made to acquire $200,000 of equipment with an expected useful life of five years (no residual value) and a minimum desired rate of return of 10%. The new equipment is expected to generate a net cash inflow of $50,000 each year. Should the firm acquire the equipment? 44

40. Present Value of an Annuity of $1 = Equal Annual Cash Flows x
10-2
Present Value of an Annuity of $1 =
Equal Annual Cash Flows x
Table Value from Exhibit 2 =
$50,000 x
Table Value from Exhibit 2
Present Value of an Annuity of $1
Refer to Exhibit 2 45

41. Present Value of an Annuity of $1 at Compound Interest
Partial Present Value of an Annuity Table
10-2
Present Value of an Annuity of $1 at Compound Interest
Year 6% % % % %
3.791 46

42. Present Value of an Annuity of $1
10-2
Present Value of an Annuity of $1 =
$50,000 x
$189,550 =
$50,000 x
Present Value Index =
$189,550
$200,000
= 0.948
The proposal should be rejected because the present value index is less than one. 47

43. Considers cash flows and the time value of money
Advantage and Disadvantage of Net Present Value Method
10-2
Advantage:
Considers cash flows and the time value of money
Disadvantage:
Assumes that cash received can be reinvested at the rate of return

44. 10-2
Example Exercise 10-3
A project has estimated annual net cash flows of $50,000 for seven years and is estimated to cost $240,000. Assume a minimum acceptable rate of return of 12%. Using Exhibit 2, determine the (a) net present value of the project and (b) the present value index, rounded to two decimal places. 49

45. 10-2
Follow My Example 10-3
($11,800) [($50,000 x 4.564) – $240,000]
($228,200/$240,000) 50
For Practice: PE 10-3A, PE 10-3B

46. Internal Rate of Return Method
10-2
The internal rate of return (IRR) method (sometimes called the time-adjusted rate of return method) uses present value concepts to compute the rate of return from the net cash flows expected from capital investment proposals.

47. List and describe factors that complicate capital investment analysis.
10-3
Objective 3
List and describe factors that complicate capital investment analysis.

48. Unequal proposal lives Lease versus capital investment Uncertainty
Factors that Complicate Capital Investment Analysis
10-3
Income tax
Unequal proposal lives
Lease versus capital investment
Uncertainty
Changes in price levels
Qualitative considerations

49. Capital Rationing
10-4
Capital rationing is the process by which management allocates funds among competing capital investment proposals.