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Needles Powers Crosson Financial and Managerial Accounting 10e Capital Investment Analysis 24 C H A P T E R © human/iStockphoto ©2014 Cengage Learning.

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Presentation on theme: "Needles Powers Crosson Financial and Managerial Accounting 10e Capital Investment Analysis 24 C H A P T E R © human/iStockphoto ©2014 Cengage Learning."— Presentation transcript:

1 Needles Powers Crosson Financial and Managerial Accounting 10e Capital Investment Analysis 24 C H A P T E R © human/iStockphoto ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

2 Concepts Underlying Long-Term Decision Analysis  The concept of cost-benefit holds that the benefits to be gained from a course of action or alternative should be greater than the costs of providing it. –It considers both quantitative and qualitative cost and benefit measures to facilitate cost-benefit comparisons between alternatives for sound business decisions.  Capital investment decisions are decisions about when and how much to spend on capital facilities and other long-term projects. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

3 Capital Investment Analysis (slide 1 of 2)  Capital investment analysis (or capital budgeting) involves the evaluation of alternative proposals for large capital investments, including considerations for financing the projects. –Each decision made about a capital investment is vitally important because it involves a large amount of money and commits a company to a course of action for years to come. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

4 Capital Investment Analysis (slide 2 of 2)  Managers frequently follow six key steps when applying the cost-benefit concept to the capital budgeting process: –Step 1: Identify capital investment needs. –Step 2: Prepare formal requests for capital investments. –Step 3: Conduct a preliminary screening. –Step 4: Establish the acceptance-rejection standard. –Step 5: Evaluate proposals. –Step 6: Make capital investment decisions. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

5 The Minimum Rate of Return on Investment  Most companies set a minimum rate of return to guard their profitability, and any capital expenditure proposal that fails to produce that rate of return is automatically refused. –The minimum rate of return is often called a hurdle rate because it is the rate that must be exceeded, or hurdled. –If the return from a capital investment falls below the minimum rate of return, the funds can be used more profitably in another part of the organization. –If there are too many proposals to fund adequately, managers must rank the proposals according to their rates of return and begin a second selection process. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

6 Capital Investment Analysis Measures and Methods  When evaluating a proposed capital investment, managers must predict how the new asset will perform and how it will benefit the company. - Managers must measure and evaluate all the investment alternatives consistently. - The measure of expected benefit depends on the method of analyzing capital investment alternatives. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

7 Expected Benefits from a Capital Investment (slide 1 of 2)  The benefits from a capital investment can be measured by net income and net cash flows and cost savings. -Net income is calculated in the usual way: Revenue − Expenses = Net Income - Net cash inflows are the balance of increases in projected cash receipts over increases in projected cash payments resulting from a capital investment, computed as follows: ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

8 Expected Benefits from a Capital Investment (slide 2 of 2)  In some cases, equipment replacement decisions involve situations in which revenues are the same among alternatives. - In such cases, the benefits are measured by the cost savings, or the decrease in operating costs that will result from the proposed capital investments. - Either net cash inflows or cost savings can be used as the basis for an evaluation, but the two measures should not be confused. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

9 Equal Versus Unequal Cash Flows  Projected cash flows may be the same for each year of an asset’s life, or they may vary from year to year. -Unequal annual cash flows are common and must be analyzed for each year of an asset’s life. -Proposed projects with equal annual cash flows require less detailed analysis. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

10 Carrying Value of Assets  Carrying value (or book value) is the undepreciated portion of the original cost of a fixed asset—that is, the asset’s cost less its accumulated depreciation. -When a decision to replace an asset is being evaluated, the carrying value of the old asset is irrelevant because it is a past, or historical, cost and will not be altered by the decision. -Net proceeds from the asset’s sale or disposal are relevant, however, because the proceeds affect cash flows and may differ for each alternative. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

11 Depreciation Expense and Income Taxes  Income taxes alter the amount and timing of cash flows of projects under consideration by for-profit companies. -To assess the benefits of a capital project, a company must include the effects of taxes in its capital investment analyses. -Depreciation expense is deductible when determining income taxes, so depreciation expense influences the amount of income taxes a company pays and can lead to significant tax savings. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

12 Disposal or Residual Values  Proceeds from the sale of an old asset are current cash inflows and are relevant to evaluating a proposed capital investment.  Projected disposal or residual values of replacement equipment are also relevant because they represent future cash inflows and usually differ among alternatives. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

13 Net Present Value Method  The net present value method evaluates a capital investment by discounting its future cash flows to their present values and subtracting the amount of the initial investment from their sum. –Projects with the highest net present value—the amount that exceeds the initial investment—are selected. –A significant advantage of this method is that it incorporates the time value of money into the analysis.  Future cash inflows and outflows are discounted by the company’s minimum rate of return to determine their present values.  The minimum rate of return should at least equal the company’s average cost of capital. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

14 The Payback Period Method  If two investment alternatives are being studied, management should choose the investment that pays back its initial cost in the shorter time. –That period of time is known as the payback period, and the method of evaluation is called the payback period method.  The payback period method is simple to use, but it does not consider the time value of money.  The payback period is computed as follows: (The annual net cash inflows are the annual cash revenues minus the cash expenses.) ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

15 Unequal Annual Net Cash Inflows  If a proposed capital investment has unequal annual net cash inflows, the payback period is determined as follows: –When a zero balance is reached, the payback period has been determined.  The portion of the final year is computed by dividing the amount needed to reach zero (the unrecovered portion of the investment) by the entire year’s estimated cash inflow. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

16 Advantages and Disadvantages of the Payback Period Method  The payback period method is especially useful in areas in which technology changes rapidly and when risk is high. –However, this approach has several disadvantages:  The payback period method does not measure profitability.  It ignores differences in the present values of cash flows from different periods; thus, it does not adjust cash flows for the time value of money.  It emphasizes the time it takes to recover the investment rather than the long-term return on the investment.  It ignores all future cash flows after the payback period is reached. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

17 The Accounting Rate-of-Return Method  The accounting rate-of-return method is an imprecise but easy way to measure the estimated performance of a capital investment, since it uses financial statement information. –It does not use an investment’s cash flows but considers the financial reporting effects of the investment instead. –It measures expected performance using two variables: the estimated annual net income from the project and average investment cost.  The average investment cost is computed as follows : ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

18 Advantages and Disadvantages of the Accounting Rate-of-Return Method  The accounting rate-of-return method is easy to understand and apply. –However, it has several disadvantages:  Because net income is averaged over the life of the investment, it is not a reliable figure, as actual net income may vary considerably from the estimates.  It ignores cash flows.  It does not consider the time value of money; thus, future and present dollars are treated as equal. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

19 Capital Investment Analysis and the Management Process ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


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