Capital Investment Analysis Chapter 15 ©2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part Learning Objectives After studying this chapter, you should be able to: • Explain the nature and importance of capital investment analysis • Evaluate capital investment proposals using the average rate of return and cash payback methods • Evaluate capital investment proposals using the net present value and internal rate of return methods • List and describe factors that complicate capital investment analysis • Diagram the capital rationing process ©2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part Learning Objective Explain the nature and importance of capital investment analysis ©2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part Capital Investment Analysis • The process by which management plans, evaluates, and controls investments in _ • Capital investment is very important for the success of a business ©2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part Methods of Evaluating Capital Investment Proposals • Methods that not use present value: • _ • _ • Methods that use present values • _ • _ ©2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part Learning Objective Evaluate capital investment proposals, using the average rate of return and cash payback methods ©2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part Methods That Ignore Present Value • Often used to initially proposals • Useful for proposals with relatively short useful lives because the _ of cash flows is less important ©2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part Average Rate of Return • A measure of the average annual income expected to be earned from the investment over the investment life, after deducting depreciation • Also called the accounting rate of return Avg Rate of Return = ©2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part Average Rate of Return • • • • Cost = $500,000 No Residual Value 4-year useful life Estimated total income - $200,000 Avg Rate of Return = $ $ ©2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part Average Rate of Return Analysis • If the average rate of return equals or exceeds the company’s minimum rate, the project should be • Advantages: • Easy to compute • Includes the entire income to be earned over the life of the proposal • Emphasizes accounting income • Disadvantage – does not directly consider the _and _ ©2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part Net Present Value Method • Analyzes capital investment proposals by comparing the initial cash investment with the _ of the net cash flows • Also called cash flow method • The return rate is set by management – often called the _ rate • If the net present value expected from an investment equals/exceeds the initial investment, the project is ©2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part Net Present Value Calculation • Net present value analysis for the purchase of a $200,000 machine with a 5-year useful life Minimum rate of return is 10% ©2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part Present Value Index • If _are being considered, use of the present value index can help determine which projects to accept Present Value Index = ©2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part Internal Rate of Return • Uses present value concepts to compute the _from the net cash flows expected from capital investment proposals • Also called the method • Starts with net cash flows and works backward to determine the expected from the project ©2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part Internal Rate of Return • • • • Cost = $33,350 Estimated cash inflow = $10,000 Expected life – years Rate of return – 12% Exhibit 3: Net Present Value Analysis at 12% ©2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part Estimation of Internal Rate of Return Internal rate of return ©2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part Internal Rate of Return • Trial-and-error procedures are time-consuming When equal annual net cash flows are expected, the calculation can be simplified ©2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part Internal Rate of Return • When the internal rate of return exceeds a company’s cost of capital, the proposal should be considered for acceptance • Advantages: • • • Disadvantages: • • • ©2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part Learning Objective List and describe factors that complicate capital investment analysis ©2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part Factors That Complicate Capital Investment Analysis • • • • • • _ _ _ _ _ _ ©2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part Learning Objective Diagram the capital rationing process ©2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part Capital Rationing • The process by which management allocates _ among competing capital investment proposals • The proposals that meet all _ ( _) and tests should be ranked for funding • Unfunded proposals may be reconsidered if funds become available later • Let’s look at a diagram of the capital rationing decision process: ©2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part Capital Rationing Decision Process Continued… ©2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part Capital Rationing Decision Process …continued ©2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part End of Chapter 15 ©2013 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part ... Rate of Return • A measure of the average annual income expected to be earned from the investment over the investment life, after deducting depreciation • Also called the accounting rate of return... payback period is the expected period of time between the date of an investment and the complete recovery in cash (or equivalent) of the amount invested • The excess of cash flowing in from revenue... because today’s $1 can be invested and earn interest • Present Value of an Annuity – sum of the present values of a series of equal cash flows at intervals ©2013 Cengage Learning All Rights