1. Explain the nature and importance of capital investment analysis

1. Explain the nature and importance of capital investment analysis.

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

3. List and describe factors that complicate capital investment analysis.

Chapter 24 - Capital Investment AnalysisChapter 24 - Capital Investment Analysis

Objectives

Nature of Capital Investment AnalysisNature of Capital Investment AnalysisNature of Capital Investment AnalysisNature of Capital Investment Analysis

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. The process should include a plan for encouraging and rewarding employees for submitting proposals.

Capital budgeting is the process by which management plans, evaluates, and controls long-term investments in fixed assets.

Capital budgeting is the process by which management plans, evaluates, and controls long-term investments in fixed assets.

Methods of Evaluating Methods of Evaluating Capital Investment ProposalsCapital Investment Proposals

Methods of Evaluating Methods of Evaluating Capital Investment ProposalsCapital Investment Proposals

Here’s a survey of business practices in a variety of industries. It reports the capital investment analysis methods

used by large U.S. companies.

Here’s a survey of business practices in a variety of industries. It reports the capital investment analysis methods

used by large U.S. companies.

Average rate of return

Cash payback method

Net present value method

Internal rate of return method

0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

15%

53%

85%

76%

Journal of Business and Management (Winter 2002)

Easy to calculate Considers accounting income (often used to

evaluate managers)

Average Rate of Return Method

Advantages:

Ignores cash flows

Ignores the time value of money

Disadvantages:

Methods that Ignore Present ValueMethods that Ignore Present ValueMethods that Ignore Present ValueMethods that Ignore Present Value

Machine cost $500,000Expected useful life 4 yearsResidual value noneExpected total income $200,000

Assumptions:

Average Rate of Return

Estimated AverageAnnual Income

Average Investment=

Average Rate of Return MethodAverage Rate of Return MethodAverage Rate of Return MethodAverage Rate of Return Method

Average Rate of Return =

$200,000 ÷ 4 years=

($500,000 + $0) / 220%

Average annual income $ 30,000 $ 36,000Average investment $120,000 $180,000

Assumptions: Proposal A Proposal B

$30,000

$120,000= 25%


Average annual income $ 30,000 $ 36,000Average investment $120,000 $180,000

Assumptions: Proposal A Proposal B

$36,000

$180,000= 20%


Considers cash flows

Shows when funds are available for reinvestment

Ignores profitability (accounting income) Ignores cash flows after the payback

period

Cash Payback Method

Methods that Ignore Present ValueMethods that Ignore Present ValueMethods that Ignore Present ValueMethods that Ignore Present Value

Advantages:

Disadvantages:

Cash Payback MethodCash Payback MethodCash Payback MethodCash Payback Method

Investment cost $200,000Expected useful life 8 yearsExpected annual net cash flows (equal) $40,000

Assumptions:

CashPayback Period

Total Investment

Annual NetCash Inflows

=

CashPaybackPeriod

$200,000=

$40,000= 5 years

Year 1 $ 60,000 $ 60,000Year 2 80,000 140,000Year 3 105,000 245,000Year 4 155,000 400,000Year 5 100,000 500,000Year 6 90,000 590,000

Net Cash CumulativeFlow Net Cash Flow

Cash Payback MethodCash Payback MethodCash Payback MethodCash Payback Method

If the proposed investment is $400,000, the payback period is at

the end of Year 4.

If the proposed investment is $400,000, the payback period is at

the end of Year 4.

The time value of money concept is used in many business decisions. This concept is an important consideration in capital investment analysis.

PresentValue $ ????

What is the present value of $1,000 to be received one year from today at 8% per year?

What is the present value of $1,000 to be received one year from today at 8% per year?

Present Value MethodsPresent Value MethodsPresent Value MethodsPresent Value Methods

$ 925.93 = $1,000 ÷ 1.08

How much would have to be invested on February 1, 2006 in order to receive

$1,000 on February 1, 2009 if the interest rate compounded annually is 12%?

How much would have to be invested on February 1, 2006 in order to receive

$1,000 on February 1, 2009 if the interest rate compounded annually is 12%?


Refer to the partial present value table in Slide 18 to

answer the question.

Refer to the partial present value table in Slide 18 to

answer the question.


$1,000, 3 years, 12%

compounded annually

Calculating Present ValuesCalculating Present ValuesCalculating Present ValuesCalculating Present Values

Present values can be determined using present value tables, mathematical formulas, a calculator or a computer.

Present Value of $1 with Compound InterestPresent Value of $1 with Compound Interest

1 0.943 0.909 0.893 0.870 0.833

2 0.890 0.826 0.797 0.756 0.694

3 0.840 0.751 0.712 0.658 0.579

4 0.792 0.683 0.636 0.572 0.482

5 0.747 0.621 0.567 0.497 0.402

6 0.705 0.564 0.507 0.432 0.335

Year 6% 10% 12% 15% 20%

$1,000 x .712 = $712$1,000 x .712 = $712

0.7120.712

Present Value of an AmountPresent Value of an AmountPresent Value of an AmountPresent Value of an Amount

If $712 is invested on February 1, 2006 at an annual rate of 12 percent, $1,000 will accumulate by February 1, 2009.

If $712 is invested on February 1, 2006 at an annual rate of 12 percent, $1,000 will accumulate by February 1, 2009.

$1,000 x .712 = $712$1,000 x .712 = $712

Present Value of an AmountPresent Value of an AmountPresent Value of an AmountPresent Value of an Amount

Feb. 1

2006 Feb. 1

2007 Feb. 1

2008 Feb. 1

2009

$712 x 1.12 $797 x 1.12 $893 x 1.12 $1,000

Present Value of an AnnuityPresent Value of an AnnuityPresent Value of an AnnuityPresent 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 sum of the present values of each

cash flows.

An annuity is a series of equal net cash flows at fixed time intervals.

The present value of an annuity is the sum of the present values of each

cash flows.

What would be the present value of a $100 annuity for five periods at 12?

What would be the present value of a $100 annuity for five periods at 12?

Present Value of an Annuity of $1Present Value of an Annuity of $1

1 0.943 0.909 0.893 0.870 0.833

2 1.833 1.736 1.690 1.626 1.528

3 2.673 2.487 2.402 2.283 2.106

4 3.465 3.170 3.037 2.855 2.589

5 4.212 3.791 3.605 3.353 2.991

6 4.917 4.355 4.111 3.785 3.326

Year 6% 10% 12% 15% 20%

Calculating Present Values of AnnuitiesCalculating Present Values of AnnuitiesCalculating Present Values of AnnuitiesCalculating Present Values of Annuities

3.605 x $100 = $360.50

3.6053.605

Net Present Net Present Value Value

MethodMethod

Net Present Net Present Value Value

MethodMethod

The net present value method analyzes capital investment proposals by

comparing the initial cash investment with the present value of the net

cash flows.

The net present value method analyzes capital investment proposals by

comparing the initial cash investment with the present value of the net

cash flows.

Considers cash flows and the time value of money

Net Present Value MethodNet Present Value MethodNet Present Value MethodNet Present Value Method

Advantage:

Assumes that cash received can be reinvested at the rate of return

Disadvantage:

Cash Flow Present Value

At the beginning of 2006, 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.

At the beginning of 2006, 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.


A net cash flow of $70,000 is expected at the end of 2006. This net cash flow is expected to decline

$10,000 each year (except 2010) until the machine is retired. The firm expects a minimum rate of return

of 10%. Should the equipment be purchased?

A net cash flow of $70,000 is expected at the end of 2006. This net cash flow is expected to decline

$10,000 each year (except 2010) until the machine is retired. The firm expects a minimum rate of return

of 10%. Should the equipment be purchased?

First, we must determine which table to use… the present value of

$1 or the present value of an annuity of $1.

First, we must determine which table to use… the present value of

$1 or the present value of an annuity of $1.


Because there are multiple years of net cash flows, shouldn’t we

use the present value of an annuity of $1?

Because there are multiple years of net cash flows, shouldn’t we

use the present value of an annuity of $1?


That would be true if the net cash flows remained constant from 2006 through 2010. Note that the net cash flows are $70,000, $60,000, $50,000, $40,000,

and $40,000, respectively.

That would be true if the net cash flows remained constant from 2006 through 2010. Note that the net cash flows are $70,000, $60,000, $50,000, $40,000,

and $40,000, respectively.


So, we have to use the present value of $1 for each

of the five years.

So, we have to use the present value of $1 for each

of the five years.

$ 63,630 $70,000 x 0.909 (n = 1; i = 10%) $ 49,560 $60,000 x 0.826 (n = 2; i = 10%) $ 37,550 $50,000 x 0.751 (n = 3; i = 10%) $ 27,320 $40,000 x 0.683 (n = 4; i = 10%) $ 24,840 $40,000 x 0.621 (n = 5; i = 10%)

Jan. 1

2006 Dec. 31

2006 Dec. 31

2007 Dec. 31

2008 Dec. 31

2009 Dec. 31

2010

$<200,000> $70,000 $60,000 $50,000 $40,000 $40,000


$ 63,630 $ 49,560 $ 37,550 $ 27,320 $ 24,840$ 2,900


Jan. 1

2006 Dec. 31

2006 Dec. 31

2007 Dec. 31

2008 Dec. 31

2009 Dec. 31

2010

$<200,000> $70,000 $60,000 $50,000 $40,000 $40,000

The equipment should be purchased because the net present value is

positive.

The equipment should be purchased because the net present value is

positive.

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 using a present value index.

(a.k.a. profitability index)

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 using a present value index.

(a.k.a. profitability index)


Total present value $107,000 $86,400 $93,600Total investment 100,000 80,000 90,000Net present value $ 7,000 $ 6,400 $ 3,600

Present value index 1.07 1.08 1.04

Assumptions:Assumptions: ProposalsA B C

$107,000 ÷ $107,000 ÷ $100,000$100,000

$107,000 ÷ $107,000 ÷ $100,000$100,000

$86,400 ÷ $86,400 ÷ $80,000$80,000

$86,400 ÷ $86,400 ÷ $80,000$80,000

$93,600 ÷ $93,600 ÷ $90,000$90,000

$93,600 ÷ $93,600 ÷ $90,000$90,000

The The bestbestThe The bestbest


Considers cash flows and the time value of money

Ability to compare projects of unequal size

Advantages:

Disadvantages: Requires complex calculations

Assumes that cash can be reinvested at the internal rate of return

Internal Rate of Return MethodInternal Rate of Return MethodInternal Rate of Return MethodInternal Rate of Return Method


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.

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 ErrorTrial and Error

Computer FunctionComputer Function

Use a computer function to calculate exactly the expected rate of return.

$97,360

$20,000= 4.868

Determine the table value using the present value for an annuity of $1 table.


Amount to be invested

Equal annual cash flow

Management is evaluating a proposal to acquire equipment costing $97,360. The equipment is expected to provide annual net cash flows of

$20,000 per year for seven years.

Management is evaluating a proposal to acquire equipment costing $97,360. The equipment is expected to provide annual net cash flows of

$20,000 per year for seven years.

Present Value of an Annuity of $1Present Value of an Annuity of $1Present Value of an Annuity of $1Present Value of an Annuity of $1

1 0.943 0.909 0.893 0.870

2 1.833 1.736 1.690 1.626

3 2.673 2.487 2.402 2.283

4 3.465 3.170 3.037 2.855

5 4.212 3.791 3.605 3.353

6 4.917 4.355 4.111 3.785

7 5.582 4.868 4.564 4.160

Year 6% 10% 12% 15%

4.8684.868


Find the seven year line on the table. Then, go across the 7-year line until the closest amount to 4.868 is located.

Move vertically to the top of the table to determine the interest rate

10%

Factors That Complicate Capital Factors That Complicate Capital Investment AnalysisInvestment Analysis

Factors That Complicate Capital Factors That Complicate Capital Investment AnalysisInvestment Analysis

Income tax Unequal proposal lives Lease versus capital investment Uncertainty Changes in price levels Qualitative considerations

Qualitative ConsiderationsQualitative ConsiderationsQualitative ConsiderationsQualitative 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

Improvements that increase competitiveness and quality are difficult to quantify. The following qualitative factors are important considerations.

Capital RationingCapital RationingCapital RationingCapital Rationing

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.

Documents

1. Explain the nature and importance of capital investment analysis