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C9 - 1
Learning Objectives
Power Notes
1. Nature of Capital Investment Analysis
2. Methods of Evaluating Capital Investment Proposals
3. Factors That Complicate Capital Investment Analysis
4. Capital Rationing
Chapter M9
C9
Capital Investment AnalysisCapital Investment Analysis
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• Nature of Capital Investment Decisions
• Average Rate of Return; Cash Payback
• The Time Value of Money
• Present Value Analysis
• Other Considerations
Slide # Power Note Topics
Note: To select a topic, type the slide # and press Enter.
Power Notes
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Chapter M9
Capital Investment AnalysisCapital Investment Analysis
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Nature of Capital Investment DecisionsNature 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.
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Methods of Evaluating Capital InvestmentsMethods of Evaluating Capital Investments
Average rate of return method
Cash payback method
Net present value method
Internal rate of return method
Methods that do not use present valuesMethods that do not use present values
Methods that use present valuesMethods that use present values
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Easy to calculate
Considers accounting income (often used to evaluate managers)
Average Rate of ReturnAverage Rate of Return
Cash PaybackCash Payback
Advantages:
Ignores cash flows
Ignores the time value of money
Disadvantages:
Considers cash flows
Shows when funds are available for reinvestment
Advantages: Disadvantages:Ignores profitability (accounting income)
Ignores cash flows after the payback period
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Considers cash flows and the time value of money
Net Present ValueNet Present Value
Internal Rate of ReturnInternal Rate of Return
Advantages:
Assumes that cash received can be reinvested at the rate of return
Disadvantages:
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
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Average Rate of Return MethodAverage Rate of Return Method
Machine cost $500,000Expected useful life 4 yearsResidual value noneExpected total income $200,000
Assumptions:Assumptions:
Average Rate of Return
Estimated AverageAnnual Income
Average Investment=
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Average Rate of Return MethodAverage Rate of Return Method
Machine cost $500,000Expected useful life 4 yearsResidual value noneExpected total income $200,000
Assumptions:Assumptions:
Average Rate of Return
Estimated AverageAnnual Income
Average Investment=
=$200,000 / 4 yrs.Average Rate
of Return =($500,000 + $0) / 2
20%
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Average Rate of Return MethodAverage Rate of Return Method
Average annual income $30,000 $36,000Average investment $120,000 $180,000Average rate of return
Assumptions:Assumptions:
Average Rate of Return
Estimated AverageAnnual Income
Average Investment=
Proposal A Proposal B
What is the average rate of return for each proposal?What is the average rate of return for each proposal?
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Average Rate of Return MethodAverage Rate of Return Method
Average annual income $30,000 $36,000Average investment $120,000 $180,000Average rate of return 25% 20%
Assumptions:Assumptions: Proposal A Proposal B
This method emphasizes accounting income which is commonly used in evaluating management performance.
This method emphasizes accounting income which is commonly used in evaluating management performance.
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Cash Payback MethodCash Payback Method
Investment cost $200,000Expected useful life 8 yearsExpected annual net cash flows (equal) $40,000
Assumptions:Assumptions:
CashPayback Period
Total Investment
Annual NetCash Inflows
=
What is the cash payback period?What is the cash payback period?
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Cash Payback MethodCash Payback Method
Investment cost $200,000Expected useful life 8 yearsExpected annual net cash flows (equal) $40,000
Assumptions:Assumptions:
=$200,000Cash
PaybackPeriod
=$40,000
5 years
CashPayback Period
Total Investment
Annual NetCash Inflows
=
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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
Assumptions:Assumptions:Net Cash Cumulative
Flow Net Cash Flow
Cash Payback MethodCash Payback Method
If the proposed investment is $400,000, what is the payback period?
If the proposed investment is $400,000, what is the payback period?
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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
Assumptions:Assumptions:
Cash Payback MethodCash Payback Method
If the proposed investment is $450,000, what is the payback period?
If the proposed investment is $450,000, what is the payback period?
Net Cash CumulativeFlow Net Cash Flow
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The Time Value of Money – Future ValueThe 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.
PresentValue
FutureValue
$1,000
$ ????
What is the future value of $1,000 invested today (present value) at 8% per year?
What is the future value of $1,000 invested today (present value) at 8% per year?
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The Time Value of Money – Future ValueThe 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.
PresentValue
FutureValue
$1,000
= $1,000 + ($1,000 x 8%)= $1,000 x 108% or 1.08
What is the future value of $1,000 invested today (present value) at 8% per year?
What is the future value of $1,000 invested today (present value) at 8% per year?
$1,080
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The Time Value of Money – Present ValueThe 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.
PresentValue
FutureValue
$ ????
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?
$1,000
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The Time Value of Money – Present ValueThe 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.
PresentValue
FutureValue
$ 925.93 = $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?
What is the present value of $1,000 to be received one year from today at 8% per year?
$1,000
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Calculating Present ValuesCalculating Present Values
Present values can be determined using present value tables, mathematical formulas, calculators or computers.
Present Value of $1 with Compound Interest
1 .9434 = $1.0000 / 1.06
CalculatorPV Table
Period 6%
One dollar at the end of one period at 6% per period is equal to $.9434 today (present value).
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Calculating Present ValuesCalculating Present Values
Present values can be determined using present value tables, mathematical formulas, calculators or computers.
Present Value of $1 with Compound Interest
PV Table
Period 6%
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.
1 .9434.9434 = $1.0000 / 1.06
2 .8900 = $$ .9434.9434 / 1.06
Calculator
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Calculating Present ValuesCalculating Present Values
Present values can be determined using present value tables, mathematical formulas, calculators or computers.
Present Value of $1 with Compound Interest
PV Table
Period 6%
One dollar at the end of three periods at 6% per period is equal to $.8396 today (present value).
1 .9434 = $1.0000 / 1.06
2 .8900.8900 = $ .9434 / 1.06
3 .8396 = $ .8900$ .8900 / 1.06
Calculator
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Calculating Present ValuesCalculating Present Values
Present values can be determined using present value tables, mathematical formulas, calculators or computers.
Present Value of $1 with Compound Interest
1 .9434 = $1.0000 / 1.06
2 .8900 = $ .9434 / 1.06
3 .8396 = $ .8900 / 1.06
4 .7921 = $ .8396 / 1.06
5 .7432 = $ .7921 / 1.06
6 .7050 = $ .7432 / 1.06
PV Table
Period 6%
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.
Calculator
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Calculating Present Values of AnnuitiesCalculating Present Values of Annuities
Present Value of $1 — Annuity of 1$
PV Table Annuity
Period 6% 6%
CalculationSum of Periods
1 .9434.9434 .9434 = Period 1
2 .8900.8900 1.8334 = Periods 1–2
3 .8396 2.6730 = Periods 1–3
4 .7921 3.4651 = Periods 1–4
5 .7432 4.2124 = Periods 1–5
4.2124
The PV of an annuity of $1 to be received each year for two years is $1.8334. This is the sum of the PV of the two amounts for periods 1 and 2.
Annuities represent a series of equal amounts to be paid or received in the future over equal periods.
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Calculating Present Values of AnnuitiesCalculating Present Values of Annuities
Present Value of $1 — Annuity of 1$
PV Table Annuity
Period 6% 6%
CalculationSum of Periods
1 .9434.9434 .9434 = Period 1
2 .8900.8900 1.8334 = Periods 1–2
3 .8396.8396 2.6730 = Periods 1–3
4 .7921 3.4651 = Periods 1–4
5 .7432 4.2124 = Periods 1–5
4.2124
The PV of an annuity of $1 to be received each year for three years is $2.6730. This is the sum of the PV of the three amounts for periods 1–3.
Annuities represent a series of equal amounts to be paid or received in the future over equal periods.
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Calculating Present Values of AnnuitiesCalculating 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% 6%
CalculationSum of Periods
1 .9434 .9434 = Period 1
2 .8900 1.8334 = Periods 1–2
3 .8396 2.6730 = Periods 1–3
4 .7921 3.4651 = Periods 1–4
5 .7473 4.2124 = Periods 1–5
4.2124Total
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= $ 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
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
Assumptions:Assumptions:
Cash Flow Present Value
Present Value MethodPresent Value Method
Investment $200,000Useful life 5 yearsResidual value noneMinimum rate of return 10%
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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
What is the meaning of an index over 1.0?What is the meaning of an index over 1.0?
Present Value MethodPresent Value Method
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Internal 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.
Use a computer function to calculate exactly the expected rate of return.
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
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Qualitative 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.
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The Capital Rationing ProcessThe 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.