capital investment analysis

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Capital Capital Investment Investment

AnalysisAnalysis

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Explain the nature and importance of capital investment

analysis.

Objective 1Objective 1Objective 1Objective 1

10-1


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Capital investment analysis (or capital budgeting) is the

process by which management plans,

evaluates, and controls investments in fixed assets.

Capital Investment Analysis 10-1


4

Evaluate capital investment proposals, using the

following methods: average rate of return, cash payback,

net present value, and internal rate of return.


10-2


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Methods of Evaluating Capital Investment Proposals

The average rate of return method The cash payback method

Methods that ignore present values:

The net present value method The internal rate of return method

Methods that use present values:

10-2


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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%

Percentage of Respondents Reporting the Use of the Method as “Always” or “Often”

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).

10-2


7

Easy to calculate

Considers accounting income (often used to evaluate managers)

Advantages:

Ignores cash flows

Ignores the time value of money

Disadvantages:

Average Rate of Return Method 10-2


811

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

Assumptions:


Estimated AverageAnnual Income

Average Investment=


$200,000/4($500,000 + $0)/2

= = 20%

Purchase of Machine Example 10-2


912

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

Proposal A Proposal B

$30,000

$120,000

25%Average rate of return

10-2


1013

Estimated average annual income $ 30,000 $ 36,000

Average investment $120,000 $180,000

Proposal A Proposal B

$360,000

$180,000

20%25%Average rate of return

Proposal A would be preferred over

Proposal B.

Proposal A would be preferred over

Proposal B.

10-2


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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.

For Practice: PE 10-1A, PE 10-1B

Follow My Example 10-1

Est. average annual income: $91,200 ($273,600/3 years)

Average investment: $380,000 ($690,000 + $70,000)/2

Average rate of return: 24% ($91,200/$380,000)

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Cash Payback Method

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.

10-2


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The excess of cash flowing in from revenue over the cash flowing out for expenses is

termed net cash flow.

10-2


1417

Investment cost $200,000Expected annual net cash flow (equal) $40,000

Assumptions:

Cashpayback period

Total Investment

Annual NetCash Flow

=

= 5 yearsCash

payback period

$200,000$40,000

=

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Considers cash flows

Shows when funds are available for reinvestment

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

period

Advantages:

Disadvantages:

Advantages and Disadvantages of the Cash Payback Method

10-2


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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.

For Practice: PE 10-2A, PE 10-2B


3.5 years ($105,000/$30,000)

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Present Value Concepts

Present value concepts can be divided into:

the present value of an amount and

the present value of an annuity.

10-2


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Present Value of an Amount

On January 1, 2008, you invest $1 in an account that

earns 12% interest compounded annually.

Interest earning interest is called compounding.

10-2


1924

Jan. 1

2009 Jan. 1

2010 Jan. 1

2011

$1.00 x 1.12 $1.12 x 1.12

Present Value Concepts

$1.254 x 1.12

Jan. 1

2008

$1.00

$1.00 $1.12 $1.254 $1.404

10-2


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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.

10-2


2126

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%

0.7120.712

Partial Present Value of $1 Table

Left click the mouse for solution.

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Present value = Table value

x

Present value = 0.712 x $1,404

Present value = $1,000.00 (rounded)

Summary: If the interest rate is 12%, then $1,404 in three years is worth $1,000 today.

Amount to be received on

January 1, 2011

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Present 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 amount of cash needed today to

yield a series of equal net cash flows at fixed time intervals in the future.

10-2


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Net Present Value Method

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.

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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.

10-2

Equipment Example

(Continued)


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A net cash flow of $70,000 is expected at the end of 2008. 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?

10-2

Equipment Example

(Continued)


2732

$ 63,630

$70,000 x 0.909 (n = 1; i =10%)

Jan. 1

2008 Dec. 31

2008 Dec. 31

2009 Dec. 31

2010 Dec. 31

2011 Dec. 31

2012

$(200,000) $70,000 $60,000 $50,000 $40,000 $40,000

10-2

Equipment Example

(Continued)


2833

$ 63,630

Jan. 1

2008 Dec. 31

2008 Dec. 31

2009 Dec. 31

2010 Dec. 31

2011 Dec. 31

2012

$(200,000) $70,000 $60,000 $50,000 $40,000 $40,000

$ 49,560

$60,000 x 0.826 (n = 2; i = 10%)

10-2

Equipment Example

(Continued)


2934

$ 63,630

Jan. 1

2008 Dec. 31

2008 Dec. 31

2009 Dec. 31

2010 Dec. 31

2011 Dec. 31

2012

$(200,000) $70,000 $60,000 $50,000 $40,000 $40,000

$ 49,560

$ 37,550

$50,000 x 0.751 (n = 3; i = 10%)

10-2

Equipment Example

(Continued)


3035

$ 63,630

Jan. 1

2008 Dec. 31

2008 Dec. 31

2009 Dec. 31

2010 Dec. 31

2011 Dec. 31

2012

$(200,000) $70,000 $60,000 $50,000 $40,000 $40,000

$ 49,560

$ 37,550 $ 27,320

$40,000 x 0.683 (n = 4; i =10%)

10-2

Equipment Example

(Continued)


3136

$ 63,630

Jan. 1

2008 Dec. 31

2008 Dec. 31

2009 Dec. 31

2010 Dec. 31

2011 Dec. 31

2012

$(200,000) $70,000 $60,000 $50,000 $40,000 $40,000

$ 49,560

$ 37,550 $ 27,320$40,000 x 0.621 (n = 5; i = 10%)

$ 24,840

10-2

Equipment Example

(Continued)


3237

$ 63,630

Jan. 1

2008 Dec. 31

2008 Dec. 31

2009 Dec. 31

2010 Dec. 31

2011 Dec. 31

2012

$(200,000) $70,000 $60,000 $50,000 $40,000 $40,000

$ 49,560

$ 37,550 $ 27,320 $ 24,840 $ 2,900 Net present value

The equipment should be purchased because the net present value is positive.

Total present value of the net cash flow is $202,900

10-2

Equipment Example

(Concluded)


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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.

Present Value Index 10-2


3439

Present value index =

Total present value of net cash flow

Amount to be invested

Present value index =$202,900*

$200,000= 1.0145

10-2


3540

Total present value of net cash flow$107,000 $86,400$86,400Amount to be invested 100,000 80,000 90,000Net present value $ 7,000$ 6,400$ 3,600

Present value index

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

Proposal A Proposal B Proposal C

1.07

Ranking Various Proposals Using a Present Value Index

10-2


3641

Total present value ofnet cash flow $107,000 $86,400 $86,400

Amount to be invested 100,000 80,000 90,000Net present value $ 7,000 $ 6,400 $ 3,600

Present value index 1.07

$86,400$86,400 $80,000$80,000$86,400$86,400 $80,000$80,000

1.08


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3742



Present value index 1.07 1.08


0.96

$86,400$86,400 $90,000$90,000$86,400$86,400 $90,000$90,000

10-2


3843

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.



Present value index 1.07 1.08


0.96

10-2


3944

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?

10-2


4045

Refer to Exhibit 2


of $1=

Equal Annual Cash Flows

xTable Value

from Exhibit 2

= $50,000 xTable Value

from Exhibit 2


of $1

10-2


4146

Partial Present Value of an Annuity Table

Present Value of an Annuity of $1 at Compound InterestPresent Value of an Annuity of $1 at Compound InterestPresent Value of an Annuity of $1 at Compound InterestPresent Value of an Annuity of $1 at Compound Interest

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

7 5.582 4.868 4.564 4.160 3.605

8 6.210 5.335 4.968 4.487 3.837

Year 6% 10% 12% 15% 20%

3.7913.791

10-2


4247

= $50,000 x 3.791Present Value of an Annuity

of $1

$189,550 = $50,000 x 3.791

Present Value Index =$189,550$200,000

= 0.948

The proposal should be rejected because the present value index is less than one.

10-2


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Considers cash flows and the time value of money

Advantage:

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

Disadvantage:

Advantage and Disadvantage of Net Present Value Method

10-2


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10-2


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.

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For Practice: PE 10-3A, PE 10-3B50

10-2


(a) ($11,800) [($50,000 x 4.564) – $240,000]

(b) 0.95 ($228,200/$240,000)


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Internal Rate of Return Method

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.

10-2


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List and describe factors that

complicate capital investment analysis.


10-3


48

Income tax

Factors that Complicate Capital Investment Analysis

10-3

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


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10-4

Capital Rationing

Capital rationing is the process by which

management allocates funds among competing capital

investment proposals.

capital investment analysis

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