nobles finmgr5 ppt_26

Chapter 26Capital

Investment Decisions

© 2016 Pearson Education, Inc.

Learning Objectives

1. Describe the importance of capital investments and the capital budgeting process

2. Use the payback and the accounting rate of return methods to make capital investment decisions

26-2© 2016 Pearson Education, Inc.

Learning Objectives

3. Use the time value of money to compute the present values of lump sums and annuities

4. Use discounted cash flow methods to make capital investment decisions


Learning Objective 1

Describe the importance of capital investments and the capital budgeting process


What Is Capital Budgeting?

• Capital asset: An operational asset used for a long period of time.

• Capital investment: The acquisition of a capital asset.

• Capital budgeting: The process of planning to invest in long-term assets in a way that returns the most profitability to the company.


The Capital Budgeting Process



• Capital rationing: The process of ranking and choosing among alternative capital investments based on the availability of funds.

• Post-audit: The comparison of the actual results of capital investments to the projected results.



• Four popular methods of analyzing potential capital investments are: – Payback– Accounting rate of return (ARR)– Net present value (NPV)– Internal rate of return (IRR)



• Stages of capital budgeting:1. Screen the potential capital investments using

one or both of the methods that do not incorporate the time value of money.

2. Further analyze the potential investments using the net present value and/or internal rate of return methods.


Focus on Cash Flows

• Generally Accepted Accounting Principles (GAAP) are based on accrual accounting.

• Capital budgeting focuses on cash flows.


Focus on Cash Flows



Use the payback and the accounting rate of return methods to make capital investment decisions


How Do the Payback and Accounting Rate of Return Methods Work?

• Two capital investment analysis methods that companies use to evaluate shorter capital investments are:– Payback – Accounting rate of return

• Payback is a capital investment analysis method that measures the length of time it takes to recover, in net cash inflows, the cost of the initial investment.


Payback with Equal AnnualNet Cash Inflows

• Smart Touch Learning is considering investing $240,000 in:– Hardware and software to provide a business-

to-business (B2B) portal. Smart Touch Learning expects the portal to save $60,000 per year for each of the six years of its useful life.



• Net cash flows arise from an increase in revenues, a decrease in expenses, or both.

• When net cash inflows are equal each year, managers compute the payback with the following formula:



• Smart Touch Learning computes the investment’s payback as:



• Assume Smart Touch Learning is considering whether to, instead, invest $240,000 to upgrade its Web site. The company expects the upgraded Web site to generate $80,000 in net cash inflows each year of its three-year life. The payback is:


Payback with Unequal AnnualNet Cash Inflows


Payback with Unequal AnnualNet Cash Inflows

• For the payback with unequal cash flows, the payback period is calculated using the following formula:

• The shortest payback period is for the Web site:


Criticism of Payback


Payback


Accounting Rate ofReturn (ARR)

• The accounting rate of return (ARR) is a capital investment analysis method that measures profitability of an investment.



• Before calculating the ARR, first determine the average annual operating income using the following formula:



• The B2B portal’s average annual operating income and ARR are as follows:



• The Z80 portal’s average annual operating income and ARR are as follows:



Use the time value of money to compute the present values of lump sums and annuities


What Is the Time Value of Money?

• A dollar received today is worth more than a dollar to be received in the future.

• The fact that invested cash earns interest over time is called the time value of money.

• Two methods of capital investment analysis incorporate the time value of money:• Net present value (NPV)• Internal rate of return (IRR)


Time Value of Money Concepts

• The time value of money depends on several key factors:– The principal amount (p)—The amount of the

investment (Principal is stated as either a single lump sum or an annuity.)

– The number of periods (n)—The length of time from the beginning of the investment until termination

– The interest rate (i)—The annual percentage earned on the investment


Simple Interest Versus Compound Interest

• Simple interest means that interest is calculated only on the principal amount.

• Compound interest means that interest is calculated on the principal and on all previously earned interest.


Simple Interest Versus Compound Interest


Present Value Factors

• The future value of the investment in our example is simply its worth at the end of the five-year term.

• The future value is the principal plus interest earned.



• The future value of a $10,000 principal, for five years, at 6% interest is:

• Then rearrange the equation:



Table Used to calculate the value today of

• Present Value of $1 (Appendix B, Table B-1)

One future amount(a lump sum)

• Present Value of Ordinary Annuity of $1 (Appendix B, Table B-2)

A series of equal future amounts (annuities)


Present Value of a Lump Sum

• How much would you need to invest today (in the present time) to have $13,383 in five years if the interest rate is 6%?

• Use the PV factor from the table Present Value of $1 (Appendix B, Table B-1).


Present Value of an Annuity

• A series of equal payments over equal intervals (years) is an annuity.

• Assume instead of receiving a lump sum at the end of five years, you will receive $2,000 at the end of each year.


Summary

• Assume you have won the lottery after purchasing a $5 lottery ticket. You have the following options:


Present Value of an Annuity



Use discounted cash flow methods to make capital investment decisions


How Do Discounted Cash Flow Methods Work?

• Neither payback nor ARR recognizes the time value of money.

• The methods incorporating compound interest are: – Net present value (NPV)– Internal rate of return (IRR)


Net Present Value (NPV)

• Net present value (NPV) is a capital investment analysis method that measures the net difference between the present value of an investment’s net cash inflows and the investment’s initial cost.

• The discount rate is management’s minimum desired rate of return on a capital investment.


Net Present Value (NPV)

• Compare two projects: produce laptop computers or produce desktop computers.


NPV with Equal Periodic Net Cash Inflows

• Smart Touch Learning expects the laptop project to generate $305,450 of net cash inflows each year for five years.

• The NPV is $48,610 calculated as follows:


NPV with Equal Periodic Net Cash Inflows


NPV with Unequal Periodic Net Cash Inflows


NPV of a Project with Residual Value

• Suppose Smart Touch Learning expects that the laptop project equipment will be worth $100,000 at the end of its five-year life. The revised NPV is as follows:


Smart Touch LearningCapital Investment Options


Profitability Index

• Choose the project with the highest NPV when comparing projects with similar investments.

• Use the profitability index when initial investment amounts differ.


Profitability Index

• The profitability index is computed as follows:


Profitability Index


Profitability Index

• Comparison of the laptop and desktop projects (without residual value) using the profitability index is as follows:


Internal Rate of Return (IRR)

• The internal rate of return (IRR) is the rate of return, based on discounted cash flows, of a capital investment.

• It is the interest rate that makes the NPV of the investment equal to zero.


IRR with Equal Periodic Net Cash Inflows

• Smart Touch Learning’s laptop project would cost $1,000,000 with five equal yearly cash inflows of $305,450.

• Use the following formula to find the annuity factor:

• Then look up the factor to determine the applicable interest rate.


Internal Rate of Return (IRR)


IRR with Unequal PeriodicNet Cash Flows


Comparing Capital Investment Analysis Methods


Sensitivity Analysis

• Microsoft Excel can be used to perform “what if” analysis.


Capital Rationing
