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Chapter 25 Capital Investment Analysis Accounting, 21st Edition Warren Reeve Fess PowerPoint Presentation by Douglas CloudProfessor Emeritus of AccountingPepperdine University

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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. 4. Diagram the capital rationing process. Objectives After studying this chapter, you should be able to:

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

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Nature 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.

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Methods of Evaluating Capital 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.

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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%

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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 Value

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Machine cost $500,000 Expected useful life 4 years Residual value none Expected total income $200,000 Assumptions: Average Rate of Return Estimated Average Annual Income Average Investment = Average Rate of Return Method Average Rate of Return 20%

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Average annual income $ 30,000 $ 36,000 Average investment $120,000 $180,000 Assumptions: Proposal A Proposal B Average Rate of Return Method

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Average annual income $ 30,000 $ 36,000 Average investment $120,000 $180,000 Assumptions: Proposal A Proposal B Average Rate of Return Method

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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 Cash Payback Method Methods that Ignore Present Value Advantages: Disadvantages:

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Cash Payback Method Investment cost $200,000 Expected useful life 8 years Expected annual net cash flows (equal) $40,000 Assumptions: Cash Payback Period

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Year 1 $ 60,000 $ 60,000 Year 2 80,000 140,000 Year 3 105,000 245,000 Year 4 155,000 400,000 Year 5 100,000 500,000 Year 6 90,000 590,000 Net Cash Cumulative Flow Net Cash Flow Cash Payback Method If the proposed investment is $400,000, the payback period is at the end of Year 4.

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The time value of money concept is used in many business decisions. This concept is an important consideration in capital investment analysis. Present Value $ ???? What is the present value of $1,000 to be received one year from today at 8% per year? Present Value Methods

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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%? Present Value Methods

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Refer to the partial present value table in Slide 18 to answer the question. Present Value Methods $1,000, 3 years, 12% compounded annually

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Calculating Present Values Present values can be determined using present value tables, mathematical formulas, a calculator or a computer. Present 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 0.712

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

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Present Value of an Amount $712 x 1.12 $797 x 1.12 $893 x 1.12 $1,000

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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 sum of these net cash flows.

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

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Present 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 Annuities 3.605 x $100 = $360.50 3.605

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Net Present Value Method The net present value method analyzes capital investment proposals by comparing the initial cash investment with the present value of the net cash flows.

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Considers cash flows and the time value of money Net Present Value Method Advantage: Assumes that cash received can be reinvested at the rate of return Disadvantage:

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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. Net Present Value Method

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Cash Flow Present 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? Net Present Value Method

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First, we must determine which table to use… the present value of $1 or the present value of an annuity of $1. Net Present Value Method

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Because there are multiple years of net cash flows, shouldn’t we use the present value of an annuity of $1? Net Present Value Method

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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. Net Present Value Method

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So, we have to use the present value of $1 for each of the five years. Net Present Value Method

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$ 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%) $<200,000> $70,000 $60,000 $50,000 $40,000 $40,000 Net Present Value Method

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$ 63,630 $ 49,560 $ 37,550 $ 27,320 $ 24,840 $ 2,900 Net Present Value Method $<200,000> $70,000 $60,000 $50,000 $40,000 $40,000

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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 using a present value index. Net Present Value Method

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Total present value $107,000 $86,400 $93,600 Total investment 100,000 80,000 90,000 Net present value $ 7,000 $ 6,400 $ 3,600 Present value index 1.07 1.08 1.04 Assumptions: Proposals A B C $107,000 ÷ $100,000 $86,400 ÷ $80,000 $93,600 ÷ $90,000 The most desirable proposal according to the present value index. Net Present Value Method

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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 Method

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Internal 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 Error Computer Function Use a computer function to calculate exactly the expected rate of return.

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Internal Rate of Return Method 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.

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Internal Rate of Return Method

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Internal Rate of Return Method

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Present 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% 4.868 Internal Rate of Return Method

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Internal Rate of Return Method Present 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% 4.868 10% 10%

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Factors That Complicate Capital Investment Analysis Income tax Unequal proposal lives Lease versus capital investment Uncertainty Changes in price levels Qualitative considerations

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Qualitative 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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Capital 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.

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The End Chapter 25