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Click to edit Master title style 1 Capital Investment Analysis 10.

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Presentation on theme: "Click to edit Master title style 1 Capital Investment Analysis 10."— Presentation transcript:

1 Click to edit Master title style 1 Capital Investment Analysis 10

2 Click to edit Master title style 2 Explain the nature and importance of capital investment analysis. Objective

3 Click to edit Master title style 3 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 Click to edit Master title style 4 Evaluate capital investment proposals, using the following methods: average rate of return, cash payback, net present value, and internal rate of return. Objective

5 Click to edit Master title style 5 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

6 Click to edit Master title style 6 9 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 Click to edit Master title style 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

8 Click to edit Master title style 8 11 Machine cost$500,000 Expected useful life4 years Residual valuenone Expected total income$200,000 Assumptions: Average rate of return Estimated Average Annual Income Average Investment = Average rate of return $200,000/4 ($500,000 + $0)/2 = = 20% Purchase of Machine Example 10-2

9 Click to edit Master title style 9 12 Estimated average annual income$ 30,000$ 36,000 Average investment$120,000$180,000 Proposal AProposal B $30,000 $120,000 25%Average rate of return 10-2

10 Click to edit Master title style Estimated average annual income$ 30,000$ 36,000 Average investment$120,000$180,000 Proposal AProposal B $360,000 $180,000 20%25%Average rate of return Proposal A would be preferred over Proposal B. 10-2

11 Click to edit Master title style 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) 14

12 Click to edit Master title style 12 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

13 Click to edit Master title style 13 The excess of cash flowing in from revenue over the cash flowing out for expenses is termed net cash flow. 10-2

14 Click to edit Master title style Investment cost$200,000 Expected annual net cash flow (equal)$40,000 Assumptions: Cash payback period Total Investment Annual Net Cash Flow = = 5 years Cash payback period $200,000 $40,000 = 10-2

15 Click to edit Master title style 15  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

16 Click to edit Master title style Example Exercise 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 Follow My Example years ($105,000/$30,000) 21

17 Click to edit Master title style 17 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

18 Click to edit Master title style 18 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

19 Click to edit Master title style Jan Jan Jan $1.00 x 1.12$1.12 x 1.12 Present Value Concepts $1.254 x 1.12 Jan $1.00 $1.12$1.254$

20 Click to edit Master title style 20 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

21 Click to edit Master title style Present Value of $1 with Compound Interest Year 6% 10% 12% 15% 20% Partial Present Value of $1 Table Left click the mouse for solution. 10-2

22 Click to edit Master title style Present value = Table value x Present value = x $1,404 Present value = $1, (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,

23 Click to edit Master title style 23 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

24 Click to edit Master title style 24 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. 10-2

25 Click to edit Master title style 25 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 Equipment Example (Continued)

26 Click to edit Master title style 26 A net cash flow of $70,000 is expected at the end of 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)

27 Click to edit Master title style $ 63,630 $70,000 x (n = 1; i =10%) Jan Dec Dec Dec Dec Dec $(200,000) $70,000 $60,000 $50,000 $40,000 $40, Equipment Example (Continued)

28 Click to edit Master title style $ 63,630 Jan Dec Dec Dec Dec Dec $(200,000) $70,000 $60,000 $50,000 $40,000 $40,000 $ 49,560 $60,000 x (n = 2; i = 10%) 10-2 Equipment Example (Continued)

29 Click to edit Master title style $ 63,630 Jan Dec Dec Dec Dec Dec $(200,000) $70,000 $60,000 $50,000 $40,000 $40,000 $ 49,560 $ 37,550 $50,000 x (n = 3; i = 10%) 10-2 Equipment Example (Continued)

30 Click to edit Master title style $ 63,630 Jan Dec Dec Dec Dec Dec $(200,000) $70,000 $60,000 $50,000 $40,000 $40,000 $ 49,560 $ 37,550 $ 27,320 $40,000 x (n = 4; i =10%) 10-2 Equipment Example (Continued)

31 Click to edit Master title style $ 63,630 Jan Dec Dec Dec Dec Dec $(200,000) $70,000 $60,000 $50,000 $40,000 $40,000 $ 49,560 $ 37,550 $ 27,320 $40,000 x (n = 5; i = 10%) $ 24, Equipment Example (Continued)

32 Click to edit Master title style $ 63,630 Jan Dec Dec Dec Dec Dec $(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, Equipment Example (Concluded)

33 Click to edit Master title style 33 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

34 Click to edit Master title style Present value index = Total present value of net cash flow Amount to be invested Present value index = $202,900* $200,000 =

35 Click to edit Master title style Total present value of net cash flow$107,000$86,400$86,400 Amount to be invested 100,000 80,000 90,000 Net present value$ 7,000$ 6,400$ 3,600 Present value index $107,000 $100,000 Proposal A Proposal B Proposal C 1.07 Ranking Various Proposals Using a Present Value Index 10-2

36 Click to edit Master title style Total present value of net cash flow$107,000$86,400$86,400 Amount to be invested 100,000 80,000 90,000 Net present value$ 7,000$ 6,400$ 3,600 Present value index 1.07 $86,400 $80, Proposal A Proposal B Proposal C 10-2

37 Click to edit Master title style Total present value of net cash flow$107,000$86,400$86,400 Amount to be invested 100,000 80,000 90,000 Net present value$ 7,000$ 6,400$ 3,600 Present value index Proposal A Proposal B Proposal C 0.96 $86,400 $90,

38 Click to edit Master title style 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. Total present value of net cash flow$107,000$86,400$86,400 Amount to be invested 100,000 80,000 90,000 Net present value$ 7,000$ 6,400$ 3,600 Present value index Proposal A Proposal B Proposal C

39 Click to edit Master title style 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

40 Click to edit Master title style Refer to Exhibit 2 Present Value of an Annuity of $1 = Equal Annual Cash Flows x Table Value from Exhibit 2 = $50,000 x Table Value from Exhibit 2 Present Value of an Annuity of $1 10-2

41 Click to edit Master title style Partial Present Value of an Annuity Table Present Value of an Annuity of $1 at Compound Interest Year 6% 10% 12% 15% 20%

42 Click to edit Master title style = $50,000 x Present Value of an Annuity of $1 $189,550 = $50,000 x Present Value Index = $189,550 $200,000 = The proposal should be rejected because the present value index is less than one. 10-2

43 Click to edit Master title style 43  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

44 Click to edit Master title style Example Exercise 10-3 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. 49

45 Click to edit Master title style 45 For Practice: PE 10-3A, PE 10-3B Follow My Example 10-3 (a) ($11,800) [($50,000 x 4.564) – $240,000] (b) 0.95 ($228,200/$240,000)

46 Click to edit Master title style 46 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

47 Click to edit Master title style 47 List and describe factors that complicate capital investment analysis. Objective

48 Click to edit Master title style 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

49 Click to edit Master title style Capital Rationing Capital rationing is the process by which management allocates funds among competing capital investment proposals.


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