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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. Chapter 24 - Capital Investment Analysis Objectives

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

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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% Journal of Business and Management (Winter 2002)

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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 life4 years Residual valuenone 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 = $200,000 ÷ 4 years = ($500,000 + $0) / 2 20%

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Average annual income$ 30,000$ 36,000 Average investment$120,000$180,000 Assumptions: Proposal AProposal B $30,000 $120,000 = 25% Average Rate of Return Method

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Average annual income$ 30,000$ 36,000 Average investment$120,000$180,000 Assumptions: Proposal AProposal B $36,000 $180,000 = 20% 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 life8 years Expected annual net cash flows (equal)$40,000 Assumptions: Cash Payback Period Total Investment Annual Net Cash Inflows = Cash Payback Period $200,000 = $40,000 = 5 years

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Year 1$ 60,000$ 60,000 Year 280,000140,000 Year 3105,000245,000 Year 4155,000400,000 Year 5100,000500,000 Year 690,000590,000 Net CashCumulative FlowNet 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 $ 925.93 = $1,000 ÷ 1.08

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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 10.9430.9090.8930.8700.833 20.8900.8260.7970.7560.694 30.8400.7510.7120.6580.579 40.7920.6830.6360.5720.482 50.7470.6210.5670.4970.402 60.7050.5640.5070.4320.335 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 Feb. 1 2006 Feb. 1 2007 Feb. 1 2008 Feb. 1 2009 $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 the present values of each cash flows. 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 10.9430.9090.8930.8700.833 21.8331.7361.6901.6261.528 32.6732.4872.4022.2832.106 43.4653.1703.0372.8552.589 54.2123.7913.6053.3532.991 64.9174.3554.1113.7853.326 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 FlowPresent 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 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?

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

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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%) Jan. 1 2006 Dec. 31 2006 Dec. 31 2007 Dec. 31 2008 Dec. 31 2009 Dec. 31 2010 $ $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 Jan. 1 2006 Dec. 31 2006 Dec. 31 2007 Dec. 31 2008 Dec. 31 2009 Dec. 31 2010 $ $70,000 $60,000 $50,000 $40,000 $40,000 The equipment should be purchased because the net present value is positive.

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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. (a.k.a. profitability 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 index1.07 1.08 1.04 Assumptions: Assumptions: Proposals ABC $107,000 ÷ $100,000 $86,400 ÷ $80,000 $93,600 ÷ $90,000 The best 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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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 Trial and Error Computer Function Computer Function Use a computer function to calculate exactly the expected rate of return.

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$97,360 $20,000 = 4.868 Determine the table value using the present value for an annuity of $1 table. Internal Rate of Return Method Amount to be invested Equal annual cash flow 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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Present Value of an Annuity of $1 10.9430.9090.8930.870 21.8331.7361.6901.626 32.6732.4872.4022.283 43.4653.1703.0372.855 54.2123.7913.6053.353 64.9174.3554.1113.785 75.5824.8684.5644.160 Year 6% 10% 12% 15% 4.868 Internal Rate of Return Method Find the seven year line on the table. Then, go across the 7- year line until the closest amount to 4.868 is located. Move vertically to the top of the table to determine the interest rate 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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