2 LEARNING OBJECTIVES When you finish this chapter, you should be able to
3 1.Explain the nature & importance of capital investment analysis. 2.Evaluate capital investment proposals using the following methods: average rate of return, cash payback, net present value, & internal rate of return. 3.List, describe factors that complicate capital investment analysis 4.Diagram capital rationing process. LEARNING OBJECTIVES
4 LEARNING OBJECTIVE 1 Explain nature, importance of capital investment analysis.
5 CAPTIAL INVESTMENT ANALYSIS Capital investment analysis (capital budgeting) is the process by which managers Plan Evaluate Control investments in fixed assets LO 1
6 LEARNING OBJECTIVE 2 Evaluate capital investment proposals.
7 EVALUATION METHODS Methods not using present values Average rate of return Payback Methods that do use present values Net present value Internal rate of return LO 2
8 AVERAGE RATE OF RETURN LO 2 Measure of average income as a percent of average investment in fixed assets. Average rate of return = Estimated average income / Average investment
9 AVERAGE RATE OF RETURN : Example LO 2 Purchase of machine for $500,000 expected to generate $200,000 profit over 4 years. Average rate of return = ($200,000/4) / ($500,000/2) = $50,000 / $250,000 20%
10 AVERAGE RATE OF RETURN : Analysis LO 2 Purchase of the machine will help generate an average return of 20% per year for 4 years after taking into consideration its depreciation. However, it does not consider the present value of money.
11 PAYBACK PERIOD LO 2 Expected time between investment and recapture of cash outlay. Payback period = Cost / (Expected revenues – expenses)
12 PAYBACK PERIOD : Example LO 2 Purchase of machine for $200,000 with 8 year life expected to generate $40,000 net profit annually. Payback period = $200,000 / ($50,000 – 10,000) = $200,000 / $40,000 5 years
13 PAYBACK PERIOD : Analysis LO 2 It will take 5 years to pay for the machine, assuming $40,000 net profit and with no consideration for alternative uses for the money or the time value of money.
14 LO 2 Present value methods employ the time value of money to determine the return on purchase of a long term asset.
15 PRESENT VALUE $1 LO 2 Present value of $1 measures the cost in today’s dollars of a single investment to be withdrawn at a point in the future.
16 PRESENT VALUE : Annuity LO 2 Present value of an annuity measures the cost in today’s dollars of a series of investments to be withdrawn at a point in the future.
17 LO 2 Net present value (discounted cash flow) compares initial cash investment with present value of net cash flows.
18 NET PRESENT VALUE : Example LO 2 Purchase of machine for $200,000 with 5 year life, 10% minimum rate of return. NPV = $200,000 – 3.605 ($70,000) = $200,000 - $202,900 $2,900
19 NET PRESENT VALUE : Analysis LO 2 Return from investment in a long term asset costing $200,000 exceeds its cost by a positive $2,209, after considering the time value of money.
20 LO 2 Internal rate of return uses present value concepts to compute the rate of return expected from capital investment proposals.
21 INTERNAL RATE OF RETURN : Example LO 2 A machine costing $33,530 must generate a 12% return to be viable. The expected annual return is $10,000 each year for 5 years. ($10,000 * 3.605) - $33,000 = $2,520
22 INTERNAL RATE OF RETURN : Analysis LO 2 Return from investment in a long term asset costing $33,530 exceeds its cost by a positive $2,520, after considering the time value of money. This equates to an internal rate of return of 15%.
23 LEARNING OBJECTIVE 3 List, describe factors that complicate capital investment analysis.
24 COMPLICATING FACTORS Income tax Proposals with unequal lives Lease vs. capital investment Uncertainty Changes in price levels Qualitative considerations LO 3
25 LEARNING OBJECTIVE 4 Diagram capital rationing process.
26 LO 4 What is capital rationing? Capital rationing is the process by which managers allocate funds among competing proposals.
27 LO 4 EXHIBIT 6
28 CAPITAL RATIONING : Analysis LO 4 Capital rationing proposes an analytical process to choose among competing proposals. Those proposals that meet all quantitative (financial) and qualitative tests should be ranked for funding along with rejected proposals that change outcomes because of qualitative tests.