Managerial Accounting 2002e Belverd E. Needles, Jr. Susan Crosson - - - - - - - - - - - Multimedia Slides by: Harry Hooper Santa Fe Community College Copyright © Houghton Mifflin Company. All rights reserved.

Chapter 12 Capital Investment Analysis

Copyright © Houghton Mifflin Company. All rights reserved. LEARNING OBJECTIVES Define capital investment analysis and describe its relation to the management cycle. State the purpose of the minimum rate of return and identify the methods used to arrive at that rate. Identify the types of projected costs and revenues used to evaluate alternatives for capital investment. Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. LEARNING OBJECTIVES Apply the concept of the time value of money. Analyze capital investment proposals using the net present value method. Analyze capital investment proposals using the accounting rate-of-return method and the payback period method. Copyright © Houghton Mifflin Company. All rights reserved.

The Capital Investment Process OBJECTIVE 1 Define capital investment analysis and describe its relation to the management cycle.

Capital Investment Decisions Capital investment decisions are decisions about when and how much to spend on capital facilities and other long-term projects. Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. Capital Facilities Capital facilities and projects may include: Machinery. Systems or processes. Building additions. New building structures. New divisions or product lines. Distribution and software systems. Copyright © Houghton Mifflin Company. All rights reserved.

Capital Investment Analysis or Capital Budgeting Capital budgeting consists of five steps. Identifying the need for a capital investment. Analyzing courses of action to meet that need. Preparing reports for managers. Choosing the best alternative. Dividing funds among competing needs. Copyright © Houghton Mifflin Company. All rights reserved.

Capital Investment Analysis in the Management Cycle The planning phase of capital investment analysis cycle consists of the following steps: Identification of capital investment needs. Formal requests for capital investments. Preliminary screening. Establishment of the acceptance-rejection standard. Evaluation of proposals. Capital investment decisions. Copyright © Houghton Mifflin Company. All rights reserved.

Capital Investment Analysis in the Management Cycle Copyright © Houghton Mifflin Company. All rights reserved.

Capital Investment Analysis in the Management Cycle Executing Phase — scheduling projects and overseeing their development, construction, or purchase, on time, within budget, and at the desired level of quality. Reviewing Phase — isolating how a decision affects a company’s overall operating results, by carrying out a post-completion audit. Reporting Phase — comparing actual results with budgets or projections. Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. Discussion Q. What are the five steps in capital budgeting? A. 1. Identifying. 2. Analyzing. 3. Preparing. 4. Choosing. 5. Dividing. Copyright © Houghton Mifflin Company. All rights reserved.

The Minimum Rate of Return on Investment OBJECTIVE 2 State the purpose of the minimum rate of return and identify the methods used to arrive at that rate.

Copyright © Houghton Mifflin Company. All rights reserved. Desired Rate of Return Capital investment requests must exceed a minimum desired rate of return. The most common rate-of-return measures include: Cost of capital. Corporate return on investment. Industry average return on investment. Bank interest rates. Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. Cost of Capital The average cost of capital components include: Cost of debt. Cost of preferred stock. Cost of common stock. Cost of retained earnings. Copyright © Houghton Mifflin Company. All rights reserved.

Average Cost of Capital In calculating the average cost of capital, each source of capital is weighted by its proportion of the organization’s total amount of debt and equity. Cost of capital is the preferred measure for determining minimum rate of return. Copyright © Houghton Mifflin Company. All rights reserved.

Ranking Capital Investment Proposals Rank proposals in descending order of projected rate of return. Identify capital investment needs of each proposal. Select proposals whose rate of return exceeds cut off measure (minimum desired rate) up to total funds available. Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. Discussion Q. What are the common rate-of-return measures? A. 1. Cost of debt. 2. Cost of preferred stock. 3. Cost of common stock. 4. Cost of retained earnings. Copyright © Houghton Mifflin Company. All rights reserved.

Measures Used in Capital Investment Analysis OBJECTIVE 3 Identify the types of projected costs and revenues used to evaluate alternatives for capital investment.

Copyright © Houghton Mifflin Company. All rights reserved. Relevant Information The types of information relevant to capital investment decision evaluations include: Net income and net cash inflow (or cost savings). Equal versus unequal cash flows. Carrying value of assets. Depreciation expense and Income taxes. Disposal or residual values. Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. Discussion Q. What types of information are relevant to capital investment analysis? A. 1. Cost savings versus net cash inflow. 2. Book value of assets. 3. Disposal or salvage values. 4. Depreciation expense. 5. Equal versus unequal cash flows. Copyright © Houghton Mifflin Company. All rights reserved.

OBJECTIVE 4 Apply the concept of the time value of money.

Copyright © Houghton Mifflin Company. All rights reserved. The Time Value of Money The time value of money concept states that cash flows of equal dollar amounts separated by an interval of time have different present values because of the effect of compound interest. Compound interest is assumed. The earning of interest is assumed. Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. The Time Value of Money The net present value method considers the time value of money. Use compounding to find the future value of an amount now held. Copyright © Houghton Mifflin Company. All rights reserved.

Interest Simple Interest assumes the amount on which the interest is computed stays the same from period to period. Interest = Principal x Rate x Time Compound Interest assumes the amount on which the interest is computed includes all interest paid in previous periods. Year Principal Amount at Beginning of Year Annual Amount of Interest (col. 2 x .06) Accumulated Amount at End of Year (col. 2 + col.3) 1 $5,000.00 $300.00 $5,300.00 2 5,300.00 318.00 5,618.00 3 337.08 5,955.08

Present Value Present value is the amount that must be invested today at a given rate of compound interest to produce a given future value. PV = FV  (1 + Interest Rate)n Future value is the amount an investment will be worth at a future date if invested today at compound interest. n = number of periods

Present Value Calculations An ordinary annuity is a series of equal payments or receipts that will begin one time period from the current date. The Present Value of a single sum in the future and the present value of an ordinary annuity are usually determined using a business calculator, a computer, or from Present Value Tables.

Copyright © Houghton Mifflin Company. All rights reserved. The Time Value of Money Use discounting to find the present value of an amount to be received. Consider the differences between a single payment and a series of payments. Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. Discussion Q. What is meant by the time value of money? A. The time value of money concept states that cash flows of equal dollar amounts separated by an interval of time have different present values because of the effect of compound interest. Copyright © Houghton Mifflin Company. All rights reserved.

The Net Present Value Method OBJECTIVE 5 Analyze capital investment proposals using the net present value method.

Copyright © Houghton Mifflin Company. All rights reserved. Net Present Value The basis for the net present value method is that cash flows from different time periods have different values when measured in current dollars. The method is applied by first discounting all cash flows to the present. Copyright © Houghton Mifflin Company. All rights reserved.

Net Present Value Method The cost of the asset to be purchased is subtracted from the net present value of all the future cash flows. Projects with the highest positive net present value are selected for implementation. Copyright © Houghton Mifflin Company. All rights reserved.

Net Present Value Analysis: Equal Versus Unequal Cash Flows Copyright © Houghton Mifflin Company. All rights reserved.

The Accounting Rate-of-Return and Payback Period Methods OBJECTIVE 6 Analyze capital investment proposals using the accounting rate-of-return method and the payback period method.

The Accounting Rate-of-Return Method The accounting rate-of-return method is an imprecise but easy way to measure the estimated performance of a capital investment. Copyright © Houghton Mifflin Company. All rights reserved.

Accounting Rate-of-Return Project’s Average Annual Net Income = Average Investment Cost Copyright © Houghton Mifflin Company. All rights reserved.

Average Investment Cost (Total Investment + Salvage Value) = 2 Copyright © Houghton Mifflin Company. All rights reserved.

The Accounting Rate-of-Return Method Using this method, managers select the alternative that yields the highest ratio of average annual net income to average cost of investment. Capital investment proposals must meet the minimum desired rate of return. Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. Disadvantages The method has some disadvantages, including: The method is unreliable if estimated annual income differs from year to year. Time value of money is not considered in calculating the accounting rate-of-return so future and present dollars are treated as equal. Copyright © Houghton Mifflin Company. All rights reserved.

The Payback Period Method Cost of Investment Annual Net Cash Inflows Payback Period = The payback period is expressed as a number of years. Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. Disadvantages Disadvantages of the payback period method are: It does not measure profitability. It ignores differences in the present values of cash flows from different periods. It emphasizes the time it takes to recover the investment rather than the long-term return on the investment. Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. Discussion Q. What is the basis for the net present value method? A. The basis for the net present value method is that cash flows from different time periods have different values when measured in current dollars. Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. Discussion Q. What are three common methods used to evaluate capital expenditure proposals? A. 1. Accounting rate-of-return. 2. Payback period. 3. Net present value. Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. OK, Let’s Review Define capital investment analysis and describe its relation to the management cycle. State the purpose of the minimum rate of return and identify the methods used to arrive at that rate. Identify the types of projected costs and revenues used to evaluate alternatives for capital investment. Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. And Finally . . . Apply the concept of the time value of money. Analyze capital investment proposals using the net present value method. Analyze capital investment proposals using the accounting rate-of-return method and the payback period method. Copyright © Houghton Mifflin Company. All rights reserved.