c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Capital Investment Analysis Chapter 25

Learning Objectives 1. Explain the nature and importance of capital investment analysis. 2. Evaluate capital investment proposals using the average rate of return and cash payback methods. 3. Evaluate capital investment proposals using the net present value and internal rate of return methods. 4. List and describe factors that complicate capital investment analysis. 5. Diagram the capital rationing process.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Explain the nature and importance of capital investment analysis. 1

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Nature of Capital Investment Analysis o Capital investment analysis (or capital budgeting) is the process by which management plans, evaluates, and controls investments in fixed assets.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Nature of Capital Investment Analysis o Methods that do not use present values  Average rate of return method  Cash payback method o Methods that use present values  Net present value method  Internal rate of return method

N ATURE OF C APITAL I NVESTMENT A NALYSIS

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Nature of Capital Investment Analysis o The time value of money concept recognizes that a dollar today is worth more than a dollar tomorrow because today’s dollar can earn interest.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Evaluate capital investment proposals using the average rate of return and cash payback methods. 2

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Average Rate of Return Method o The average rate of return, sometimes called the accounting rate of return, measures the average income as a percent of the average investment. The average rate of return is computed as follows: Average Rate of Return Estimated Average Annual Income Average Investment = (Initial Cost + Residual Value)/2

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Average Rate of Return Method o Management is evaluating the purchase of a new machine as follows: Machine cost$500,000 Residual value0 Estimated total income from machine200,000 Expected useful life4 years Average Rate of Return Estimated Average Annual Income Average Investment = Average Rate of Return $200,000/4 ($500,000 + $0)/2 = 20% = 20%

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Average Rate of Return Method o The average rate of return of 20% should be compared to the minimum rate of return required by management. If the average rate of return equals or exceeds the minimum rate, the machine should be purchased or considered for further analysis.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Average Rate of Return Method o The average rate of return has the following three advantages:  It is easy to compute.  It includes the entire amount of income earned over the life of the proposal.  It emphasizes accounting income.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Average Rate of Return Method o The average rate of return has the following two disadvantages:  It does not directly consider the expected cash flows from the proposal.  It does not directly consider the timing of the expected cash flows.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Cash Payback Method o The expected period of time that will pass between the date of an investment and the complete recovery in cash of the amount invested is the cash payback period.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Cash Payback Method o When annual net cash inflows are equal, the cash payback period is computed as follows: Cash Payback Period Initial Cost Annual Net Cash Inflow =

Cost of new machine$200,000 Cash revenue from machine per year50,000 Expenses of machine per year30,000 Depreciation per year20,000 Net cash inflow per year: Cash revenue from machine$50,000 Less cash expenses of machine: Expenses of machine$30,000 Less depreciation 20,000 10,000 Net cash inflow per year$40,000 Net cash inflow per year: Cash revenue from machine$50,000 Less cash expenses of machine: Expenses of machine$30,000 Less depreciation 20,000 10,000 Net cash inflow per year$40,000 (continued) Cash Payback Method

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. 5 years = 5 years Cash Payback Period $200,000 $40,000 = Cash Payback Period Initial Cost Annual Net Cash Inflow = Cash Payback Method o The time required for the net cash inflow to equal the cost of the new machine is the payback period. The estimated cash payback period for the investment in the machine is five years, as computed below.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Cash Payback Method o Assume that a proposed investment has an initial cost of $400,000. The annual and cumulative net cash inflows over the proposal’s six-year life are as follows:

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Cash Payback Method o The cash payback method has the following two advantages:  It is simple to use and understand.  It analyzes cash flows.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Cash Payback Method o The cash payback method has the following two disadvantages:  It ignores cash flows occurring after the payback period.  It does not use present value concepts in valuing cash flows occurring in different periods.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Evaluate capital investment proposals using the net present value and internal rate of return methods. 3

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Present Value Concepts o Both the net present value and the internal rate of return methods use the following two present value concepts:  Present value of an amount  Present value of an annuity

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Present Value of an Amount o If you had $1 to invest for three years at 12%, how much would you have after one year? By the end of the second year? By the end of the third year? $1 x 1.12 = $1.12 $1.12 x 1.12 = $1.254 $1.254 x 1.12 = $1.404

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Present Value of an Amount o This process of interest earning interest is called compounding. The illustration below demonstrates the concept of compounding.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Present Value of an Amount o On January 1, 2014, what is the present value of $1.404 to be received on December 31, 2016 (assuming an interest rate of 12 percent)? To determine the answer, we need to go to Exhibit 1 (next slide) and find the table value for three years at 12 percent. Using the PV of $1 Table

$ × $1.404 = $1.00 P RESENT V ALUE OF AN A MOUNT

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Present Value of an Amount o Another way of stating this is that the present value of $1.404 to be received in three years using a compound interest rate of 12% is $1, as shown below.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Present Value of an Annuity o An annuity is a series of equal net cash flows at fixed time intervals. o 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.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Present Value of an Annuity o The present value of a $100 annuity for five periods at 12% could be determined by using the present value factors in Exhibit 1. This is shown graphically in the next slide.

P RESENT V ALUE OF AN A NNUITY

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Using the PV of an Annuity of $1 Table Present Value of an Annuity o Using a present value of an annuity of $1 table, such as the one in Exhibit 2 (next slide), is a simpler approach.

$ × $100 = $ P RESENT V ALUE OF AN A NNUITY

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Net Present Value Method o The net present value method compares the amount to be invested with the present value of the net cash inflows. It is sometimes called the discounted cash flow method.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Cost of new equipment$200,000 Expected useful life5 years Minimum desired rate of return10% Expected cash flows to be received each year: Year 1$70,000 Year 260,000 Year 350,000 Year 440,000 Year 5 40,000 $260,000 Total expected cash flows$260,000 Net Present Value Method o Assume the following data for a proposed investment in new equipment:

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Net Present Value Method o Using the present value of $1 (Exhibit 1) at 10%, the present value of the net cash flow for each year is shown below.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Net Present Value Method o The preceding computations are also graphically illustrated below.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Net Present Value Method o The net present value of $2,900 indicates that the purchase of the new equipment is expected to recover the investment and provide more than the minimum rate of return of 10%.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Net Present Value Method o Capital investment proposals can be ranked by using a present value index. The present value index is computed as follows: Present Value Index = Total Present Value of Net Cash Flow Amount to Be Invested

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Present Value Index = Total Present Value of Net Cash Flow Amount to Be Invested Present Value Index = $202,900 $200, = Net Present Value Method o The present value index for the investment in the preceding slides is , as computed below.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Most desirable proposal Net Present Value Method o A company is considering three proposals. The net present value and the present value index for each proposal are as follows:

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Net Present Value Method o The net present value method has the following three advantages:  It considers the cash flows of the investment.  It considers the time value of money.  It can rank equal lived projects using the present value index.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Net Present Value Method o The net present value method has the following two disadvantages:  It has more complex computations than methods that don’t use present value.  It assumes the cash flows can be reinvested at the minimum desired rate of return, which may not be valid.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Internal Rate of Return Method o The internal rate of return (IRR) method uses present value concepts to compute the rate of return from a capital investment proposal based on its expected net cash flows. o This method, sometimes called the time- adjusted rate of return method, starts with the proposal’s net cash flows and works backward to estimate the proposal’s expected rate of return.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Cost of new equipment$33,530 Yearly expected cash flows to be received10,000 Expected life5 years Minimum desired rate of return12% Internal Rate of Return Method o Management is evaluating the following proposal to purchase new equipment:

I NTERNAL R ATE OF R ETURN M ETHOD The present value of the net cash flows, using the present value of an annuity table (Exhibit 2), is $2,520, as shown below in Exhibit 3.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Internal Rate of Return Method o Through trial and error, the rate of return equating the $33,530 cost of the investment with the present value of the net cash flows can be determined to be 15%, as shown on the next slide.

I NTERNAL R ATE OF R ETURN M ETHOD

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Internal Rate of Return Method o A trial-and-error procedure is time-consuming. To illustrate a simpler procedure, assume that management is considering a proposal to acquire equipment costing $97,360. The equipment is expected to provide equal annual net cash flows of $20,000 for seven years.

$97,360 $20, = Amount to be Invested Equal Annual Net Cash Flows (continued) Internal Rate of Return Method STEP 1: Determine the present value factor for an annuity of $1 as follows:

(continued) Internal Rate of Return Method STEP 2: Find the seven-year line on Exhibit 2 (the present value of an annuity of $1 at compound interest). Proceed horizontally across the table until you find the present value factor computed in Step 1 (or the closest present value factor).

Internal Rate of Return Method 3.605

Internal Rate of Return Method STEP 3: Now that you have located on the seven-year line, go vertically to the top of the table to determine the interest rate.

The minimum acceptable rate of return is 10%. Internal Rate of Return Method

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Internal Rate of Return Method o The internal rate of return method has the following three advantages:  It considers the cash flows of the investment.  It considers the time value of money.  It ranks proposals based upon the cash flows over their complete useful life, even if the project lives are not the same.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Internal Rate of Return Method o The internal rate of return method has the following two disadvantages:  It has complex computations, requiring a computer if the periodic cash flows are not equal (an annuity).  It assumes the cash received from a proposal can be reinvested at the internal rate of return, which may not be valid.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective List and describe factors that complicate capital investment analysis. 4

Factors That Complicate Capital Investment Analysis 1. Income tax 2. Proposals with unequal lives 3. Leasing versus purchasing 4. Uncertainty 5. Changes in price levels 6. Qualitative factors

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Income Tax o For federal income tax purposes, depreciation on fixed assets can be much shorter than the actual useful lives. Also, depreciation for tax purposes often differs from depreciation for financial statement purposes.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Unequal Proposal Lives o Assume that a company is considering purchasing a new truck or a new computer network. The data for each proposal are shown below.

(continued) U NEQUAL P ROPOSAL L IVES

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Lease versus Capital Investment o Some advantages of leasing a fixed asset include the following:  The company has use of the fixed asset without spending large amounts of cash to purchase the asset.  The company eliminates the risk of owning an obsolete asset.  The company may deduct the annual lease payments for income tax purposes.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Lease versus Capital Investment o One disadvantage of leasing a fixed asset is the following:  The leasing arrangement normally is more costly than the outright purchase of the asset.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Uncertainty o All capital investment analyses rely on factors that are uncertain.  Estimates of revenue and expenses  The amount of cash flows

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Changes in Price Levels o General price levels often increase in a rapidly growing economy, which is called inflation. o Price levels may change for foreign investments. This occurs as currency exchange rates change. Currency exchange rates are the rates at which currency in another country can be exchanged for U.S. dollars.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Qualitative Considerations o Improvements that increase quality and competitiveness are difficult to quantify. The following qualitative factors are important considerations.  Product quality  Manufacturing flexibility  Employee morale  Manufacturing productivity  Market (strategic) opportunities

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Diagram the capital rationing process. 5

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Capital Rationing o Capital rationing is the process by which management allocates funds among competing capital investment proposals.

C APITAL R ATIONING

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Capital Investment Analysis The End