t n e m t s e v

t n e m t s e v n I s i l s a t y i l a p Ca An 5 2 r e t p a h C c. 2014 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 Objectives 1. 2. 3. 4. 5. Explain the nature and importance of capital investment analysis. Evaluate capital investment proposals using the average rate of return and cash payback methods. Evaluate capital investment proposals using the net present value and internal rate of return methods. List and describe factors that complicate capital investment analysis. Diagram the capital rationing process.

Lear ning O b jectiv Expl ain th e e na ture a and i capit mpo al inv rtanc estm e of ent a nalys is. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. 1

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. 2014 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 Ø Average rate of return method Ø Cash payback method o Methods that use present values Ø Net present value method Ø Internal rate of return method c. 2014 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

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. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Lear ning Obje c t i ve E valua prop osa te c retur ls using capital in v n an d cas the avera estment g h pa ybac e rate o f k me thod s. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. 2

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. 2014 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 Residual value Estimated total income from machine Expected useful life Average Rate of Return = $500, 000 0 200, 000 4 years Estimated Average Annual Income Average Investment Average Rate $200, 000/4 of Return = ($500, 000 + $0)/2 = 20% c. 2014 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. 2014 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: Ø It is easy to compute. Ø It includes the entire amount of income earned over the life of the proposal. Ø It emphasizes accounting income. c. 2014 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: Ø It does not directly consider the expected cash flows from the proposal. Ø It does not directly consider the timing of the expected cash flows. c. 2014 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. 2014 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 c. 2014 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 Cost of new machine Cash revenue from machine per year Expenses of machine per year Depreciation per year $200, 000 50, 000 30, 000 20, 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 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. Cash Payback = Period Initial Cost Annual Net Cash Inflow Cash $200, 000 Payback = $40, 000 = 5 years Period c. 2014 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. 2014 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: Ø It is simple to use and understand. Ø It analyzes cash flows. c. 2014 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: Ø It ignores cash flows occurring after the payback period. Ø It does not use present value concepts in valuing cash flows occurring in different periods. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Lear ning Obje c t i ve prop E v aluat osals ec u apita sing and l inter nal r the net p investm ate o r e f retu esent val nt ue rn m etho ds. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. 3

Present Value Concepts o Both the net present value and the internal rate of return methods use the following two present value concepts: Ø Present value of an amount Ø Present value of an annuity c. 2014 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 x 1. 12 = $1. 254 x 1. 12 = $1. 404 c. 2014 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. 2014 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 Using the PV of $1 Table 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. c. 2014 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 0. 712 × $1. 404 = $1. 00

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. 2014 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. 2014 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. c. 2014 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

Present Value of an Annuity Using the PV of an Annuity of $1 Table o Using a present value of an annuity of $1 table, such as the one in Exhibit 2 (next slide), is a simpler approach. c. 2014 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 3. 605 × $100 = $360. 50

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. 2014 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 Assume the following data for a proposed investment in new equipment: Cost of new equipment $200, 000 Expected useful life 5 years Minimum desired rate of return 10% Expected cash flows to be received each year: Year 1 $70, 000 Year 2 60, 000 Year 3 50, 000 Year 4 40, 000 Year 5 40, 000 Total expected cash flows $260, 000 c. 2014 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. 2014 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. 2014 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. 2014 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: Total Present Value of Net Cash Flow Present Value Index = Amount to Be Invested c. 2014 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 present value index for the investment in the preceding slides is 1. 0145, as computed below. Total Present Value of Net Cash Flow Present Value Index = Amount to Be Invested $202, 900 = 1. 0145 Present Value Index = $200, 000 c. 2014 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 A company is considering three proposals. The net present value and the present value index for each proposal are as follows: Most desirable proposal c. 2014 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: Ø It considers the cash flows of the investment. Ø It considers the time value of money. Ø It can rank equal lived projects using the present value index. c. 2014 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: Ø It has more complex computations than methods that don’t use present value. Ø It assumes the cash flows can be reinvested at the minimum desired rate of return, which may not be valid. c. 2014 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. 2014 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 Management is evaluating the following proposal to purchase new equipment: Cost of new equipment Yearly expected cash flows to be received Expected life Minimum desired rate of return $33, 530 10, 000 5 years 12% c. 2014 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 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.

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. c. 2014 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

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. c. 2014 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 STEP 1: Determine the present value factor for an annuity of $1 as follows: Amount to be Invested Equal Annual Net Cash Flows $97, 360 = 4. 868 $20, 000 (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). (continued)

Internal Rate of Return Method 3. 605

Internal Rate of Return Method STEP 3: Now that you have located 4. 868 on the seven-year line, go vertically to the top of the table to determine the interest rate.

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

Internal Rate of Return Method o The internal rate of return method has the following three advantages: Ø It considers the cash flows of the investment. Ø It considers the time value of money. Ø It ranks proposals based upon the cash flows over their complete useful life, even if the project lives are not the same. c. 2014 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: Ø It has complex computations, requiring a computer if the periodic cash flows are not equal (an annuity). Ø It assumes the cash received from a proposal can be reinvested at the internal rate of return, which may not be valid. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Lear ning Obje c t i v List a e n d de co ompl s icate cribe fac t capit al inv ors that estm ent analy sis. c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. 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

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. 2014 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. c. 2014 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 (continued)

UNEQUAL PROPOSAL LIVES

Lease versus Capital Investment o Some advantages of leasing a fixed asset include the following: Ø The company has use of the fixed asset without spending large amounts of cash to purchase the asset. Ø The company eliminates the risk of owning an obsolete asset. Ø The company may deduct the annual lease payments for income tax purposes. c. 2014 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: Ø The leasing arrangement normally is more costly than the outright purchase of the asset. c. 2014 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. Ø Estimates of revenue and expenses Ø The amount of cash flows c. 2014 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 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. 2014 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. Ø Product quality Ø Manufacturing flexibility Ø Employee morale Ø Manufacturing productivity Ø Market (strategic) opportunities c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Lear ning O b jectiv Diag ram the c e apita l l ratio ning proc ess. c. 2014 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

Capital Rationing o Capital rationing is the process by which management allocates funds among competing capital investment proposals. c. 2014 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

t n e m t s e v n I s i l s a t y i l a p Ca An d n E e Th c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.