no slide title · capital investment analysis. 2. evaluate capital investment proposals using the...
TRANSCRIPT
Prepared by: C. Douglas Cloud
Professor Emeritus of Accounting
Pepperdine University
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Capital Investment Analysis
Chapter 25
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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.
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Learning Objectives
5. Diagram the capital rationing process.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Learning Objective 1
Explain the nature
and importance of
capital investment
analysis.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Nature of Capital Investment Analysis
Capital investment analysis (or capital
budgeting) is the process by which
management plans, evaluates, and
controls investments in fixed assets.
LO 1
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Nature of Capital Investment Analysis
Methods that do not use present values
Average rate of return method
Cash payback method
Methods that use present values
Net present value method
Internal rate of return method
LO 1
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Nature of Capital Investment Analysis
LO 1
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Nature of Capital Investment Analysis
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.
LO 1
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Learning Objective 2
Evaluate capital
investment proposals
using the average rate
of return and cash
payback methods.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Average Rate of Return Method
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
LO 2
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Average Rate of Return Method
LO 2
Machine cost $500,000
Residual value 0
Estimated total income from machine 200,000
Expected useful life 4 years
Average Rate
of Return
Estimated Average Annual Income
Average Investment =
Management is evaluating the purchase of a new
machine as follows:
Average Rate
of Return $200,000/4
($500,000 + $0)/2 = = 20%
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Average Rate of Return Method
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.
LO 2
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Average Rate of Return Method
The average rate of return has the following
three advantages:
1. It is easy to compute.
2. It includes the entire amount of income
earned over the life of the proposal.
3. It emphasizes accounting income.
LO 2
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The average rate of return has the following
two disadvantages:
1. It does not directly consider the expected
cash flows from the proposal.
2. It does not directly consider the timing of the expected cash flows.
Average Rate of Return Method
LO 2
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EE 25-1
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Cash Payback Method
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.
LO 2
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Cash Payback Method
When annual net cash inflows are equal,
the cash payback period is computed as
follows:
Cash
Payback
Period
Initial Cost
Annual Net Cash Inflow
=
LO 2
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Cash Payback Method
LO 2
Cost of new machine $200,000
Cash revenue from machine per year 50,000
Expenses of machine per year 30,000
Depreciation per year 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)
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Cash Payback Method
LO 2
= 5 years Cash
Payback
Period
$200,000
$40,000 =
Cash
Payback
Period
Initial Cost
Annual Net Cash Inflow
=
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.
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Cash Payback Method
LO 2
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:
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The cash payback method has the
following two advantages:
1. It is simple to use and understand.
2. It analyzes cash flows.
Cash Payback Method
LO 2
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Cash Payback Method
LO 2
The cash payback method has the
following two disadvantages:
1. It ignores cash flows occurring after the
payback period.
2. It does not use present value concepts in valuing cash flows occurring in different
periods.
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EE 25-2
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Learning Objective 3
Evaluate capital
investment proposals
using the net present
value and internal
rate of return
methods.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Present Value Concepts
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
LO 3
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Present Value of an Amount
LO 3
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
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This process of interest earning interest is
called compounding. The illustration below
demonstrates the concept of
compounding.
Present Value of an Amount
LO 3
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Present Value of an Amount
On January 1, 2012, what is the present value of
$1.404 to be received on December 31, 2014
(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.
LO 3
Using the PV of $1 Table
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Present Value of an Amount
LO 3
0.712 × $1.404 = $1.00
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Present Value of an Amount
LO 3
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.
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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
amount of cash needed today to yield a
series of equal net cash flows at fixed time intervals in the future.
LO 3
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Present Value of an Annuity
LO 3
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.
Left-click your mouse on the button to go to Exhibit 1.
Type “32” and press “Enter” to return to this slide.
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Present Value of an Annuity
LO 3
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Present Value of an Annuity
LO 3
Using a present value of an annuity of $1 table,
such as the one in Exhibit 2 (next slide), is a
simpler approach.
Using the PV of an Annuity of $1 Table
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Present Value of an Annuity
LO 3
3.605 × $100 = $360.50
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Net Present Value Method
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.
LO 3
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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
Net Present Value Method
LO 3
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Net Present Value Method
LO 3
Using the present value of $1 (Exhibit 1) at 10%,
the present value of the net cash flow for each year
is shown below.
Left-click your mouse on the button to go to Exhibit 1.
Type “38” and press “Enter” to return to this slide.
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Net Present Value Method
LO 3
The preceding computations are also graphically
illustrated below.
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Net Present Value Method
LO 3
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%.
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Capital investment proposals can be
ranked by using a present value index. The
present value index is computed as follows:
Net Present Value Method
LO 3
Present Value Index =
Total Present Value
of Net Cash Flow
Amount to Be
Invested
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Net Present Value Method
LO 3
The present value index for the investment in the
preceding slides is 1.0145, as computed below.
Present Value Index =
Total Present Value
of Net Cash Flow
Amount to Be
Invested
Present Value Index = $202,900
$200,000 = 1.0145
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Net Present Value Method
LO 3
A company is considering three proposals. The net
present value and the present value index for each
proposal are as follows:
Most desirable proposal
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The net present value method has the
following three advantages:
1. It considers the cash flows of the
investment.
2. It considers the time value of money.
3. It can rank equal lived projects using the
present value index.
Net Present Value Method
LO 3
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The net present value method has the
following two disadvantages:
1. It has more complex computations than
methods that don’t use present value.
2. It assumes the cash flows can be reinvested at the minimum desired rate of return,
which may not be valid.
Net Present Value Method
LO 3
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EE 25-3
Left-click on the button with your mouse to go to Exhibit
2. Type “46” and press “Enter” to return to this slide.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Internal Rate of Return Method
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.
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.
LO 3
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Internal Rate of Return Method
LO 3
Management is evaluating the following
proposal to purchase new equipment:
Cost of new equipment………………… $33,530
Yearly expected cash flows to be
received…………………………………. 10,000
Expected life……………………………… 5 years
Minimum desired rate of return……….. 12%
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Internal Rate of Return Method
LO 3
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.
Left-click on the button with your mouse to go to Exhibit
2. Type “49” and press “Enter” to return to this slide.
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Internal Rate of Return Method
LO 3
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.
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Internal Rate of Return Method
LO 3
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Internal Rate of Return Method
LO 3
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.
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Internal Rate of Return Method
LO 3
STEP 1: Determine the present value factor
for an annuity of $1 as follows:
$97,360
$20,000 = 4.868
Amount to be Invested
Equal Annual Net Cash Flows
(continued)
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Internal Rate of Return Method
LO 3
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)
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3.605
Internal Rate of Return Method
LO 3
(continued)
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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
LO 3
(continued)
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3.605
Internal Rate of Return Method
LO 3
The minimum acceptable
rate of return is 10%. (concluded)
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Internal Rate of Return Method
LO 3
The internal rate of return method has the
following three advantages:
1. It considers the cash flows of the
investment.
2. It considers the time value of money.
3. It ranks proposals based upon the cash
flows over their complete useful life, even if
the project lives are not the same.
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The internal rate of return method has the
following two disadvantages:
1. It has complex computations, requiring a
computer if the periodic cash flows are not
equal (an annuity).
2. It assumes the cash received from a
proposal can be reinvested at the internal
rate of return, which may not be valid.
LO 3
Internal Rate of Return Method
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EE 25-4
Left-click on the button with your mouse to go to Exhibit
2. Type “60” and press “Enter” to return to this slide.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Learning Objective 4
List and describe
factors that complicate
capital investment
analysis.
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Factors That Complicate Capital Investment Analysis
Income tax
Proposals with unequal lives
Leasing versus purchasing
Uncertainty
Changes in price levels
Qualitative factors
LO 4
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Income Tax
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.
LO 4
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Unequal Proposal Lives
Assume that a company is considering purchasing
a new truck or a new computer network. The data
for each proposal are shown below.
LO 4
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Unequal Proposal Lives
LO 4
(continued)
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LO 4
Unequal Proposal Lives
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EE 25-5
Left-click on the green button with your mouse to go to Exhibit 1 and red
button to go to Exhibit 2. Type “67” and press “Enter” to return to this slide.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Lease versus Capital Investment
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.
LO 4
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Lease versus Capital Investment
One disadvantage of leasing a fixed asset is:
The leasing arrangement normally is more costly than the outright purchase of the asset.
LO 4
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Uncertainty
All capital investment analyses rely on
factors that are uncertain.
Estimates of revenue and expenses
The amount of cash flows
LO 4
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Changes in Price Levels
General price levels often increase in a
rapidly growing economy, which is called
inflation.
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.
LO 4
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Qualitative Considerations
Improvements that increase quality and
competitiveness are difficult to quantify.
The following qualitative factors are
important considerations.
1. Product quality
2. Manufacturing flexibility
3. Employee morale
4. Manufacturing productivity
5. Market (strategic) opportunities
LO 4
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Learning Objective 5
Diagram the
capital rationing
process.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Capital Rationing
Capital rationing is the process by which
management allocates funds among
competing capital investment proposals.
LO 5
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Capital Rationing
(continued)
LO 5
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
LO 5
Capital Rationing
Prepared by: C. Douglas Cloud
Professor Emeritus of Accounting
Pepperdine University
© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Capital Investment Analysis
The End