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PowerPointPowerPoint Presentation by Presentation by
Gail B. WrightGail B. WrightProfessor of AccountingProfessor of AccountingBryant UniversityBryant University
© Copyright 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star Logo, and South-Western are trademarks used herein under license.
CARL S. WARRENCARL S. WARREN
SURVEY OF ACCOUNTINGSURVEY OF ACCOUNTING
Chapter 15
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LEARNING OBJECTIVES
When you finish this chapter, you should be able to
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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 OBJECTIVESLEARNING OBJECTIVES
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LEARNING OBJECTIVELEARNING OBJECTIVE
1Explain nature, importance of capital investment analysis.
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CAPTIAL INVESTMENT ANALYSIS
Capital investment analysis (capital budgeting) is the process by which managersPlanEvaluateControl
investments in fixed assets
LO 1
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LEARNING OBJECTIVELEARNING OBJECTIVE
2 Evaluate capital investment proposals.
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EVALUATION METHODS
Methods not using present valuesAverage rate of returnPayback
Methods that do use present valuesNet present valueInternal rate of return
LO 2
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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
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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%
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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.
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PAYBACK PERIOD
LO 2
Expected time between investment and recapture of cash outlay.
Payback period =
Cost / (Expected revenues – expenses)
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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
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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.
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LO 2
Present value methods employ the time value of money to determine the
return on purchase of a long term asset.
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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.
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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.
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LO 2
Net present value (discounted cash flow) compares initial cash
investment with present value of net cash flows.
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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
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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.
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LO 2
Internal rate of return uses present value concepts to compute the rate of return
expected from capital investment proposals.
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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
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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%.
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LEARNING OBJECTIVELEARNING OBJECTIVE
3List, describe factors that complicate capital investment analysis.
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COMPLICATING FACTORS
Income taxProposals with unequal livesLease vs. capital investmentUncertaintyChanges in price levelsQualitative considerations
LO 3
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LEARNING OBJECTIVELEARNING OBJECTIVE
4Diagram capital
rationing process.
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LO 4
What is capital rationing?
Capital rationing is the process by which managers
allocate funds among competing proposals.
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LO 4
EX
HIB
IT
EX
HIB
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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.
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THE END
CHAPTER 15