Chapter 24 - Capital Investment Analysis

Objectives

1. Explain the nature and importance of capital

investment analysis.
2. Evaluate capital investment proposals, using the
following methods: average rate of return, cash
payback, net present value, and internal rate of
return.
3. List and describe factors that complicate capital
investment analysis.
 Nature
Nature of
of Capital
Capital Investment
Investment Analysis
Analysis
Capital
Capital budgeting
budgeting isis the
the process
process by
by which
which
management
management plans,
plans, evaluates,
evaluates, and
and controls
controls long-
long-
term
term investments
investments in
in fixed
fixed assets.
assets.

1. Management plans, evaluates, and controls investments

in fixed assets.
2. Capital investments involve a long-term commitment of
funds.
3. Investments must earn a reasonable rate of return.
4. The process should include a plan for encouraging and
rewarding employees for submitting proposals.
 Methods
Methods ofof Evaluating
Evaluating
Capital
Capital Investment
Investment Proposals
Proposals
Here’s
Here’s aa survey
survey ofof business
business practices
practices in
in
aa variety
variety of
of industries.
industries. ItIt reports
reports the
the
capital
capital investment
investment analysis
analysis methods
methods
used
used byby large
large U.S.
U.S. companies.
companies.
Average rate
of return 15%

Cash payback
53%
method
Net present 85%
value method
Internal rate
of return 76%
method
0% 10% 20% 30% 40% 50% 60% 70% 80%
90%
Journal of Business and Management (Winter 2002)
Methods
Methods that
that Ignore
Ignore Present
Present Value
Value
Average Rate of Return Method
Advantages:
 Easy to calculate
 Considers accounting income (often used to
evaluate managers)

Disadvantages:
 Ignores cash flows
 Ignores the time value of money
 Average
Average Rate
Rate of
of Return
Return Method
Method
Assumptions:
Machine cost $500,000
Expected useful life 4 years
Residual value none
Expected total income $200,000

Estimated Average
Average Rate Annual Income
of Return =
Average Investment

Average Rate $200,000 ÷ 4 years

of Return = = 20%
($500,000 + $0) / 2
 Average
Average Rate
Rate of
of Return
Return Method
Method
Assumptions: Proposal A Proposal B
Average annual income $ 30,000 $ 36,000
Average investment $120,000 $180,000

$30,000
= 25%
$120,000
 Average
Average Rate
Rate of
of Return
Return Method
Method
Assumptions: Proposal A Proposal B
Average annual income $ 30,000 $ 36,000
Average investment $120,000 $180,000

$36,000
= 20%
$180,000
Methods
Methods that
that Ignore
Ignore Present
Present Value
Value
Cash Payback Method
Advantages:
 Considers cash flows
 Shows when funds are available
for reinvestment
Disadvantages:
 Ignores profitability (accounting income)
 Ignores cash flows after the payback
period
 Cash
Cash Payback
Payback Method
Method
Assumptions:
Investment cost $200,000
Expected useful life 8 years
Expected annual net
cash flows (equal) $40,000
Cash Total Investment
Payback =
Annual Net
Period Cash Inflows

Cash $200,000 = 5 years

Payback =
$40,000
Period
 Cash
Cash Payback
Payback Method
Method
Net Cash Cumulative
Flow Net Cash Flow
Year 1 $ 60,000 $ 60,000
Year 2 80,000 140,000
Year 3 105,000 245,000
Year 4 155,000 400,000
Year 5 100,000 500,000
Year 6 90,000 590,000

IfIf the
the proposed
proposed investment
investment isis
$400,000,
$400,000, the the payback
payback period
period isis at
at
the
the end
end of
of Year
Year 4.
4.
 Present
Present Value
Value Methods
Methods
The time value of money concept is used in many
business decisions. This concept is an important
consideration in capital investment analysis.

Present
Value $$925.93
???? = $1,000 ÷ 1.08

What
What isis the
the present
present value
value of
of
$1,000
$1,000 toto bebe received
received one
one year
year
from
from today
today at at 8%
8% per
per year?
year?
 Present
Present Value
Value Methods
Methods
How
How much
much would
would have
have to
to be
be invested
invested on on
February
February 1,1, 2006
2006 in
in order
order toto receive
receive
$1,000
$1,000 onon February
February 1,
1, 2009
2009 ifif the
the interest
interest
rate
rate compounded
compounded annually
annually isis 12%?
12%?
Present
Present Value
Value Methods
Methods
Refer
Refer to
to the
the partial
partial present
present
value
value table
table in
in Slide
Slide 18
18 to
to
answer
answer thethe question.
question.

$1,000, 3
years, 12%
compounded
annually
 Calculating
Calculating Present
Present Values
Values
Present values can be determined using present value
tables, mathematical formulas, a calculator or a computer.
Present Value of $1 with Compound Interest
Year 6% 10% 12% 15% 20%
1 0.943 0.909 0.893 0.870 0.833
2 0.890 0.826 0.797 0.756 0.694
3 0.840 0.751 0.712 0.658 0.579
4 0.792 0.683 0.636 0.572 0.482
5 0.747 0.621 0.567 0.497 0.402
6 0.705 0.564 0.507 0.432 0.335

$1,000
$1,000 xx .712
.712 == $712
$712
Present
Present Value
Value of
of an
an Amount
Amount
IfIf $712
$712 isis invested
invested on
on February
February 1,1, 2006
2006
atat an
an annual
annual rate
rate of
of 12
12 percent,
percent, $1,000
$1,000
will
will accumulate
accumulate by by February
February 1,
1, 2009.
2009.

$1,000
$1,000 xx .712
.712 == $712
$712
 Present
Present Value
Value of
of an
an Amount
Amount

$712 x 1.12 $797 x 1.12 $893 x 1.12 $1,000

e b.1 eb .1 e b .1 e b.1
F 6 F 7 F 8 F 9
200 2 00 200 200
 Present
Present Value
Value of
of an
an Annuity
Annuity

An
An annuity
annuity isis aa series
series of
of equal
equal netnet cash
cash
flows
flows at
at fixed
fixed time
time intervals.
intervals. TheThe
present
present value
value ofof an
an annuity
annuity isis the
the sum
sum of
of
the
the present
present values
values ofof each
each cash
cash flows.
flows.

What
What would
would be
be the
the present
present value
value of
of aa
$100
$100 annuity
annuity for
for five
five periods
periods at
at 12?
12?
Calculating
Calculating Present
Present Values
Values of
of Annuities
Annuities

Present Value of an Annuity of $1

Year 6% 10% 12% 15% 20%
1 0.943 0.909 0.893 0.870 0.833
2 1.833 1.736 1.690 1.626 1.528
3 2.673 2.487 2.402 2.283 2.106
4 3.465 3.170 3.037 2.855 2.589
5 4.212 3.791 3.605
3.605 3.353 2.991
6 4.917 4.355 4.111 3.785 3.326

3.605 x $100 = $360.50

 The
The net
net present
present value
value
method
method analyzes
analyzes capital
capital
Net
Net Present
Present investment
investment proposals
proposals by by
Value
Value comparing
comparing thethe initial
initial
cash
cash investment
investment with
with the
the
Method
Method present
present value
value of
of the
the net
net
cash
cash flows.
flows.
 Net
Net Present
Present Value
Value Method
Method
Advantage:
 Considers cash flows and the time value
of money
Disadvantage:
 Assumes that cash received can be
reinvested at the rate of return
 Net
Net Present
Present Value
Value Method
Method
At
At the
the beginning
beginning of of 2006,
2006, equipment
equipment withwith
an
an expected
expected
Cash Flow
life
life of
of five
five years
years can
can be
be
Present Value
purchased
purchased for for $200,000.
$200,000. At At the
the end
end ofof
five
five years
years itit isis anticipated
anticipated that
that the
the
equipment
equipment willwill havehave nono residual
residual value.
value.
AA net
net cash
cash flow
flow of
of $70,000
$70,000 isis expected
expected atat the
the end
end of
of
2006.
2006. This
This net
net cash
cash flow
flow isis expected
expected to to decline
decline
$10,000
$10,000 each
each year
year (except
(except 2010)
2010) until
until the
the machine
machine isis
retired.
retired. The
The firm
firm expects
expects aa minimum
minimum rate rate of
of return
return
of
of 10%.
10%. Should
Should thethe equipment
equipment be be purchased?
purchased?
 Net
Net Present
Present Value
Value Method
Method

First,
First, we
we must
must determine
determine which
which table
table
to
to use…
use… the
the present
present value
value of
of $1
$1 or
or
the
the present
present value
value of
of an
an annuity
annuity of
of $1.
$1.
Net
Net Present
Present Value
Value Method
Method

Because
Because there
there are
are multiple
multiple years
years of
of
net
net cash
cash flows,
flows, shouldn’t
shouldn’t we
we use
use the
the
present
present value
value of
of an
an annuity
annuity of
of $1?
$1?
 Net
Net Present
Present Value
Value Method
Method
That
That would
would be be true
true ifif the
the net
net cash
cash flows
flows
remained
remained constant
constant from
from 2006 2006 through
through 2010.
2010.
Note
Note that
that the
the net
net cash
cash flows
flows are
are $70,000,
$70,000,
$60,000,
$60,000, $50,000,
$50,000, $40,000,
$40,000, and and $40,000,
$40,000,
respectively.
respectively.

So,
So, we
we have
have toto use
use the
the
present
present value
value ofof $1
$1 for
for each
each
of
of the
the five
five years.
years.
 Net
Net Present
Present Value
Value Method
Method
1
Jan. 6 . 31 . 31 . 31 . 31 . 31
Dec 6 Dec 7 Dec 8 Dec 9 Dec 0
200 200 200 200 200 201

$<200,000> $70,000 $60,000 $50,000 $40,000 $40,000

$ 63,630 $70,000 x 0.909 (n = 1; i = 10%)
$ 49,560 $60,000 x 0.826 (n = 2; i = 10%)
$ 37,550 $50,000 x 0.751 (n = 3; i = 10%)
$ 27,320 $40,000 x 0.683 (n = 4; i = 10%)
$ 24,840 $40,000 x 0.621 (n = 5; i = 10%)
 Net
Net Present
Present Value
Value Method
Method
1
Jan. 6 . 31 . 31 . 31 . 31 . 31
Dec 6 Dec 7 Dec 8 Dec 9 Dec 0
200 200 200 200 200 201

The
The equipment
equipment should
should
be
be purchased
purchased because
because
$<200,000> $70,000 $60,000 the$50,000 $40,000 $40,000
the net present value isis
net present value
$ 63,630
$ 49,560
positive.
positive.
$ 37,550
$ 27,320
$ 24,840
$ 2,900
 Net
Net Present
Present Value
Value Method
Method
When
Whencapital
capitalinvestment
investmentfunds
fundsare
are
limited
limitedandandthe
thealternative
alternativeproposals
proposals
involve
involvedifferent
differentamounts
amountsofofinvestment,
investment,
ititisisuseful
usefultotoprepare
prepareaaranking
rankingofofthe
the
proposals
proposalsusing
usingaapresent
presentvalue
valueindex.
index.
(a.k.a.
(a.k.a.profitability
profitabilityindex)
index)
 Net
Net Present
Present Value
Value Method
Method
Assumptions: Proposals
A B C
Total present value $107,000$86,400$93,600
Total investment 100,000 80,000 90,000
Net present value $ 7,000$ 6,400$ 3,600
Present value index 1.07 1.08 1.04

$107,000
$107,000 ÷÷ $86,400
$86,400 ÷÷ $93,600
$93,600 ÷÷
$100,000
$100,000 $80,000
$80,000 $90,000
$90,000

The
The
best
best
Internal
Internal Rate
Rate of
of Return
Return Method
Method
Advantages:
 Considers cash flows and the time value
of money
 Ability to compare projects of unequal
size
Disadvantages:
 Requires complex calculations
 Assumes that cash can be reinvested
at the internal rate of return
 Internal
Internal Rate
Rate of
of Return
Return Method
Method
The internal rate of return method uses the net cash
flows to determine the rate of return expected from the
proposal. The following approaches may be used:
Trial and Error
Assume a rate of return and calculate the present
value. Modify the rate of return and calculate a
new present value. Continue until the present
value approximates the investment cost.
Computer Function
Use a computer function to calculate exactly the
expected rate of return.
 Internal
Internal Rate
Rate of
of Return
Return Method
Method
Management
Management isis evaluating
evaluating aa proposal
proposal toto acquire
acquire
equipment
equipment costing
costing $97,360.
$97,360. The
The equipment
equipment isis
expected
expected to
to provide
provide annual
annual net
net cash
cash flows
flows of
of
$20,000
$20,000 per per year
year for
for seven
seven years.
years.
Determine the table value using
the present value for an annuity
of $1 table.
Amount to be invested
Equal annual cash flow
$97,360
= 4.868
$20,000
 Internal
Internal Rate
Rate of
of Return
Return Method
Method
Find the seven year line on the table. Then, go across the 7-
year line until the closest amount to 4.868 is located.

Present
PresentValue
Valueofofan
anAnnuity
Annuityof
of $1
$1
Year 6% 10% 12% 15%
1 0.943 0.909 0.893 0.870
2 1.833 1.736 1.690 1.626
3 2.673 2.487 2.402 2.283
10% 4 3.465 3.170 3.037 2.855
5 4.212 3.791 3.605 3.353
6 4.917 4.355 4.111 3.785
7 5.582 4.868
4.868 4.564 4.160

Move vertically to the top of the table to determine the interest rate
Factors
Factors That
That Complicate
Complicate Capital
Capital
Investment
Investment Analysis
Analysis
 Income tax
 Unequal proposal lives
 Lease versus capital investment
 Uncertainty
 Changes in price levels
 Qualitative considerations
 Qualitative
Qualitative Considerations
Considerations
Improvements that increase competitiveness and
quality are difficult to quantify. The following
qualitative factors are important considerations.
1. Improve product quality
2. Reduce defects and manufacturing cycle time
3. Increase manufacturing flexibility
4. Reduce inventories and need for inspection
5. Eliminate non-value-added activities
 Capital
Capital Rationing
Rationing
1. Identify potential projects.
2. Eliminate projects that do not meet minimum cash
payback or average rate of return expectations.
3. Evaluate the remaining projects, using present
value methods.
4. Consider the qualitative benefits of all projects.
5. Rank the projects and allocate available funds.