Capital Investment Analysis

Chapter 25 Capital Investment Analysis Accounting, 21st Edition Warren Reeve Fess

PowerPoint Presentation by Douglas Cloud Professor Emeritus of Accounting Pepperdine University

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Objectives Objectives 1. Explain the nature and importance of capital After studying studying this this investment After analysis. chapter, you chapter, you should should 2. Evaluate capital investment proposals, be to: using the following methods: be able able to: average rate of return, cash payback, net present value, and internal rate of return. 3. List and describe factors that complicate capital investment analysis. 4. Diagram the capital rationing process.

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-term long-term investments investments in in fixed fixed assets. assets.

Nature Nature of of Capital Capital Investment Investment Analysis Analysis 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 of of Evaluating Evaluating Capital Capital Investment Investment Proposals Proposals Here’s Here’s aa survey survey of of 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 by by large large U.S. U.S. companies. companies.

Average rate of return

15%

Cash payback method

53%

Net present value method

85%

Internal rate of return method

76% 0% 90%

10% 20%

30% 40% 50%

60% 70%

80%

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 = ($500,000 + $0) / 2

= 20%

Average Average Rate Rate of of Return Return Method Method Assumptions:

Proposal A Proposal B

Average annual income Average investment

$ 30,000 $120,000

$ 36,000 $180,000

$30,000 = 25% $120,000

Average Average Rate Rate of of Return Return Method Method Assumptions: Average annual income Average investment

Proposal A Proposal B

$ 30,000 $120,000

$ 36,000 $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 Expected useful life Expected annual net cash flows (equal) Cash Payback Period

=

Cash Payback = Period

$200,000 8 years $40,000

Total Investment Annual Net Cash Inflows

$200,000 = 5 years $40,000

Cash Cash Payback Payback Method Method Net Cash Flow Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

$ 60,000 80,000 105,000 155,000 100,000 90,000

Cumulative Net Cash Flow $ 60,000 140,000 245,000 400,000 500,000 590,000

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

???? = $1,000 ÷ 1.08 $$925.93

What What isis the the present present value value of of $1,000 $1,000 to to be be 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 to to receive receive $1,000 $1,000 on on 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 the the 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 1

6% 0.943

10% 0.909

12% 0.893

15% 0.870

20% 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, at at 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

.1 b e F 6 200

$797 x 1.12

.1 b e F 7 200

$893 x 1.12

.1 b e F 8 200

$1,000

.1 b e F 9 200

Present Present Value Value of of an an Annuity Annuity An An annuity annuity isis aa series series of of equal equal net net cash cash flows flows at at fixed fixed time time intervals. intervals. The The present present value value of of an an annuity annuity isis the the sum sum of of these these net net cash cash flows. flows.

Present Present Value Value of of an an Annuity Annuity 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 1

6% 0.943

10% 0.909

12% 0.893

15% 0.870

20% 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

Net Net Present Present Value Value Method Method

The The net net present present value value method method analyzes analyzes capital capital investment investment proposals proposals by by comparing comparing the the initial initial cash cash investment investment with with the the 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 with with an life of five years can be an expected expected life of five years can be Cash Flow Present Value purchased purchased for for $200,000. $200,000. At At the the end end of of five five years years itit isis anticipated anticipated that that the the equipment equipment will will have have no no residual residual value. value.

Net Net Present Present Value Value Method Method A A net net cash cash flow flow of of $70,000 $70,000 isis expected expected at at the the end end of of 2006. net cash decline Presentto Value 2006. This ThisCash netFlow cash flow flow isis expected expected to 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 the the 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.

Net Net Present Present Value Value Method Method

So, So, we we have have to to use use the the present present value value of of $1 $1 for for each each of of the the five five years. years.

Net Net Present Present Value Value Method Method .1 Jan 6 200

. 31 Dec 6 200

. 31 Dec 7 200

$<200,000>

$70,000

$ $ $ $ $

$70,000 x 0.909 (n = 1; i = 10%) $60,000 x 0.826 (n = 2; i = 10%) $50,000 x 0.751 (n = 3; i = 10%) $40,000 x 0.683 (n = 4; i = 10%) $40,000 x 0.621 (n = 5; i = 10%)

63,630 49,560 37,550 27,320 24,840

$60,000

. 31 Dec 8 200

$50,000

. 31 Dec 9 200

. 31 Dec 0 201

$40,000

$40,000

Net Net Present Present Value Value Method Method .1 Jan 6 200

$<200,000> $ $ $ $ $

63,630 49,560 37,550 27,320 24,840

$

2,900

. 31 Dec 6 200

$70,000

. 31 Dec 7 200

. 31 Dec 8 200

. 31 Dec 9 200

. 31 Dec 0 201

The The equipment equipment should should be be purchased purchased because because $60,000 the$50,000 $40,000 $40,000 net present value the net present value isis positive. positive.

Net Net Present Present Value Value Method Method When Whencapital capitalinvestment investmentfunds fundsare are limited limitedand andthe thealternative alternativeproposals proposals involve involvedifferent differentamounts amountsof ofinvestment, investment, ititisisuseful usefulto toprepare prepareaaranking rankingof ofthe the proposals proposalsusing usingaapresent presentvalue valueindex. index.

Net Net Present Present Value Value Method Method Proposals

Assumptions:

A Total present value $107,000 Total investment 100,000 Net present value $ 7,000 Present value index

1.07

B C $86,400 $93,600 80,000 90,000 $ 6,400 $ 3,600 1.08

1.04

$86,400 ÷÷$93,600 $107,000 $86,400 $93,600 ÷÷ $107,000 ÷ The most desirable The÷ most desirable $80,000 $90,000 $100,000 $80,000 $90,000 $100,000 proposal according to proposal according to the the present present value value index. index.

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 to to 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.

Internal Internal Rate Rate of of Return Return Method Method Determine the table value using the present value for an annuity of $1 table. Amount to be invested Equal annual cash flow $97,360 $20,000

= 4.868

Internal Internal Rate Rate of of Return Return Method Method Find the seven year line on the table. Then, go across the sevenyear line until the closest amount to 4.868 is located. Present PresentValue Valueof ofan 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

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

4.564

4.160

Internal Internal Rate Rate of of Return Return Method Method Present PresentValue Valueof ofan 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

4

3.465

3.170

3.037

2.855

5

4.212

3.791

3.605

3.353

6

4.917

4.111

3.785

7

5.582

4.355 4.868

4.564

4.160

Internal Internal Rate Rate of of Return Return Method Method Move vertically to the top of the table to determine the interest rate. Present PresentValue Valueof ofan anAnnuity Annuityof of $1 $1 Year 6% 10% 12% 15% 10% 1 0.943 0.909 0.893 0.870

10%

2

1.833

1.736

1.690

1.626

3

2.673

2.487

2.402

2.283

4

3.465

3.170

3.037

2.855

5

4.212

3.791

3.605

3.353

6

4.917

4.111

3.785

7

5.582

4.355 4.868

4.564

4.160

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. 2. 3. 4. 5.

Improve product quality Reduce defects and manufacturing cycle time Increase manufacturing flexibility Reduce inventories and need for inspection 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.

Chapter 25 The The End End