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Introduction toAccounting and Business

26

Capital Investment Analysis

Student Version

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Explain the nature and importance of capital investment analysis.

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Capital investment analysis (or capital budgeting) is the process by which management plans, evaluates, and controls investments in fixed assets.

Capital Investment Analysis

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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. Capital investment decisions are some of the most important decisions that management makes.

Nature of Capital Investment Analysis

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Evaluate capital investment proposals using the average rate of return and cash payment methods.

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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 AverageAnnual Income

Average Investment=

(Initial Cost + Residual Value)/2

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Machine cost $500,000Expected useful life 4 yearsResidual value noneExpected total income $200,000

Average rate of return

Estimated AverageAnnual Income

Average Investment=

Average rate of return

$200,000/4($500,000 + $0)/2

= = 20%

Purchase of Machine Example

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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 (or equivalent) of the amount invested is the cash payback period.

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When annual net cash flows are equal, the cash payback period is computed as follows:

Cashpayback period

Initial CostAnnual NetCash Flow

=

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Cost of new machine $200,000Cash revenue from machine per year 50,000Expenses of machine per year 30,000Depreciation per year 20,000

Purchase of New Machine Example

Net cash inflow per year:Cash revenue from machine $50,000Less cash expenses of machine:

Expenses of machine $30,000Less depreciation 20,000 10,000

Net cash inflow per year $40,000

(continued)

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= 5 yearsCash

payback period

$200,000$40,000

=

Cashpayback period

Initial CostAnnual NetCash Flow

=

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A proposed investment has an initial cost of $400,000. The annual and cumulative net cash flows over the proposal’s six-year life are as follows:

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Evaluate capital investment proposals using the net present value and internal rate of return methods.

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Present Value of an Amount

On January 1, 2010, you invest $1 in an account that earns 12% interest compounded annually. Interest earning interest is called compounding.

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On January 1, 2010, what is the present value of $1,440 to be received on December 31, 2012 (assuming an interest rate of 12 percent)? To determine the answer, we need to go to Exhibit 1 (Slide 27) and find the table value for three years at 12 percent.

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Partial Present Value of $1 TableExhibit 1

0.712 × $1.404 = $1.00

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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.

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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.

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Assume the following data for a proposed investment in new equipment:

Equipment Illustration

Cost of new equipment $200,000Expected useful life 5 yearsMinimum desired rate of return 10%Expected cash flows to be received each year:

Year 1 $70,000Year 2 60,000Year 3 50,000Year 4 40,000Year 5 40,000

Total expected cash flows $260,000

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The present value of the net cash flow is computed by multiplying the net cash flow by the present value factor of $1 for that year as shown in Slides 22 through 27.

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$ 63,630

$70,000 × 0.909 (n = 1; i =10%)

Jan. 1

2010 Dec. 31

2010 Dec. 31

2011 Dec. 31

2012 Dec. 31

2013 Dec. 31

2014

$(200,000) $70,000 $60,000 $50,000 $40,000 $40,000

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$(200,000) $70,000 $60,000 $50,000 $40,000 $40,000

$60,000 × 0.826 (n = 2; i = 10%)

Jan. 1

2010 Dec. 31

2010 Dec. 31

2011 Dec. 31

2012 Dec. 31

2013 Dec. 31

2014

$ 63,630

$ 49,560

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$ 63,630

$(200,000) $70,000 $60,000 $50,000 $40,000 $40,000

$ 49,560

$ 37,550

$50,000 × 0.751 (n = 3; i = 10%)

Jan. 1

2010 Dec. 31

2010 Dec. 31

2011 Dec. 31

2012 Dec. 31

2013 Dec. 31

2014

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$ 63,630

$(200,000) $70,000 $60,000 $50,000 $40,000 $40,000

$ 49,560

$ 37,550 $ 27,320

$40,000 × 0.683 (n = 4; i =10%)

Jan. 1

2010 Dec. 31

2010 Dec. 31

2011 Dec. 31

2012 Dec. 31

2013 Dec. 31

2014

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$ 63,630

$(200,000) $70,000 $60,000 $50,000 $40,000 $40,000

$ 49,560

$ 37,550 $ 27,320$40,000 × 0.621 (n = 5; i = 10%)

$ 24,840

Jan. 1

2010 Dec. 31

2010 Dec. 31

2011 Dec. 31

2012 Dec. 31

2013 Dec. 31

2014

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$ 63,630

$(200,000) $70,000 $60,000 $50,000 $40,000 $40,000

$ 49,560

$ 37,550 $ 27,320

$ 24,840 $ 2,900 Net present value

The equipment should be purchased because the net present value is positive.

Jan. 1

2010 Dec. 31

2010 Dec. 31

2011 Dec. 31

2012 Dec. 31

2013 Dec. 31

2014

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Management is evaluating a proposal to acquire equipment costing $33,530. The equipment is expected to provide annual net cash flows of $10,000 per year for five years. Assume a rate of return of 12%. Should the equipment be purchased?

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Internal Rate of Return Method

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Partial Present Value of an Annuity TableExhibit 2

3.605 × $10,000 = $36,050

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Net Present Value Analysis at 12%Exhibit 3

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Using a Simpler Procedure to Find the Internal Rate of Return

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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Determine the present value factor or an annuity of 1 as follows:

$97,360$20,000

= 4.868

Amount to be Invested Equal Annual Cash Flows

(continued)

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Find the seven year line on Exhibit 2 (the present value of an annuity of $1 at compound interest).

(continued)

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Exhibit 2 Partial Present Value of an Annuity Table

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Proceed horizontally across the table until you find the present value factor computed in step 1 (or the closest present value factor).

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Partial Present Value of an Annuity TableExhibit 2

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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.

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The internal rate of return for this proposal is 10%.

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Exhibit 2 Partial Present Value of an Annuity Table

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If the minimum acceptable rate of return for similar proposals is 10% or less, then the proposed investment should be considered acceptable.

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