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1 of 37Visit UMT online at www.umtweb.edu© South-Western 2004Survey of Accounting, 2/e Chapter 15,
ACCT125
ACCOUNTING ACCOUNTING FUNDAMENTALS FOR FUNDAMENTALS FOR
MANAGERSMANAGERS
University of Management and Technology1901 North Fort Myer Drive
Arlington, VA 22209Voice: (703) 516-0035 Fax: (703) 516-0985
Website: www.umtweb.edu
Visit UMT online at www.umtweb.edu 2 of 37Chapter 15,
ACCT125
Task Force Clip Art Task Force Clip Art included in this electronic included in this electronic presentation is used with presentation is used with
the permission of New the permission of New Vision Technology of Vision Technology of
Nepean Ontario, Canada.Nepean Ontario, Canada.
3 of 37Visit UMT online at www.umtweb.edu© South-Western 2004Survey of Accounting, 2/e Chapter 15,
ACCT125
Chapter 15Chapter 15
Capital Investment AnalysisCapital Investment Analysis
Visit UMT online at www.umtweb.edu 4 of 37Chapter 15,
ACCT125
After studying this After studying this chapter, you should chapter, you should
be able to:be able to:
After studying this After studying this chapter, you should chapter, you should
be able to:be able to:
ContinuedContinuedContinuedContinued
Learning ObjectivesLearning 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.
Visit UMT online at www.umtweb.edu 5 of 37Chapter 15,
ACCT125
Learning ObjectivesLearning Objectives
4. Diagram the capital rationing process.
Visit UMT online at www.umtweb.edu 6 of 37Chapter 15,
ACCT125
1Explain the nature and
importance of capital
investment analysis.
Learning ObjectiveLearning Objective
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ACCT125
Nature of Capital Investment DecisionsNature of Capital Investment Decisions
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. Should include a plan for encouraging and rewarding employees for submitting proposals.
Visit UMT online at www.umtweb.edu 8 of 37Chapter 15,
ACCT125
Evaluate capital investment proposals using the following methods: average rate of return, cash payback, net present value, and internal rate of return.
2Learning ObjectiveLearning Objective
Visit UMT online at www.umtweb.edu 9 of 37Chapter 15,
ACCT125
Methods of Evaluating Capital InvestmentsMethods of Evaluating Capital Investments
Average rate of return method
Cash payback method
Net present value method
Internal rate of return method
Methods that do not use present valuesMethods that do not use present values
Methods that use present valuesMethods that use present values
Visit UMT online at www.umtweb.edu 10 of 37Chapter 15,
ACCT125
Easy to calculate
Considers accounting income (often used to evaluate managers)
Average Rate of ReturnAverage Rate of Return
Cash PaybackCash Payback
Advantages:
Ignores cash flows
Ignores the time value of money
Disadvantages:
Considers cash flows
Shows when funds are available for reinvestment
Advantages: Disadvantages:Ignores profitability (accounting income)
Ignores cash flows after the payback period
Visit UMT online at www.umtweb.edu 11 of 37Chapter 15,
ACCT125
Considers cash flows and the time value of money
Net Present ValueNet Present Value
Internal Rate of ReturnInternal Rate of Return
Advantages:
Assumes that cash received can be reinvested at the rate of return
Disadvantages:
Considers cash flows and the time value of money
Ability to compare projects of unequal size
Advantages: Disadvantages:Requires complex calculations
Assumes that cash can be reinvested at the internal rate of return
Visit UMT online at www.umtweb.edu 12 of 37Chapter 15,
ACCT125
Average Rate of Return MethodAverage Rate of Return Method
Machine cost $500,000Expected useful life 4 yearsResidual value noneExpected total income $200,000
Assumptions:Assumptions:
Average Rate of Return
Estimated AverageAnnual Income
Average Investment=
Visit UMT online at www.umtweb.edu 13 of 37Chapter 15,
ACCT125
Average Rate of Return MethodAverage Rate of Return Method
Machine cost $500,000Expected useful life 4 yearsResidual value noneExpected total income $200,000
Assumptions:Assumptions:
Average Rate of Return
Estimated AverageAnnual Income
Average Investment=
=$200,000 / 4 yrs.Average Rate
of Return =($500,000 + $0) / 2
20%
Visit UMT online at www.umtweb.edu 14 of 37Chapter 15,
ACCT125
Average Rate of Return MethodAverage Rate of Return Method
Average annual income $30,000 $36,000Average investment $120,000 $180,000Average rate of return
Assumptions:Assumptions:
Average Rate of Return
Estimated AverageAnnual Income
Average Investment=
Proposal A Proposal B
What is the average rate of return for each proposal?What is the average rate of return for each proposal?
Visit UMT online at www.umtweb.edu 15 of 37Chapter 15,
ACCT125
Average Rate of Return MethodAverage Rate of Return Method
Average annual income $30,000 $36,000Average investment $120,000 $180,000Average rate of return 25% 20%
Assumptions:Assumptions: Proposal A Proposal B
This method emphasizes accounting income which is commonly used in evaluating management performance.
This method emphasizes accounting income which is commonly used in evaluating management performance.
Visit UMT online at www.umtweb.edu 16 of 37Chapter 15,
ACCT125
Cash Payback MethodCash Payback Method
Investment cost $200,000Expected useful life 8 yearsExpected annual net cash flows (equal) $40,000
Assumptions:Assumptions:
CashPayback Period
Total Investment
Annual NetCash Inflows
=
What is the cash payback period?What is the cash payback period?
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ACCT125
Cash Payback MethodCash Payback Method
Investment cost $200,000Expected useful life 8 yearsExpected annual net cash flows (equal) $40,000
Assumptions:Assumptions:
=$200,000Cash
PaybackPeriod
=$40,000
5 years
CashPayback Period
Total Investment
Annual NetCash Inflows
=
Visit UMT online at www.umtweb.edu 18 of 37Chapter 15,
ACCT125
Year 1 $ 60,000 $ 60,000Year 2 80,000 140,000Year 3 105,000 245,000Year 4 155,000 400,000Year 5 100,000 500,000Year 6 90,000 590,000
Assumptions:Assumptions:Net Cash Cumulative
Flow Net Cash Flow
Cash Payback MethodCash Payback Method
If the proposed investment is $400,000, what is the payback period?
If the proposed investment is $400,000, what is the payback period?
Visit UMT online at www.umtweb.edu 19 of 37Chapter 15,
ACCT125
Year 1 $ 60,000 $ 60,000Year 2 80,000 140,000Year 3 105,000 245,000Year 4 155,000 400,000Year 5 100,000 500,000Year 6 90,000 590,000
Assumptions:Assumptions:
Cash Payback MethodCash Payback Method
If the proposed investment is $450,000, what is the payback period?
If the proposed investment is $450,000, what is the payback period?
Net Cash CumulativeFlow Net Cash Flow
Visit UMT online at www.umtweb.edu 20 of 37Chapter 15,
ACCT125
The Time Value of Money – Future ValueThe Time Value of Money – Future Value
The time value of money concept is used in many business decisions. This concept is an important consideration in capital investment analysis.
PresentValue
FutureValue
$1,000
$ ????
What is the future value of $1,000 invested today (present value) at 8% per year?
What is the future value of $1,000 invested today (present value) at 8% per year?
Visit UMT online at www.umtweb.edu 21 of 37Chapter 15,
ACCT125
The Time Value of Money – Future ValueThe Time Value of Money – Future Value
The time value of money concept is used in many business decisions. This concept is an important consideration in capital investment analysis.
PresentValue
FutureValue
$1,000
= $1,000 + ($1,000 x 8%)= $1,000 x 108% or 1.08
What is the future value of $1,000 invested today (present value) at 8% per year?
What is the future value of $1,000 invested today (present value) at 8% per year?
$1,080
Visit UMT online at www.umtweb.edu 22 of 37Chapter 15,
ACCT125
The Time Value of Money – Present ValueThe Time Value of Money – Present Value
The time value of money concept is used in many business decisions. This concept is an important consideration in capital investment analysis.
PresentValue
FutureValue
$ ????
What is the present value of $1,000 to be received one year from today at 8% per year?
What is the present value of $1,000 to be received one year from today at 8% per year?
$1,000
Visit UMT online at www.umtweb.edu 23 of 37Chapter 15,
ACCT125
The Time Value of Money – Present ValueThe Time Value of Money – Present Value
The time value of money concept is used in many business decisions. This concept is an important consideration in capital investment analysis.
PresentValue
FutureValue
$ 925.93 = $1,000 / 108% or 1.08
What is the present value of $1,000 to be received one year from today at 8% per year?
What is the present value of $1,000 to be received one year from today at 8% per year?
$1,000
Visit UMT online at www.umtweb.edu 24 of 37Chapter 15,
ACCT125
Calculating Present ValuesCalculating Present Values
Present values can be determined using present value tables, mathematical formulas, calculators or computers.
Present Value of $1 with Compound Interest
1 .9434 = $1.0000 / 1.06
CalculatorPV Table
Period 6%
One dollar at the end of one period at 6% per period is equal to $.9434 today (present value).
Visit UMT online at www.umtweb.edu 25 of 37Chapter 15,
ACCT125
Calculating Present ValuesCalculating Present Values
Present values can be determined using present value tables, mathematical formulas, calculators or computers.
Present Value of $1 with Compound Interest
PV Table
Period 6%
One dollar at the end of two periods at 6% per period is equal to $.8900 today (present value).
To use the value from the prior period as the starting point, don’t clear your calculator.
1 .9434.9434 = $1.0000 / 1.06
2 .8900 = $$ .9434.9434 / 1.06
Calculator
Visit UMT online at www.umtweb.edu 26 of 37Chapter 15,
ACCT125
Calculating Present ValuesCalculating Present Values
Present values can be determined using present value tables, mathematical formulas, calculators or computers.
Present Value of $1 with Compound Interest
PV Table
Period 6%
One dollar at the end of three periods at 6% per period is equal to $.8396 today (present value).
1 .9434 = $1.0000 / 1.06
2 .8900.8900 = $ .9434 / 1.06
3 .8396 = $ .8900$ .8900 / 1.06
Calculator
Visit UMT online at www.umtweb.edu 27 of 37Chapter 15,
ACCT125
Calculating Present ValuesCalculating Present Values
Present values can be determined using present value tables, mathematical formulas, calculators or computers.
Present Value of $1 with Compound Interest
1 .9434 = $1.0000 / 1.06
2 .8900 = $ .9434 / 1.06
3 .8396 = $ .8900 / 1.06
4 .7921 = $ .8396 / 1.06
5 .7432 = $ .7921 / 1.06
6 .7050 = $ .7432 / 1.06
PV Table
Period 6%
When using a calculator, learn to use constant division. You will then enter $1 and 1.06 the first time, pressing only the equal (=) key for each successive answer.
Calculator
Visit UMT online at www.umtweb.edu 28 of 37Chapter 15,
ACCT125
Calculating Present Values of AnnuitiesCalculating Present Values of Annuities
Present Value of $1 — Annuity of 1$
PV Table Annuity
Period 6% 6%
CalculationSum of Periods
1 .9434.9434 .9434 = Period 1
2 .8900.8900 1.8334 = Periods 1–2
3 .8396 2.6730 = Periods 1–3
4 .7921 3.4651 = Periods 1–4
5 .7432 4.2124 = Periods 1–5
4.2124
The PV of an annuity of $1 to be received each year for two years is $1.8334. This is the sum of the PV of the two amounts for periods 1 and 2.
Annuities represent a series of equal amounts to be paid or received in the future over equal periods.
Visit UMT online at www.umtweb.edu 29 of 37Chapter 15,
ACCT125
Calculating Present Values of AnnuitiesCalculating Present Values of Annuities
Present Value of $1 — Annuity of 1$
PV Table Annuity
Period 6% 6%
CalculationSum of Periods
1 .9434.9434 .9434 = Period 1
2 .8900.8900 1.8334 = Periods 1–2
3 .8396.8396 2.6730 = Periods 1–3
4 .7921 3.4651 = Periods 1–4
5 .7432 4.2124 = Periods 1–5
4.2124
The PV of an annuity of $1 to be received each year for three years is $2.6730. This is the sum of the PV of the three amounts for periods 1–3.
Annuities represent a series of equal amounts to be paid or received in the future over equal periods.
Visit UMT online at www.umtweb.edu 30 of 37Chapter 15,
ACCT125
Calculating Present Values of AnnuitiesCalculating Present Values of Annuities
Annuities represent a series of equal amounts to be paid or received in the future over equal periods.
Present Value of $1 — Annuity of 1$
PV Table Annuity
Period 6% 6%
CalculationSum of Periods
1 .9434 .9434 = Period 1
2 .8900 1.8334 = Periods 1–2
3 .8396 2.6730 = Periods 1–3
4 .7921 3.4651 = Periods 1–4
5 .7473 4.2124 = Periods 1–5
4.2124Total
Visit UMT online at www.umtweb.edu 31 of 37Chapter 15,
ACCT125
= $ 63,636.36 = 49,586.78
= 37,565.74= 27,320.54= 24,836.85
$202,946.27 200,000.00 $ 2,946.27
1.015
Year 1 $70,000 / 1.10 (1 time) = Year 2 60,000 / 1.10 (2 times) = Year 3 50,000 / 1.10 (3 times) = Year 4 40,000 / 1.10 (4 times) = Year 5 40,000 / 1.10 (5 times) = Total present value Less investment Net present value
Present value index
Assumptions:Assumptions:
Cash Flow Present Value
Net Present Value MethodNet Present Value Method
Investment $200,000Useful life 5 yearsResidual value noneMinimum rate of return 10%
Visit UMT online at www.umtweb.edu 32 of 37Chapter 15,
ACCT125
Total present value $107,000 $86,400 $93,600Total investment 100,000 80,000 90,000Net present value $ 7,000 $ 6,400 $ 3,600
Present value index 1.07 1.08 1.04
Assumptions:Assumptions: ProposalsA B C
What is the meaning of an index over 1.0?What is the meaning of an index over 1.0?
Net Present Value MethodNet Present Value Method
Visit UMT online at www.umtweb.edu 33 of 37Chapter 15,
ACCT125
Internal Rate of Return MethodInternal Rate of Return Method
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.
Use a computer function to calculate exactly the expected rate of return.
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 ErrorTrial and Error
Computer FunctionComputer Function
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ACCT125
List and describe factors that complicate capital investment analysis.3
Learning ObjectiveLearning Objective
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ACCT125
Qualitative ConsiderationsQualitative 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?
Improvements that increase competitiveness and quality are difficult to quantify. The following qualitative factors are important considerations.
Visit UMT online at www.umtweb.edu 36 of 37Chapter 15,
ACCT125
Diagram the capital rationing process.4
Learning ObjectiveLearning Objective
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ACCT125
The Capital Rationing ProcessThe Capital Rationing Process
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.