Chapter 24 - Capital Investment Analysis

Objectives

1.

2.

3.

Explain the nature and importance of capital investment analysis.

Evaluate capital investment proposals, using the following methods: average rate of return, cash payback, net present value, and internal rate of return.

List and describe factors that complicate capital investment analysis.

Nature of Capital Investment Analysis

Capital budgeting

is the process by which management plans, evaluates, and controls long-term investments in fixed assets.

1. Management

plans , evaluates

, and

controls

in fixed assets.

investments 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

rewarding encouraging

employees for submitting proposals.

and

Methods of Evaluating Capital Investment Proposals

Here’s a survey of business practices in a variety of industries. It reports the capital investment analysis methods used by large U.S. companies.

Average rate of return Cash payback method Net present value method Internal rate of return method 15% 53% 76% 85% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% Journal of Business and Management (Winter 2002)

Methods that Ignore Present 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 Rate of Return Method

Assumptions: Machine cost Expected useful life Residual value Expected total income $500,000 4 years none $200,000 Average Rate of Return = Estimated Average Annual Income Average Investment Average Rate of Return = $200,000 ÷ 4 years ($500,000 + $0) / 2 = 20%

Average Rate of Return Method

Assumptions:

Average annual income Average investment

Proposal A Proposal B

$ 30,000 $120,000 $ 36,000 $180,000 $30,000 $120,000 = 25%

Average Rate of Return Method

Assumptions:

Average annual income Average investment

Proposal A Proposal B

$ 30,000 $120,000 $ 36,000 $180,000 $36,000 $180,000 = 20%

Methods that Ignore Present 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 Payback Method

Assumptions:

Investment cost Expected useful life Expected annual net cash flows (equal)

Cash Payback Period =

$200,000

Total Investment Annual Net Cash Inflows

8 years $40,000 Cash Payback Period = $200,000 $40,000

= 5 years

Cash Payback Method

Net Cash Flow Cumulative 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 $ 60,000 140,000 245,000 400,000 500,000 590,000 If the proposed investment is $400,000, the payback period is at the end of Year 4.

Present Value 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

What is the

present value

of $1,000 to be received one year from today at 8% per year?

Present Value Methods

How much would have to be invested on February 1, 2006 in order to receive $1,000 on February 1, 2009 if the interest rate compounded annually is 12%?

Present Value Methods

Refer to the partial present value table in Slide 18 to answer the question.

$1,000, 3 years, 12% compounded annually

Calculating Present 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 4 5 6 0.840

0.792

0.747

0.705

0.751

0.683

0.621

0.564

0.636

0.567

0.507

0.658

0.572

0.497

0.432

0.579

0.482

0.402

0.335

$1,000 x .712 =

$712

Present Value of an Amount

If $712 is invested on February 1, 2006 at an annual rate of 12 percent, $1,000 will accumulate by February 1, 2009.

$1,000 x .712 = $712

Present Value of an Amount

$712 x 1.12

$797 x 1.12

$893 x 1.12

$1,000

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 sum of the present values of each cash flows.

What would be the present value of a $100 annuity for five periods at 12?

Calculating Present Values of 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 3 1.833

2.673

1.736

2.487

1.690

2.402

1.626

2.283

1.528

2.106

4 5 6 3.465

4.212

4.917

3.170

3.791

4.355

3.037

4.111

2.855

3.353

3.785

2.589

2.991

3.326

3.605 x $100 =

$360.50

Net Present Value Method

The

net present value method

analyzes capital investment proposals by comparing the initial cash investment with the present value of the net cash flows.

Net Present Value 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 Present Value Method

At the beginning of 2006, equipment with an expected life of five years can be

Cash Flow Present Value

purchased for $200,000. At the end of five years it is anticipated that the equipment will have no residual value. A net cash flow of $70,000 is expected at the end of 2006. This net cash flow is expected to decline $10,000 each year (except 2010) until the machine is retired. The firm expects a minimum rate of return of 10%. Should the equipment be purchased?

Net Present Value Method

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

Net Present Value Method

Because there are multiple years of net cash flows, shouldn’t we use the present value of an annuity of $1?

Net Present Value Method

That would be true if the net cash flows remained constant from 2006 through 2010. Note that the net cash flows are $70,000, $60,000, $50,000, $40,000, and $40,000, respectively.

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

Net Present Value Method

$<200,000> $70,000 $60,000 $50,000 $40,000 $40,000 $ 63,630 $ 49,560 $ 37,550 $ 27,320 $ 24,840

$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

$ 2,900

Net Present Value Method

The equipment should be present value is positive.

Net Present Value Method

When capital investment funds are limited and the alternative proposals involve different amounts of investment, it is useful to prepare a ranking of the proposals using a

present value index. (a.k.a. profitability

index)

Net Present Value Method

Assumptions:

Total present value Total investment Net present value Present value index

A

$107,000 100,000 $ 7,000 1.07

Proposals B C

$86,400 80,000 $ 6,400 1.08 $93,600 90,000 $ 3,600 1.04 $107,000 ÷ $100,000 $86,400 ÷ $80,000 $93,600 ÷ $90,000 The best

Internal Rate of Return 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 Rate of Return 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 Rate of Return Method

Management is evaluating a proposal to acquire equipment costing $97,360. The equipment is expected to provide annual net cash flows of $20,000 per year for seven 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 $20,000 = 4.868

Internal Rate of Return 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.

10%

Present Value of an Annuity of $1 Year 6% 10% 12% 15% 1 0.943

0.909

0.893

0.870

2 3 1.833

2.673

1.736

2.487

1.690

2.402

1.626

2.283

4 5 6 7 3.465

4.212

4.917

5.582

3.170

3.791

4.355

3.037

3.605

4.111

4.564

2.855

3.353

3.785

4.160

Move vertically to the top of the table to determine the interest rate

Factors That Complicate Capital Investment Analysis

 Income tax  Unequal proposal lives  Lease versus capital investment  Uncertainty  Changes in price levels  Qualitative considerations

Qualitative 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 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.