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Cornerstones of Financial & Managerial Accounting Rich/Jones/Heitger/Mowen/Hansen Chapter 24 Learning Objectives LO1. Explain the meaning of capital investment decisions, and distinguish between independent and mutually exclusive capital investment decisions. Capital investment decisions are concerned with the acquisition of long-term assets and usually involve a significant outlay of funds. The two types of capital investment projects are independent and mutually exclusive. Independent projects are projects that, whether accepted or rejected, do not affect the cash flows of other projects. Mutually exclusive projects are those projects that, if accepted, preclude the acceptance of all other competing projects. LO2. Compute the payback period and accounting rate of return for a proposed investment, and explain their roles in capital investment decisions. Managers make capital investment decisions by using formal models to decide whether to accept or reject proposed projects. These decision models are classified as nondiscounting and discounting, depending on whether they address the question of the time value of money. The two nondiscounting models are the payback period and the ARR. The payback period is the time required for a firm to recover its initial investment. For even cash flows, it is calculated by dividing the investment by the annual cash flow. For uneven cash flows, the cash flows are summed until the investment is recovered. If only a fraction of a year is needed, then it is assumed that the cash flows occur evenly within each year. The payback period ignores the time value of money and the profitability of projects because it does not consider the cash inflows available beyond the payback period. However, it does supply some useful information. The payback period is useful for assessing and controlling risk, minimizing the impact of an investment on a firm’s liquidity, and controlling the risk of obsolescence. The ARR is computed by dividing the average income expected from an investment by either the original or average investment. Unlike the payback period, the ARR does consider the profitability of a project; however, it ignores the time value of money. The ARR may be useful to managers for screening new investments to ensure that certain accounting ratios are not adversely affected (specifically, accounting ratios that may be monitored to ensure compliance with debt covenants). LO3. Use net present value analysis for capital investment decisions involving independent projects. NPV is the difference between the present value of future cash flows and the initial investment outlay. To use the NPV model, a required rate of return must be identified (usually the cost of capital). The NPV method uses the required rate of return to compute the present value of a project’s cash inflows and outflows. If the present value of the inflows is greater than the present value of the outflows, then the NPV is greater than zero, and the project is profitable; if the NPV is less than zero, then the project is not profitable and should be rejected. LO4. Use the internal rate of return to assess the acceptability of independent projects. The IRR is computed by finding the interest rate that equates the present value of a project’s cash inflows with the present value of its cash outflows. If the IRR is greater than the required rate of return (cost of capital), then the project is acceptable; if the IRR is less than the required rate of return, then the project should be rejected. LO5. Explain the role and value of postaudits. Postauditing of capital projects is an important step in capital investment. Postaudits evaluate the actual performance of a project in relation to its expected performance. A postaudit may lead to corrective action to improve the performance of the project or to abandon it. Postaudits also serve as an incentive for managers to make capital investment decisions prudently. LO6. Explain why net present value is better than internal rate of return for capital investment decisions involving mutually exclusive projects. In evaluating mutually exclusive or competing projects, managers have a choice of using NPV or IRR. When choosing among competing projects, the NPV model correctly identifies the best investment alternative. IRR, at times, may choose an inferior project. Thus, since NPV always provides the correct signal, it should be used.