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SURVEY OF ACCOUNTING
Chapter 15
PowerPoint Presentation by
Gail B. Wright
Professor of Accounting
Bryant University
CARL S. WARREN
© Copyright 2007 Thomson South-Western, a part of The
Thomson Corporation. Thomson, the Star Logo, and
South-Western are trademarks used herein under license.
LEARNING OBJECTIVES
When you finish this
chapter, you should be
able to
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LEARNING OBJECTIVES
1. Explain the nature & importance of capital
investment analysis.
2. Evaluate capital investment proposals using the
following methods: average rate of return, cash
payback, net present value, & internal rate of
return.
3. List, describe factors that complicate capital
investment analysis
4. Diagram capital rationing process.
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LEARNING OBJECTIVE
1
Explain nature,
importance of capital
investment analysis.
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LO 1
CAPTIAL INVESTMENT
ANALYSIS
Capital investment analysis (capital
budgeting) is the process by which
managers
Plan
Evaluate
Control
investments in fixed assets
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LEARNING OBJECTIVE
2
Evaluate capital
investment proposals.
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LO 2
EVALUATION METHODS
Methods not using present values
Average rate of return
Payback
Methods that do use present values
Net present value
Internal rate of return
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LO 2
AVERAGE RATE OF RETURN
Measure of average income as a percent of average investment
in fixed assets.
Average rate of return =
Estimated average income / Average investment
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LO 2
AVERAGE RATE OF RETURN:
Example
Purchase of machine for $500,000 expected to generate
$200,000 profit over 4 years.
Average rate of return =
($200,000/4) / ($500,000/2) =
$50,000 / $250,000
20%
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LO 2
AVERAGE RATE OF RETURN:
Analysis
Purchase of the machine will help generate an
average return of 20% per year for 4 years
after taking into consideration its depreciation.
However, it does not consider the present
value of money.
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LO 2
PAYBACK PERIOD
Expected time between investment and recapture of cash outlay.
Payback period =
Cost / (Expected revenues – expenses)
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LO 2
PAYBACK PERIOD:
Example
Purchase of machine for $200,000 with 8 year life expected to
generate $40,000 net profit annually.
Payback period =
$200,000 / ($50,000 – 10,000) =
$200,000 / $40,000
5 years
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LO 2
PAYBACK PERIOD:
Analysis
It will take 5 years to pay for the machine,
assuming $40,000 net profit and with no
consideration for alternative uses for the
money or the time value of money.
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LO 2
Present value methods
employ the time value of
money to determine the
return on purchase of a long
term asset.
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LO 2
PRESENT VALUE $1
Present value of $1 measures the cost in
today’s dollars of a single investment to be
withdrawn at a point in the future.
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LO 2
PRESENT VALUE: Annuity
Present value of an annuity measures the cost
in today’s dollars of a series of investments to
be withdrawn at a point in the future.
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LO 2
Net present value
(discounted cash flow)
compares initial cash
investment with present
value of net cash flows.
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LO 2
NET PRESENT VALUE:
Example
Purchase of machine for $200,000 with 5 year life, 10%
minimum rate of return.
NPV =
$200,000 – 3.605 ($70,000) =
$200,000 - $202,900
$2,900
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LO 2
NET PRESENT VALUE: Analysis
Return from investment in a long term asset
costing $200,000 exceeds its cost by a positive
$2,209, after considering the time value of
money.
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LO 2
Internal rate of return uses
present value concepts to
compute the rate of return
expected from capital
investment proposals.
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LO 2
INTERNAL RATE OF RETURN:
Example
A machine costing $33,530 must generate a 12% return to
be viable. The expected annual return is $10,000 each
year for 5 years.
($10,000 * 3.605) - $33,000 = $2,520
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LO 2
INTERNAL RATE OF RETURN:
Analysis
Return from investment in a long term asset
costing $33,530 exceeds its cost by a positive
$2,520, after considering the time value of
money. This equates to an internal rate of
return of 15%.
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LEARNING OBJECTIVE
3
List, describe factors
that complicate
capital investment
analysis.
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LO 3
COMPLICATING FACTORS
Income tax
Proposals with unequal lives
Lease vs. capital investment
Uncertainty
Changes in price levels
Qualitative considerations
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LEARNING OBJECTIVE
4
Diagram capital
rationing process.
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LO 4
What is capital
rationing?
Capital rationing is the
process by which managers
allocate funds among
competing proposals.
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EXHIBIT 6
LO 4
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LO 4
CAPITAL RATIONING: Analysis
Capital rationing proposes an analytical
process to choose among competing proposals.
Those proposals that meet all quantitative
(financial) and qualitative tests should be
ranked for funding along with rejected
proposals that change outcomes because of
qualitative tests.
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CHAPTER 15
THE END
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