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Chapter 14:
Capital Investment Decisions
Cornerstones of Managerial Accounting, 4e
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Learning Objectives
1.
2.
3.
4.
5.
6.
7.
Explain the meaning of capital investment decisions, and distinguish
between independent and mutually exclusive capital investment
decisions.
Compute the payback period and accounting rate of return for a
proposed investment, and explain their roles in capital investment
decisions.
Use net present value analysis for capital investment decisions involving
independent projects.
Use the internal rate of return to assess the acceptability of independent
projects.
Explain the role and value of postaudits.
Explain why net present value is better than internal rate of return for
capital investment decisions involving mutually exclusive projects.
(Appendix 14A) Explain the relationship between current and future
dollars.
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1
Types of
Capital Investment Decisions
► Capital investment decisions are concerned with the process
of planning, setting goals and priorities, arranging financing,
and using certain criteria to select long-term assets.
► The process of making capital investment decisions often is
referred to as capital budgeting.
► Two types of capital budgeting projects will be considered:
independent projects and mutually exclusive projects.
►Independent projects are projects that, if 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.
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1
Making
Capital Investment Decisions
► In general terms, a sound capital investment will earn back its
original capital outlay over its life and, at the same time,
provide a reasonable return on the original investment.
► After making this assessment, managers must decide on the
acceptability of independent projects and compare
competing projects on the basis of their economic merits.
► To make a capital investment decision, a manager must
► estimate the quantity and timing of cash flows
► assess the risk of the investment
► consider the impact of the project on the firm’s profits
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2
Basic Capital Investment
Decision Models
►The basic capital investment decision models
can be classified into two major categories:
►Nondiscounting models ignore the time value of
money.
►Discounting models explicitly consider the time
value of money.
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2
Nondiscounting Models:
Payback Period
► The payback period is a nondiscounting model that presents
the time required for a firm to recover its original investment.
► If the cash flows of a project are an equal amount each
period, payback period is computed as follows:
► If the cash flows are unequal, the payback period is computed
by adding the annual cash flows until such time as the original
investment is recovered.
► If a fraction of a year is needed, it is assumed that cash flows
occur evenly within each year.
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2
Cornerstone 14-1
Calculating Payback
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2
Using Payback Period
to Assess Risk
► One way to use the payback period is to set a maximum
payback period for all projects and to reject any project that
exceeds this level.
► Some analysts suggest that the payback period can be used as
a rough measure of risk, with the notion that the longer it
takes for a project to pay for itself, the riskier it is.
► Also, firms with riskier cash flows in general could require a
shorter payback period than normal.
► Additionally, firms with liquidity problems would be more
interested in projects with quick paybacks.
► Another critical concern is obsolescence. Firms with higher
risk of obsolescence such as computer manufacturers would
be interested in recovering funds rapidly.
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2
Using the Payback Period
to Choose Among Alternatives
► The payback period can be used to choose among competing
alternatives.
► Under this approach, the investment with the shortest
payback period is preferred over investments with longer
payback periods.
► However, this use of the payback period is less defensible
because this measure suffers from two major deficiencies:
►It ignores the cash flow performance of the investments
beyond the payback period.
►It ignores the time value of money.
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2
Nondiscounting Models:
Accounting Rate of Return
►The accounting rate of return (ARR) measures the return
on a project in terms of income, as opposed to using a
project’s cash flow.
►The accounting rate of return is computed by the
following formula:
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Cornerstone 14-2
2
Calculating the Accounting Rate of Return
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2
Limitations of the
Accounting Rate of Return
► Unlike the payback period, the ARR does consider a project’s
profitability.
► However, the ARR has other potential drawbacks, including
the following:
►Ignoring Time Value of Money: Like the payback period, it ignores
the time value of money.
►Dependency on Net Income: ARR is dependent upon net income,
which is the financial measure most likely to be manipulated by
managers.
►Managers’ Incentive: Additionally, because bonuses to managers
often are based on accounting income or return on assets,
managers may have a personal interest in selecting investments
that contribute to net income in the short-run.
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3
Discounting Models:
The Net Present Value Method
► Discounting models use discounted cash flows which are
future cash flows expressed in terms of their present value.
► One discounting model is the net present value (NPV), which
is the difference between the present value of the cash
inflows and outflows associated with a project.
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3
Net Present Value
► NPV measures the profitability of an investment.
► A positive NPV indicates that the investment increases the
firm’s wealth.
► To use the NPV method, a required rate of return must be
defined.
► The required rate of return is the minimum acceptable rate
of return.
► It also is referred to as the discount rate, hurdle rate, and cost
of capital.
► In theory, if future cash flows are known with certainty, then
the correct required rate of return is the firm’s cost of capital.
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3
Net Present Value
(continued)
► In practice, managers often choose a discount rate higher than the cost of
capital to deal with uncertainty.
► However, if the rate chosen is excessively high, it will bias the selection
process toward short-term investments.
► Once the NPV for a project is computed, it can be used to determine
whether or not to accept an investment.
► If the NPV is greater than zero the investment is profitable and, therefore,
acceptable.
► A positive NPV signals that (1) the initial investment has been
recovered, (2) the required rate of return has been recovered, and (3)
a return in excess of (1) and (2) has been received.
► If the NPV equals zero, the decision maker will find acceptance or
rejection of the investment equal.
► If the NPV is less than zero, the investment should be rejected. In this
case, it is earning less than the required rate of return.
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Cornerstone 14-3
3
Assessing Cash Flows
and Calculating Net Present Value
Information:
A detailed market study revealed expected annual revenues of
$300,000 for new earphones. Equipment to produce the earphones
will cost $320,000. After five years, the equipment can be sold for
$40,000. In addition to equipment, working capital is expected to
increase by $40,000 because of increases in inventories and
receivables. The firm expects to recover the investment in working
capital at the end of the project’s life. Annual cash operating
expenses are estimated at $180,000. The required rate of return is
12 percent.
Required:
Estimate the annual cash flows, and calculate the NPV.
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Cornerstone 14-3
3
Assessing Cash Flows
and Calculating Net Present Value (continued)
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Cornerstone 14-3
3
Assessing Cash Flows
and Calculating Net Present Value (continued)
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3
NPV, Discount Rates, and Cash Flows
► It is common to provide pessimistic and most likely cash flow scenarios to
help assess a project’s risk.
► As the discount rate increases, the present value of future cash flows
decreases, making it harder for a project to achieve a positive NPV.
► Plotting the NPV as the discount rate varies provides good insight into the
risk and economic viability of the proposed project.
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4
Internal Rate of Return
► The internal rate of return (IRR), another discounting model,
is defined as the interest rate that sets the present value of a
project’s cash inflows equal to the present value of the
project’s cost.
► It is the interest rate that sets the project’s NPV at zero.
► The following equation can be used to determine a project’s
IRR, where t = 1, …, n :
► The right side of this equation is the present value of future cash flows
► The left side is the investment.
► I, CFt, and t are known.
► Thus, the IRR (the interest rate, i, in the equation) can be found using
trial and error.
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4
Internal Rate of Return
(continued)
►Once the IRR for a project is computed, it is
compared with the firm’s required rate of return:
►If the IRR is greater than the required rate, the project is
deemed acceptable.
►If the IRR is less than the required rate of return, the
project is rejected.
►If the IRR is equal to the required rate of return, the firm is
indifferent between accepting or rejecting the investment
proposal.
►The IRR is the most widely used of the capital
investment techniques.
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4
Internal Rate of Return:
Multiple Period
► If the investment produces a series of uniform cash flows, a
single discount factor from the present value table can be
used to compute the present value of the annuity.
► If the cash flows are not uniform, then the IRR equation must
be used.
► For a multiple-period setting, this equation can be solved by
trial and error or by using a business calculator or a
spreadsheet program.
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Cornerstone 14-4
4
Calculating Internal Rate of Return
With Uniform Cash Flows
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You Decide
4
IRR and Uncertainty in Estimates of
Cash Savings and Project Life
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4
You Decide
IRR and Uncertainty in Estimates of
Cash Savings and Project Life (continued)
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5
Postaudit of Capital Projects
► A key element in the capital investment process is a follow-up
analysis of a capital project once it is implemented.
► A postaudit compares the actual benefits with the estimated
benefits and actual operating costs with estimated operating
costs.
► It evaluates the overall outcome of the investment and
proposes corrective action if needed.
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5
Postaudit Benefits
►Firms that perform postaudits of capital projects
experience a number of benefits, including the
following:
►Resource Allocation: By evaluating profitability, postaudits
ensure that resources are used wisely.
►Positive Impact on Managers’ Behavior: If managers are
held accountable for the results of a capital investment
decision, they are more likely to make such decisions in
the best interests of the firm.
►Independent Perspective: Postaudit by an independent
party ensures more objective results.
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5
Postaudit Limitations
►Postaudits are costly.
►The assumptions driving the original analysis
may often be invalidated by changes in the
actual operating environment.
►Accountability must be qualified to some
extent by the impossibility of foreseeing every
possible eventuality.
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6
Mutually Exclusive Projects
►Up to this point, we have focused on independent
projects.
►NPV and IRR both yield the same decision for independent
projects.
►However, many capital investment decisions deal
with mutually exclusive projects.
►For competing projects, the two methods can produce
different results.
►Choosing the project with the largest NPV is consistent
with maximizing the wealth of shareholders.
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6
Net Present Value Compared
with Internal Rate of Return
►NPV differs from IRR in two major ways:
►The NPV method assumes that each cash inflow received
is reinvested at the required rate of return, whereas the
IRR method assumes that each cash inflow is reinvested at
the computed IRR. Reinvesting at the required rate of
return is more realistic and produces more reliable results
when comparing mutually exclusive projects.
►The NPV method measures profitability in absolute terms,
whereas the IRR method measures it in relative terms.
NPV measures the amount by which the value of the firm
changes.
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Net
Present
Value
Compared
with
6
Internal Rate of Return (continued)
► When choosing between projects, what counts are the total dollars
earned—the absolute profits—not the relative profits.
► Accordingly, NPV, not IRR, should be used for choosing among
competing, mutually exclusive projects or competing projects when
capital funds are limited.
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6
Net Present Value
for Mutually Exclusive Projects
►There are three steps in selecting the best project
(with the largest NPV) from several competing
projects:
►Step 1: Assess the cash flow pattern for each project.
►Step 2: Compute the NPV for each project.
►Step 3: Identify the project with the greatest NPV.
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Cornerstone 14-5
6 Calculating Net Present Value and Internal Rate
of Return for Mutually Exclusive Projects
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Cornerstone 14-5
6 Calculating Net Present Value and Internal Rate of
Return for Mutually Exclusive Projects (continued)
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6
Special Considerations for the
Advanced Manufacturing Environment
► For advanced manufacturing environments, like those using
automated systems, capital investment decisions can be more
complex because they must take special considerations into
account.
► Great care must be exercised to assess the actual cost of an
automated system because it is easy to overlook substantial
peripheral costs like software, engineering, and training.
► More effort is needed to measure intangible and indirect
benefits, like reduced lead time, reliability, and customer
satisfaction, in order to assess more accurately the potential
value of investments.
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7
Appendix 14A:
Present Value Concepts
► An important feature of money is that it can be invested and can
earn interest.
► A dollar today is not the same as a dollar tomorrow.
► This fundamental principle is the backbone of discounting
methods.
► Future value is expressed as: F = P(1 + i), where F is the future
amount, P is the initial or current outlay, and i is the interest
rate.
► The earning of interest on interest is referred to as
compounding of interest, expressed as follows for n periods
into the future:
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7
Present Value
► Often, a manager needs to compute not the future value but the
amount that must be invested now in order to yield some given
future value.
► The amount that must be invested now to produce the future value
is known as the present value of the future amount.
► To compute the present value of a future outlay, all we need to do
is solve the compounding interest equation for P:
► The process of computing the present value of future cash flows is
often referred to as discounting.
► The interest rate used to discount the future cash flow is the
discount rate. The expression 1/(1 + i)n in the present value
equation is the discount factor.
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7
Annuities
►An annuity is a series of future cash flows.
►If the annuity is uneven, then each future cash flow
must be discounted using individual discount rates
(the present value for each cash flow is calculated
separately and then summed).
► For even cash flows, a single discount rate, which is
the sum of each discount rate for each cash flow, can
be used.
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