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Chapter M9
Power Notes
Capital Investment Analysis
Learning Objectives
1. Nature of Capital Investment Analysis
2. Methods of Evaluating Capital
Investment Proposals
3. Factors That Complicate Capital
Investment Analysis
4. Capital Rationing
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Chapter M9
Power Notes
Capital Investment Analysis
Slide #
3
7
15
26
29
Power Note Topics
•
•
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Nature of Capital Investment Decisions
Average Rate of Return; Cash Payback
The Time Value of Money
Present Value Analysis
Other Considerations
Note: To select a topic, type the slide # and press Enter.
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Nature 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.
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Methods of Evaluating Capital Investments
Methods that do not use present values
Average rate of return method
Cash payback method
Methods that use present values
Net present value method
Internal rate of return method
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Average Rate of Return
Advantages:
Easy to calculate
Disadvantages:
Ignores cash flows
Considers accounting
income (often used to
evaluate managers)
Ignores the time
value of money
Cash Payback
Advantages:
Considers cash flows
Shows when funds
are available for
reinvestment
Disadvantages:
Ignores profitability
(accounting income)
Ignores cash flows after
the payback period
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Net Present Value
Advantages:
Considers cash flows
and the time value of
money
Disadvantages:
Assumes that cash
received can be
reinvested at the rate
of return
Internal Rate of Return
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
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Average Rate of Return Method
Assumptions:
Machine cost
Expected useful life
Residual value
Expected total income
$500,000
4 years
none
$200,000
Estimated Average
Average Rate
Annual Income
=
of Return
Average Investment
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Average Rate of Return Method
Assumptions:
Machine cost
Expected useful life
Residual value
Expected total income
$500,000
4 years
none
$200,000
Estimated Average
Average Rate
Annual Income
=
of Return
Average Investment
Average Rate
$200,000 / 4 yrs.
=
= 20%
of Return
($500,000 + $0) / 2
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Average Rate of Return Method
Assumptions:
Average annual income
Average investment
Average rate of return
Proposal A Proposal B
$30,000
$36,000
$120,000 $180,000
Estimated Average
Average Rate
Annual Income
=
of Return
Average Investment
What is the average rate of return for each proposal?
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Average Rate of Return Method
Assumptions:
Average annual income
Average investment
Average rate of return
Proposal A Proposal B
$30,000
$36,000
$120,000 $180,000
25%
20%
This method emphasizes accounting
income which is commonly used in
evaluating management performance.
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Cash Payback Method
Assumptions:
Investment cost
Expected useful life
Expected annual net
cash flows (equal)
Cash
Payback =
Period
$200,000
8 years
$40,000
Total Investment
Annual Net
Cash Inflows
What is the cash payback period?
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Cash Payback Method
Assumptions:
Investment cost
Expected useful life
Expected annual net
cash flows (equal)
Cash
Payback =
Period
Cash
Payback =
Period
$200,000
8 years
$40,000
Total Investment
Annual Net
Cash Inflows
$200,000
$40,000
= 5 years
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Cash Payback Method
Assumptions:
Net Cash
Cumulative
Flow
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,
what is the payback period?
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Cash Payback Method
Assumptions:
Net Cash
Cumulative
Flow
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 $450,000,
what is the payback period?
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The 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.
Present
Value
$1,000
What is the future value of $1,000 invested
today (present value) at 8% per year?
Future
Value
$ ????
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The 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.
Present
Value
$1,000
What is the future value of $1,000 invested
today (present value) at 8% per year?
Future
Value
$1,080
= $1,000 + ($1,000 x 8%)
= $1,000 x 108% or 1.08
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The 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.
Present
Value
$ ????
What is the present value of $1,000 to be
received one year from today at 8% per year?
Future
Value
$1,000
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The 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.
Present
Value
$ 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?
Future
Value
$1,000
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Calculating 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%
1
.9434
Calculator
= $1.0000 / 1.06
One dollar at the end of one
period at 6% per period is equal
to $.9434 today (present value).
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Calculating 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%
Calculator
1
.9434
= $1.0000 / 1.06
2
.8900
= $ .9434 / 1.06
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.
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Calculating 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%
Calculator
1
.9434
= $1.0000 / 1.06
2
.8900
= $ .9434 / 1.06
3
.8396
= $ .8900 / 1.06
One dollar at the end of three
periods at 6% per period is equal
to $.8396 today (present value).
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Calculating 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%
Calculator
1
.9434
= $1.0000 / 1.06
2
.8900
= $ .9434 / 1.06
3
.8396
= $ .8900 / 1.06
4
.7921
= $ .8396 / 1.06
5
.7432
= $learn
.7921to /use
1.06constant division.
When using
a calculator,
You will
enter $1 =
and
first time, pressing
6 then.7050
$ 1.06
.7432the
/ 1.06
only the equal (=) key for each successive answer.
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Calculating 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
Period
6%
Annuity
6%
1
.9434
.9434
2
.8900
1.8334
Calculation
Sum of Periods
= Period 1
= Periods 1–2
3 The PV
.8396
2.6730 of $1
= Periods
of an annuity
to be 1–3
4 received
.7921each 3.4651
= Periods
year for two
years is1–4
This is
the sum =ofPeriods
the PV 1–5
of
5 $1.8334.
.7432
4.2124
the two amounts for periods 1 and 2.
4.2124
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Calculating 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
Period
6%
Annuity
6%
Calculation
Sum of Periods
1
.9434
.9434
= Period 1
2
.8900
1.8334
= Periods 1–2
3
.8396
2.6730
= Periods 1–3
4 The PV
.7921
3.4651 of $1
= Periods
of an annuity
to be 1–4
5 received
.7432each 4.2124
= Periods
year for three
years 1–5
is
$2.6730.
This is the sum of the PV of
4.2124
the three amounts for periods 1–3.
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Calculating 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
Period
6%
Annuity
6%
Calculation
Sum 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
Total
.7473
4.2124
= Periods 1–5
4.2124
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Present Value Method
Assumptions:
Investment
$200,000
Useful life
5 years
Residual value
none
Minimum rate of return
10%
Cash Flow
Year 1 $70,000 / 1.10
Year 2
60,000 / 1.10
Year 3
50,000 / 1.10
Year 4
40,000 / 1.10
Year 5
40,000 / 1.10
Total present value
Less investment
Net present value
Present value index
(1 time)
(2 times)
(3 times)
(4 times)
(5 times)
Present Value
= $ 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
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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 $93,600
80,000
90,000
$ 6,400 $ 3,600
1.08
1.04
What is the meaning of an index over 1.0?
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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.
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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?
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The 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.
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Chapter M9
Power Notes
Capital Investment Analysis
This is the last slide in Chapter M9.
Note: To see the topic slide, type 2 and press Enter.
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