Download Chapter 14: Capital Investment Decisions

CHAPTER 14:
CAPITAL INVESTMENT
DECISIONS
Cornerstones of Managerial
Accounting, 6e
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Types of Capital Investment Decisions
 Capital investment decisions include 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.
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Types of Capital Investment Decisions
 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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Making Capital Investment
Decisions
 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.
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Making Capital Investment
Decisions (cont.)
 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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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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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:
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Cornerstone 14.1
Calculating Payback
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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.
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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
Calculating the Accounting Rate
of Return
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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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Discounting Models:
The Net Present Value Method (cont.)
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Net Present Value
 NPV measures the profitability of an investment.
 A positive NPV indicates that the investment
increases the firm’s wealth.
 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.
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Net Present Value (cont.)
 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.
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Net Present Value (cont.)
 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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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.
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Internal Rate of Return (cont.)
 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.
or
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Internal Rate of Return (cont.)
 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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Cornerstone 14.4
Calculating Internal Rate of Return
With Uniform Cash Flows
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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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license distributed with a certain product or service or otherwise on a password-protected website for classroom use.