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CHAPTER 14: CAPITAL INVESTMENT DECISIONS Cornerstones of Managerial Accounting, 6e © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. LO-1 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. LO-1 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. LO-1 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 LO-1 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. LO-2 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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: LO-2 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cornerstone 14.1 Calculating Payback LO-2 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. LO-2 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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: LO-2 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cornerstone 14.2 Calculating the Accounting Rate of Return LO-2 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. LO-3 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Discounting Models: The Net Present Value Method (cont.) LO-3 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. LO-3 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. LO-3 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. LO-3 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. LO-4 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 LO-4 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. LO-4 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cornerstone 14.4 Calculating Internal Rate of Return With Uniform Cash Flows LO-4 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. LO-5 © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.