Nature of Capital Investment Analysis
o Used to help evaluate long-term investments
o Capital Budgeting - is the process by which management plans, evaluates, and controls investments in fixed assets.
o Involves the long- term commitment of funds and affects operations for many years.
o Thus must earn a reasonable rate of return
o Capital budgeting decisions require careful analysis because they are usually the most difficult and risky decisions that managers make
o Risky because
 The outcome is uncertain
 Large amounts of money are usually involved
 The investment involves a long term commitment
 The decision could be difficult or impossible to reverse

Methods of Evaluating Capital Investment Proposals
o Methods that do not use present values
o Methods that use present values

Methods that ignore present values
• used to screen proposals
• management sets minimum standards for accepting proposals
o if not meeting minimum standards - dropped from consideration
o if meeting minimum standards then further analysis is completed

Average rate of return
o accounting rate of return
o a measure of the average income as a percent of the average investment in fixed assets.

Average rate of return =
Estimated average annual income
Average investment
Average investment is original investment divided by 2

Example:
Proposal A Proposal B
Estimated average annual income $30,000 $36,000
Average investment $120,000 $180,000

Average rate of return =
Estimated average annual income
Average investment

Proposal A:
= $ 30,000 = $30,000 = 50%
$120,000/2 $60,000

Proposal B:
= $ 36,000 = $36,000 = 40%
$180,000/2 $90,000

Cash Payback Period
o is the expected time period to recover the initial investment amount
o managers prefer investing in assets with shorter payback periods to reduce the risk
o Looks for project with the shortest tie period to recover the original investment.
o Net cash flow = excess cash flow from revenues minus expenses
o Cash payback period = amount of time to recover cash invested.
o Payback period = Cost of Investment
Annual net cash flow
Example: Project has an eight year life with a cost of $200,000. The annual cash flows are $40,000. What is the payback period?

Payback period = Cost of Investment
Annual net cash flow
= $200,000
$40,000

= 5 years
 Uneven cash flows
o Some projects have different cash flows each year

Year
Cash Flows Balance

1
60,000 $400,000 – 60000 = $340,000

2
80,000 $340,000 – 80,000 = $260,000

3
105,000 $260000 – 105000 = $155,000

4
155,000 155,000 – 155,000 = -0-

5
100,000

6
90,000











Methods using time value of money

 Present value methods
o an investment in fixed assets may be viewed as acquiring a series of net cash flows over a period of time.

o Period of time is an important factor in determining the value of an investment.

o
Present value interest factor of $1 per period at i% for n periods, PVIF(i,n).
Period 5% 5.50% 6.00% 6.50% 7% 10% 11% 12% 13% 14%
1 0.95238 0.94787 0.94340 0.93897 0.93458 0.90909 0.90090 0.89286 0.88496 0.87719
2 0.90703 0.89845 0.89000 0.88166 0.87344 0.82645 0.81162 0.79719 0.78315 0.76947
3 0.86384 0.85161 0.83962 0.82785 0.81630 0.75131 0.73119 0.71178 0.69305 0.67497
4 0.82270 0.80722 0.79209 0.77732 0.76290 0.68301 0.65873 0.63552 0.61332 0.59208
5 0.78353 0.76513 0.74726 0.72988 0.71299 0.62092 0.59345 0.56743 0.54276 0.51937
6 0.74622 0.72525 0.70496 0.68533 0.66634 0.56447 0.53464 0.50663 0.48032 0.45559
7 0.71068 0.68744 0.66506 0.64351 0.62275 0.51316 0.48166 0.45235 0.42506 0.39964
8 0.67684 0.65160 0.62741 0.60423 0.58201 0.46651 0.43393 0.40388 0.37616 0.35056
9 0.64461 0.61763 0.59190 0.56735 0.54393 0.42410 0.39092 0.36061 0.33288 0.30751
10 0.61391 0.58543 0.55839 0.53273 0.50835 0.38554 0.35218 0.32197 0.29459 0.26974


a> Net present value method
o analyzes capital investment proposals by comparing the initial cash investment with the present value of the net cash flows.
o Called discounted cash flow method
o rate is set by management
o if Net present value > original investment then go ahead with it
o if Net present value < original investment then no go Example: An investment of $150,000 with five year life is being considered. Management established a rate of return of 12%. The annual cash flows are: Year Cash Flow 1 70,000 2 60,000 3 40,000 4 40,000 What is the net present value? Year Net Cash Flow Present value factor at 12% PV of Net Cash Flows 1 $70,000 .8929 $62,503 2 $60,000 .7972 $47,832 3 $40,000 .7118 $28,472 4 $40,000 .6355 $25,420 TOTAL $164,227 Original Investment 150,000 Net present value $14,227 Since net present value is positive then accept the project. b> Internal Rate of Return
o uses present value concepts to compute the rate of return from the net cash flows expected from the capital investment proposals.

o STEP 1: Compute the present value factor for the investment project:
Present value factor = Amount invested
Net cash flows

o STEP 2: Identify the discount rate yielding the present value factor
 use the factor to find the value

EXAMPLE: Project with an investment of $12,000, net cash flows are $5,000 for three years. What is the internal rate of return?

STEP 1: Compute the present value factor for the investment project:
Present value factor = Amount invested
Net cash flows

$12,000
5,000

= 2.400

STEP 2: Identify the discount rate yielding the present value factor


Period 1% 5% 10% 12% 15%
3 2.941 2.7232 2.4869 2.4018 2.2832

Notice that at 12% the factor is 2.4018 the closest to 2.400. The internal rate of return is 12%.

Comparison of Capital Budgeting Methods

Payback Period Accounting Rate of Return Net Present Value Internal Rate of Return
Measurement basis Cash Flows Accrual income Cash flows Profitability Cash flows Profitability
Measurement unit Years Percent Dollars Percent
Strengths Easy to understand Easy to understand Reflects time value of money Reflects time value of money
Allows comparison of projects Allows comparison of projects Reflects varying risks over project's life allows comparisons of dissimilar projects
Limitations ignores time value of money ignores time value of money difficult to compare dissimilar projects ignores varying risks over life of project
ignores cash flows after payback period ignores annual rates over life of project