Capital Investment Analysis

ACG 2071Module 12Chapter 25

Fall 2007

Capital Budgeting

Is the process by which management plans, evaluates, and controls investments in fixed assets

Involves long term commitment of funds Must earn a reasonable rate of return

Methods

Methods – not using present value Average rate return Cash payback period

Present Value Methods Net present value

method Present value index Internal rate of return

Methods – not using PV

Used to screen proposals

Minimum standards are set for accepting or not

Average rate of return

ARR = Average annual income Average investment

Where Average investment is one half of the original cost

Example 1:

Suppose that the company is considering the purchase of a machine at a cost of $500,000. The machine is expected to have a useful life of 4 years, with no residual value and to yield total income of $200,000. Compute the average rate of return.

Average of Rate of Return

Average Rate of Return = Average annual income

Average investment Average annual income =

$200,000/4 = $50,000 Average investment = $500,000/2 = $250,000

ARR = 50,000/250,000 = 20%

Example 2:

Suppose a corporation has an investment with a cost of $400,000 and average annual income of $20,000 what is the ARR?

Cash Payback Period

Looks for project with the shortest period to recover the original investment

Net cash Flow = excess cash flow from revenues – expenses

Cash payback period = number of years to recover cash invested

Cash Payback Period

EVEN cash flows formula:

Original investment

Net cash flow

= number of years to payback investment

Example 3:

Suppose that the company is considering the purchase of a machine at a cost of $400,000. The machine is expected to have net cash flow if $100,000. What is the cash payback period?

Original investment = $400,000 = 4 years

Net cash flow $100,000

Example 4:

Suppose machine with cost of $500,000 and net cash flow of $75,000 per year. What is the payback period?

Uneven Cash Flows:

Uneven cash flows Cost is $300,000 then

subtract the flows

Year Cash Flows

1 $60,000

2 80,000

3 105,000

4 155,000

5 100,000

6 90,000

Example:

Year Cash Flows Balance at end of year

1 $60,000 $300,000 - $60,000 = $240,000

2 80,000 $240,000 - $80,000 = $160,000

3 105,000 $160,000 - $105,000 = $55,000

4 155,000 $55,000 - $155,000 = end

5 100,000

5 90,000

Present value methods

Investment in fixed assets may be reviewed as acquiring a series of net cash flows over a period of time

Time is an important factor in determining the value of an investment

Present value of $1

It allows you to compare monies received today to monies received at a future date

Due to the fact that money has a value - interest

The quicker that you receive the money the more it is worth

Net Present Value Method

Analyze capital investment proposals by comparing the initial cash investment with the present value of the net cash flows Called discounted cash flow method

Rate is set my management If Net present value > original investment

then go ahead with project

Discounted Cash Flow Method

Total present value of net cash flow =

Net cash flow x PV of Annuity

Then:

Net cash flow X PV of Annuity

LESS original investment

> 0 then take the project

Present Value of an Annuity

Year 6% 10% 12% 15% 20%

1 0.943 0.909 0.893 0.870 0.833

2 1.833 1.736 1.690 1.626 1.528

3 2.673 2.487 2.402 2.283 2.106

4 3.465 3.170 3.037 2.855 2.589

5 4.212 3.791 3.605 3.353 2.991

6 4.917 4.355 4.111 3.785 3.326

7 5.582 4.868 4.564 4.160 3.605

8 6.210 5.335 4.968 4.487 3.837

9 6.802 5.759 5.328 4.772 4.031

10 7.360 6.145 5.650 5.019 4.192

Present value tablesYear 6% 10% 12% 15% 20%

1 0.943 0.909 0.893 0.870 0.833

2 0.890 0.826 .797 0.756 0.694

3 .840 0.751 0.712 0.658 0.579

4 0.792 0.683 0.636 0.572 0.482

5 0.747 0.621 0.567 0.497 0.402

6 0.705 0.564 0.507 0.432 0.335

7 0665 0.513 0452 0.376 0.279

8 0.627 0.467 0.404 0.327 0.233

9 0.592 0.424 0.361 0.284 0.194

10 0.558 0.386 0.322 0.247 0.162

Example 5:

Suppose that a proposal to acquire $200,000 of equipment with an expected useful life of five years and a minimum desired rate of return of 10%. The net cash flow is $70,000. Should we accept the project?

Example 5:

cash flow x PV of Annuity

$70,000 x 3.170 = $221,900

Net cash flow $221,900

Original investment $200,000

Discounted cash flow 21,900

Since positive accept the proposal

Example 6: Same as 5 but uneven cash flows

Year Cash Flows

1 $70,000

2 60,000

3 40,000

4 40,000

5 20,000

6 20,000

NPV

$70,000 * 0.893 = 62,510

$60,000 * 0.797 = 47,820

40,000 * 0.712 = 28,480

40,000*.636 = $25,440

20,000 * 0.567 = 11,340

20,000 * 0.507 = 10,140

TOTAL $185,730

Example

Add the Net present values = $185,730 Cost of project is $350,000 Since project is more expensive than return Decline the deal

Example 7:

Cost of project $200,000 for 4 years

Cash flows are $90,000 $60,000 $50,000 $40,000 Rate is 10%

Example 7:

Cost is $200,000 NPV is $212,760 Difference is

positive Keep the deal

Year Cash Flow

NPV

1 $90,000 $81,810

2 $80,000 66,080

3 $50,000 37,550

4 $40,000 27,320

Total 212,760

Present value index

= total present value of net cash flow/amount to be invested

Select highest index among the projectsProposal A B C

PV cash flows $107,000 $86,400 $93,600

Original Investment 100,000 80,000 90,000

NPV 7,000 6,400 3,600

Index 1.07 1.08 1.04

Internal Rate of Return

Uses present value concepts to compute the rate of return from the net cash flows

PV of Cash Flows =

Annual cash flows X PV factor NPV = PV cash flows – cost of investment

If NPV > 0 then accept the proposal

Factors complicating capital investment analysis

Income tax Unequal proposal lives Lease versus capital

investment Uncertainty Inflation Qualitative

consideration