COPYRIGHT © 2009 South-Western/Cengage Learning

SURVEY OF ACCOUNTINGSURVEY OF ACCOUNTING

CHAPTER 15

CARL S. WARREN

LEARNING OBJECTIVESLearning Objectives

After studying this chapter, you should be able to…

1. Explain the nature and importance of capital investment analysis.

2. Evaluate capital investment proposals, using the following methods: average rate of return, cash payback, net present value, and internal rate of return.

Continued…

Learning Objectives

3. List and describe factors that complicate capital investment analysis.

4. Diagram the capital rationing process.

Learning Objective 1

Explain the nature and importance of capital investment analysis.

Capital Investment Analysis

The process by which management plans, evaluates, and controls investments in fixed assets. Also called capital budgeting.

Employees should be encouraged to submit proposals for capital investments.

Capital investment is very important for the long-term success of a business.

Learning Objective 2

Evaluate capital investment proposals, using the following

methods: average rate of return, cash payback, net present value, and

internal rate of return.

Methods of Evaluating Capital Investment Proposals

Methods that do not use present value:• Average rate of return • Cash payback

Methods that do use present value:• Net present value• Internal rate of return

Methods That Ignore Present Value

Often used to initially screen proposals.Useful for proposals with relatively short

useful lives because the timing of cash flows is less important.

Average Rate of Return

A measure of the average annual income expected to be earned from the investment over the investment life, after deducting depreciation.

Also called the accounting rate of return.

Avg. Rate of Return = Estimated Avg. Annual Income Average Investment

Assume management is considering purchasing a machine for $500,000. The machine has a 4-year

useful life with no residual value and is expected to yield total income of $200,000.

Average Rate of Return

Avg. Rate of Return = Estimated Avg. Annual Income Average Investment

20% = $200,000/4 ($500,000 cost + $0 residual)/2

Average Rate of Return Analysis

If the average rate of return exceeds the company’s minimum rate, the project should be accepted.

Advantages:• Easy to compute.• Indicates income to be earned over the life of the

proposal. • Emphasizes accounting income.

Disadvantage – does not consider time value of money.

Cash Payback

The cash payback period is the expected period of time that will pass between the date of an investment and the complete recovery in cash (or equivalent) of the amount invested.

The excess of cash flowing in from revenue over the cash flowing out for expenses is called net cash flow.

Payback Period = Initial Cash Investment Net Cash Flow

Assume management is considering purchasing a machine for $200,000. Annual cash revenues are $50,000, and annual cash expenses are $10,000.

Cash Payback

5 years = $200,000 $40,000

Payback Period = Initial Cash Investment Net Cash Flow

Cash Payback

If annual cash flows are not equal, the payback period is determined by adding the annual net cash

flows until the investment is recovered.

Cash Payback Analysis

Used for evaluating new project proposals. A short payback period is desirable.

• The sooner the cash is recovered, the sooner it can be reinvested.

• Less probability of loss. Especially useful to managers whose primary

concern is liquidity. Disadvantages:

• Ignores cash flows after the payback period.• Does not use present value.

Present Value Methods

Use both the amount and timing of cash flows to evaluate an investment.

Present Value of an Amount – $1 today is worth more than $1 three years from now because the $1 can be invested.

Present Value of an Annuity – sum of the present values of a series of cash flows at fixed intervals.

Present Value of an Amount

Present Value Calculations

Present value tables help us calculate present values for annuities and single sums.

Net Present Value Method

Analyzes capital investment proposals by comparing the initial cash investment with the present value of the net cash flows.

Also called discounted cash flow method. The return rate is set by management – often

called the hurdle rate. If the net present value expected from an

investment equals/exceeds the initial investment, the project is desirable.

Net Present Value

Net present value

analysis for the purchase of a $200,000 machine with

a 5-year useful life.

Minimum rate of return is

10%.

Present Value Index

If multiple proposals are being considered, use of the present value index can help determine which projects to accept.

Internal Rate of Return

Uses present value concepts to compute the rate of return from the net cash flows expected from capital investment proposals.

Also called the time-adjusted rate of return method.

Starts with net cash flows and works backward to determine the rate of return expected from the project.

Assume management is considering a proposal to acquire equipment costing $33,530. The equipment is expected to

provide annual net cash flows of $10,000 for five years. We’ll assume a return rate of 12%.

Internal Rate of Return

Since the present value of cash inflows is greater than the amount invested, the internal rate of return must be more

than 12%. Trial-and-error procedures show that the internal rate of return is 15%.

Internal Rate of Return

Trial-and-error procedures are time-consuming. When equal annual net cash flows are expected,

the calculation can be simplified.

Learning Objective 3

List and describe factors that complicate capital investment analysis.

Factors That Complicate Capital Investment Analysis

Income taxProposals with unequal livesLease versus capital investmentUncertaintyChanges in price levelsQualitative considerations

Learning Objective 4

Diagram the capital rationing process.

Capital Rationing

The process by which management allocates funds among competing capital investment proposals.

Let’s look at a diagram of the capital rationing decision process…

Continued…

Capital Rationing

Proposes an analytical process to choose among competing proposals.

The proposals that meet all quantitative (financial) and qualitative tests should be ranked for funding.

Unfunded proposals may be reconsidered if funds become available later.

End of Chapter 15