Capital Investment

Capital InvestmentCapital Investment

Prepared by :Charles Fitria IrawatiMerlinaRosianaFendriek

Capital InvestmentCapital Investment

DefinitionCapital investment decisions are concerned with the process of planning, setting goals and priorities, arranging financing, and using certain criteria to select long-term assets.

Why capital investment Why capital investment decision important..??decision important..??They place large amounts of resources at

risk for long periods of time and simultaneously affect the future development of the firm.

Firms have limited resources.

The process of making capital investment decisions is also referred to as capital budgeting.

Types of capital budgeting Types of capital budgeting projectsprojectsTypes of capital budgeting projects include:

- Independent projects that, if accepted or rejected, do not affect the cash flows of other projects.- Mutually exclusive projects that, if accepted, preclude the acceptance of all other competing projects. Maintaining the status quo is considered a competing alternative.

The four basic methods that guide The four basic methods that guide managers in accepting or rejecting managers in accepting or rejecting investments fall under two categoriesinvestments fall under two categories

1.Nondiscounting models ignore the time value of money.

The payback period methodThe accounting rate of return method

2.Discounting models explicitly consider the time value of money.

The net present value (NPV) methodThe internal rate of return (IRR) method

Typical Capital Budgeting ProcessTypical Capital Budgeting Process

1. Identify potential capital investments

2. Estimate future net cash inflows

3. Analyze potential investments:a. Screen out undesirable investments

using payback and/or ARRb. Further analyze investments using NPV

and/or IRR

4. Engage in capital rationing if necessary to choose among alternative investments

5. Perform post-audits

Payback PeriodPayback Period

DefinitionDefinition Investment Dictionary

The length of time required to recover the cost of an investment Investopedia Says All other things being equal, the better investment is the one with

the shorter payback period. Real Estate Dictionary

The amount of time required for cumulative estimated future income from an investment to equal the amount initially invested. It is used to compare alternative investment opportunities.

Accounting Dictionary Length of time required to recover the initial amount of a capital

investment. If the cash inflows occur at a uniform rate, it is the ratio of the amount of initial investment over expected annual cash inflows

Reasons to use the Reasons to use the payback period method payback period method include:include:

The payback period can be used as a rough measure of risk. It helps control the risk associated with the uncertainty of future cash flows.

The longer it takes for a project to pay for itself, the riskier it is.

Firms with riskier cash flows could require a shorter payback period than normal.

The payback period method helps minimize the impact of an investment on a firm’s liquidity problems.

Firms with liquidity problems would be more interested in projects with quick paybacks.

The payback period method helps control the risk of obsolescence.Firms that are concerned with the risk of obsolescence would be interested in recovering funds rapidly and, thus, would choose projects with quick paybacks.

The payback period method helps control the effect of an investment on performance measures.Managers may choose investments with quick payback periods in order to meet short-term performance goals.This may be considered a disadvantage if it causes managers to shy away from investments with healthy long-term returns

FormulasFormulas

Payback Period

Assume projected annual cash inflows are expected to be $6000 a year for five years from an investment of $18,000. The payback period on this proposal is three years, which is calculated as follows: Payback period = $18,000/$6000 = 3 years.

If annual cash inflows are not even, the payback period would have to be determined by trial and error. Assume instead that the cash inflows are $4000 in the first year, $5000 in the second year, $6000 in the third year, $6000 in the fourth year, and $8000 in the fifth year. The payback period would be 3.5 years. In three years, all but $3000 has been recovered. It takes one-half year ($3000/ $6000) to recover the balance.

When two or more projects are considered, the rule for making a selection decision is as follows: Choose the project with the shorter payback period. The rationale behind this is that the shorter the payback period, the greater the liquidity, and the less risky the project.

ExamplesExamples

Payback PeriodPayback Period

DECISION RULE: Payback Period

Investments with shorter payback periods are more desirable, all else

being equal

Accounting Rate of ReturnAccounting Rate of Return

DefinitionDefinitionA measure of profitability computed by dividing the average annual operating income from an asset by the initial investment in the asset.

Discounted-cash-flow method focuses on cash flows and the time value of money.

Accounting-rate-of-return method focuses on the incremental accounting income that results from a project.

Accounting-Rate-of-Return Accounting-Rate-of-Return MethodMethod

The following formula is used to calculate the accounting rate of

return:

AccountingAccountingrate ofrate ofreturnreturn

==

Average Average Average Average incremental incremental expenses,incremental incremental expenses, revenues including depreciationrevenues including depreciation

--

Initial investmentInitial investment

Accounting-Rate-of-Return Accounting-Rate-of-Return MethodMethod

Average annual operating income from asset Average amount invested in asset

Average amount invested in asset =

Original Investment + Residual Value2

Accounting-Rate-of-Return Accounting-Rate-of-Return MethodMethodMeyers Company wants to install

an espresso bar in its restaurant.The espresso bar:

◦Cost $140,000 and has a 10-year life.

◦Will generate incremental revenues of $100,000 and incremental expenses of $80,000 including depreciation.

What is the accounting rate of return on the investment project?

Accounting-Rate-of-Return Accounting-Rate-of-Return MethodMethod

== $100,000 - $80,000 $100,000 - $80,000 $140,000$140,000

= 14.3%= 14.3%AccountingAccountingrate of returnrate of return

Accounting-Rate-of-Return Accounting-Rate-of-Return MethodMethod

Managers compare the accounting rate of return to company’s required minimum rate of return for investments of similar risk

If the ARR is less than the required minimum, the investment is rejected

Accounting-Rate-of-Return Accounting-Rate-of-Return MethodMethod

DECISION RULE: Invest in capital

assets?

Is expected accounting rate

of return > the required rate of return?

Invest

Is expected accounting rate

of return < the required rate of return?

Do not invest

Time Value of MoneyTime Value of Money

The fact that invested money earns income over time is called the time value of money

This is why we prefer to receive cash sooner, rather than later

DefinitionDefinition

Today's Value of a Lump Sum or Stream of Cash Payments Received at a Future Point in Time

nn rPVFV 1

nn

rFV

PV)1(

Present ValuePresent Value

Present Value of $200 Present Value of $200 ((4 Years, 7% Interest4 Years, 7% Interest ) )

What if the Interest Rate Goes Up to 8% ?

0 1 2 3 4

Discounting

PV = $200

FV1 = $214 FV2 = $228.98 FV3 = $245 FV4 = $262.16

End of Year

Present Value of $200 Present Value of $200 ((4 Years, 8% Interest4 Years, 8% Interest ) )

0 1 2 3 4

Discounting

PV = $200

FV1 = $216 FV2 = $233.28 FV3 = $252 FV4 = $272.10

End of Year

The Value of a Lump Sum or Stream of Cash Payments at a Future Point in Time

FVn = PV x (1+r)n

• Future Value depends on:

– Interest Rate– Number of Periods – Compounding Interval

Future ValueFuture Value

Future Value of $200 Future Value of $200 ((4 Years, 7% Interest4 Years, 7% Interest ) )

What if the Interest Rate Goes Up to 8% ?

0 1 2 3 4

PV = $200

End of Year

FV1 = $214

FV2 = $228.98

FV3 = $245

FV4 = $262.16

Future Value of $200 Future Value of $200 ((4 Years, 8% Interest4 Years, 8% Interest ) )

0 1 2 3 4

PV = $200

End of Year

FV1 = $216

FV2 = $233.28

FV3 = $251.94

FV4 = $272.10

Compounding – The Process of Earning Interest in Each Successive Year

Future Value and Present Value Future Value and Present Value of an Ordinary Annuityof an Ordinary Annuity

Present Value

0 1 2 3 4 5

$1,000 $1,000 $1,000 $1,000 $1,000

Discounting

End of Year

FutureValue

Compounding

Future Value of Ordinary AnnuityFuture Value of Ordinary Annuity((End of 5 Years, 5.5% Interest End of 5 Years, 5.5% Interest Rate)Rate)

0 1 2 3 4 5

$1,000 $1,000 $1,000 $1,000 $1,000

$1,238.82

$1,174.24

$1,113.02

$1,055.00

$1,000.00

End of Year

08.581,5$1)1(

rrPMTFVn

How is Annuity Due Different ?

Future Value of Annuity DueFuture Value of Annuity Due((End of 5 Years, 5.5% Interest End of 5 Years, 5.5% Interest Rate)Rate)

0 1 2 3 4 5End of Year

04.888,5$11)1(

rrrPMTFVn

FV5 = $5,888.04

$1,306.96

$1,238.82

$1,174.24

$1,113.02

$1,055.00

$1,000 $1,000 $1,000 $1,000 $1,000

Annuity Due: Payments Occur at the Beginning of Each Period

$1,000 $1,000 $1,000 $1,000 $1,000

End of Year

$947.87

$898.45

$851.61

$807.22

0 1 2 3 4 5

$765.13

Present Value of Ordinary Present Value of Ordinary AnnuityAnnuity((5 Years, 5.5% Interest Rate)5 Years, 5.5% Interest Rate)

28.270,4$)1(

11

nrrPMTPV

$1,000 $1,000 $1,000 $1,000 $1,000

End of Year

$947.87

$898.45

$851.61

$807.22

0 1 2 3 4 5

Present Value of Annuity DuePresent Value of Annuity Due((5 Years, 5.5% Interest Rate)5 Years, 5.5% Interest Rate)

15.505,4$1)1(

11

rrr

PMTPV n

FV and PV of Mixed StreamFV and PV of Mixed Stream((5 Years, 4% Interest Rate)5 Years, 4% Interest Rate)

PV$5,217.7

0 1 2 3 4 5

-$10,000 $3,000 $5,000 $4,000 $3,000 $2,000.0

Discounting

End of Year

FV$6,413.8

Compounding- $12,166.5

$3,509.6

$5,624.3$4,326.4

$3,120.0

$4,622.8

$3,556.0

$2,564.4

$1,643.9

$2,884.6

Net Present ValueNet Present Value

The present value of a project’s cash inflows and outflows

Discounting cash flows accounts for the time value of money.

Choosing the appropriate discount rate accounts for risk.

NN

rCF

rCF

rCF

rCF

CFNPV)(

...)()()(

1111 3

32

210

Accept projects if NPV > 0.

Net Present ValueNet Present Value

NN

rCF

rCF

rCF

rCF

CFNPV)(

...)()()(

1111 3

32

210

A key input in NPV analysis is the discount rate.

r represents the minimum return that the project must earn to satisfy investors.

r varies with the risk of the firm and/or the risk of the project.

Net Present ValueNet Present Value

Global Wireless is a worldwide provider of wireless telephony devices.

Global Wireless evaluating major expansion of its wireless network in two different regions:• Western Europe expansion• A smaller investment in Southeast U.S. to establish a

toehold

$175Year 5 inflow

$160Year 4 inflow

$130Year 3 inflow

$80Year 2 inflow

$35Year 1 inflow

-$250Initial outlay

$32Year 5 inflow

$30Year 4 inflow

$25Year 3 inflow

$22Year 2 inflow

$18Year 1 inflow

-$50Initial outlay

Western Europe ($ millions) Southeast U.S. ($ millions)

Global WirelessGlobal Wireless

Calculating NPVs for Global Calculating NPVs for Global Wireless ProjectsWireless ProjectsAssuming Global Wireless uses 18% discount

rate, NPVs are:

5432 )18.1(175

)18.1(160

)18.1(130

)18.1(80

)18.1(352503.75$ EuropeWesternNPV

5432.. )18.1(32

)18.1(30

)18.1(25

)18.1(22

)18.1(18507.25$ SUSoutheastNPV

Western Europe project: NPV = $75.3 million

Southeast U.S. project: NPV = $25.7 million

Should Global Wireless invest in one project or both?

The Net Present Value The Net Present Value Method: SummaryMethod: Summary

Decision rule: Accept project with PI > 1.0, equal to NPV > 0

0

221

)1(...

)1()1(CF

rCF

rCF

rCF

PIN

N

• Both projects’ PI > 1.0, so both acceptable if independent.

• If the project mutually exclusive then we have to choose project with higher PI

1.5$50 million$75.7 millionSoutheast U.S.

1.3$250 million$325.3 millionWestern Europe

PIInitial OutlayPV of CF (yrs1-5)Project

Calculated by dividing the PV of a project’s cash inflows by the PV of its outflows:

Profitability IndexProfitability Index

Internal Rate of ReturnInternal Rate of Return

The rate of return (based on discounted cash flows) that a company can expect to earn by investing in a capital asset. The interest rate that makes the NPV of the investment equal to zero

DefinitionDefinition

NN

rCF

rCF

rCF

rCF

CFNPV)(

....)()()(

1111

0 33

221

0

• IRR found by computer/calculator or manually by trial and error.

Internal rate of return (IRR) is the discount rate that results in a zero NPV for the

project:

The IRR decision rule is:

• If IRR is greater than the cost of capital, accept the project.• If IRR is less than the cost of capital, reject the project.

Internal Rate of ReturnInternal Rate of Return

Calculating IRRs for Global Calculating IRRs for Global Wireless ProjectsWireless Projects

Western Europe project: IRR (rWE) = 27.8%

5432 )1(175

)1(160

)1(130

)1(80

)1(352500

WEWEWEWEWE rrrrr

Southeast U.S. project: IRR (rSE) = 36.7%

5432 )1(32

)1(30

)1(25

)1(22

)1(18500

SESESESESE rrrrr

Global Wireless will accept all projects with at least 18% IRR.

The Internal Rate of The Internal Rate of Return Method: SummaryReturn Method: Summary

Comparing Capital Comparing Capital Budgeting MethodsBudgeting Methods

• Focus is the time it takes to recover cash• Ignores cash flows after payback period• Highlights risks of investments with longer

cash recovery periods• Ignores time value of money• The method fairly quick and easy to calculate• Work well for a relatively short life span

investment• Useful to screen potential investment from

less desirable investment• Useful to find out how quickly to recoup the

cash invested

Payback PeriodPayback Period

• Focus on operating income• Only method that uses accrual accounting• Shows how investment will affect

operating income• Measures profitability of asset over its

entire life• The method fairly quick and easy to

calculate• Work well for a relatively short life span

investment• Useful to screen potential investment

from less desirable investment• Ignores time value of money

Accounting-Rate-of-Return Accounting-Rate-of-Return MethodMethod

• Incorporates time value of money and net cash flows

• Indicates if asset will earn minimum required rate of return

• Useful to show excess (deficiency) of present value of cash inflows over cost

• Profitability index can be computed for capital rationing decisions

• Appropriate for longer term investment• Useful to make preference decisionsCan properly

account for risk differences between projects

Net Present ValueNet Present Value

• Incorporates time value of money and net cash flows

• Computes unique rate of return• Useful to find out what is the exact return would

the investment provide• Appropriate for longer term investment• Useful to make preference decisions

Internal Rate of ReturnInternal Rate of Return

Masaryk Hospital Improves Medical Imaging System and Patient Care with HP Storage Works MAS

Masaryk Hospital is one of the largest in the Czech Republic, with more than 1200 beds and 1300 physicians and nurses. The hospital uses a Siemens MagicStore picture archiving and communication system (PACS) for creating, accessing, and archiving filmless records for patient image data. The images are stored digitally, and are accessible by medical workers throughout the hospital, as well as by remote medical workers for telemedicine applications.The hospital was experiencing challenges storing the images. Its existing system was jukebox DVD storage, which was so slow it could take up to an hour for an image to be displayed. In addition, the storage was unreliable, inflexible, difficult to manage, and could be difficult to expand.

Case StudyCase Study

The hospital plans to solve the problem by implement HP StorageWorks Medical Archive Solution (MAS).

They expect this HP implementation would be speeding up the display of medical images, ensured always-on availability of medical images, increased storage capacity, improved the management of medical image data, and improved patient care. These benefits would be measured by the increased efficiency, increased medical staff productivity, and increased IT staff productivity.

There are some assumptions here. The hospital want to recoup the money invested within 2.5 years, where the hurdle rate is 9%, and the HP MAS useful life is 5 year with zero salvage value at the end of year 5.

The following chart below provides the detailed cash flows:

Project Cost Start Up Year 1 Year 2 Year 3 Year 4 Year 5 Total

Initial Investment 259,690           259,690

Planning &Implementation 15,000           15,000

Annual Support   38,954 38,954 38,954 38,954 38,954 194,770

Total Project Cost 274,690 38,954 38,954 38,954 38,954 38,954 469,460

Expected Benefits Start Up Year 1 Year 2 Year 3 Year 4 Year 5 Total

Increased Efficiency   4,639 4,685 4,732 4,779 4,827 23,662

Increased StaffProductivity   103,709 104,746 105,793 106,851 107,920 529,019

Increased ITProductivity   155,814 155,814 155,814 155,814 155,814 779,070

Total Benefits   264,162 265,245 266,339 267,444 268,561 1,331,751

Year Net Value ($)Cumulative Net Value ($)

Start up (Year 0) -274,690 -274,690

Year 1 225,208 -49,482

Year 2 226,291 176,809

Year 3 227,385 404,194

Year 4 228,490 632,684

Year 5 229,607 862,291

1 year

2 year

(49482/226291) * (1 year) = 0.2 year

Payback Period = 14 months (rounded)

Payback Period < 30 months (acceptable period )

Then the project is accepted

Payback PeriodPayback Period

Average Annual Depreciations $ 274,690 / 5 = $ 54,938

Average annual incremental cash inflow from operation

(225208 + 226291 + 227385 + 228490 + 229607 ) =

5

$ 227,396.2

ARR = (227396.2 – 54938) / 274690 = 0.628 63% (rounded)

Means the asset will likely generate return of 63% then the project is accepted

Accounting Rate of ReturnAccounting Rate of Return

Year Net Value Present Value

Start up (Year 0) -274,690.00 -274,690.00

Year 1 225,208.00 206,612.84

Year 2 226,291.00 190,464.61

Year 3 227,385.00 175,582.94

Year 4 228,490.00 161,868.08

Year 5 229,607.00 149,228.80

Total NPV   609,067.26

Hurdle rate = 9%

NPV = -274690 + 225208 + 226291 + 227385 + 228490 + 229607

1.09^0 1.09^1 1.09^2 1.09^3 1.09^4 1.09^5

= $ 609,067.26

NPV>= 0 then the project is accepted

Net Present ValueNet Present Value

Year Net ValuePVIF =

9% PVPVIF = 20% PV

PVIF = 70% PV

PVIF = 80% PV

Year 0 -274,690.00 1.0000 -274,690.00 1.0000 -274,690.00 1.0000 -274,690.00 1.0000 -274,690.00

Year 1 225,208.00 1.0900 206,612.84 1.2000 187,673.33 1.7000 132,475.29 1.8000 125,115.56

Year 2 226,291.00 1.1881 190,464.61 1.7280 130,955.44 2.8900 78,301.38 3.2400 69,842.90

Year 3 227,385.00 1.2950 175,582.94 1.7280 131,588.54 4.9130 46,282.31 5.8320 38,989.20

Year 4 228,490.00 1.4116 161,868.08 2.0736 110,190.01 8.3521 27,357.19 10.4976 21,765.93

Year 5 229,607.00 1.5386 149,228.80 2.4883 92,273.90 14.1986 16,171.14 18.8957 12,151.30

      609,067.26   377,991.23   25,897.32   -6,825.12

We use interpolation to find the exact IRR, between 70% & 80%

70% + ( (25897.32 / 32722.44) * 10% ) = 77.9% 78% (rounded)

25897.32 + 6825.12 = 32722.44

80% - ( (6825.12 / 32722.44) * 10% ) = 77.9% 78% (rounded)

IRR > hurdle rate, then the project is accepted

Hurdle rate = 9%

Internal Rate of ReturnInternal Rate of Return

TERIMA KASIHTERIMA KASIH