1 of 37Visit UMT online at © South-Western 2004 Survey of Accounting, 2/eChapter 15, ACCT125 ACCOUNTING FUNDAMENTALS FOR MANAGERS University

1 of 37Visit UMT online at www.umtweb.edu© South-Western 2004Survey of Accounting, 2/e Chapter 15,

ACCT125

ACCOUNTING ACCOUNTING FUNDAMENTALS FOR FUNDAMENTALS FOR

MANAGERSMANAGERS

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Visit UMT online at www.umtweb.edu 2 of 37Chapter 15,

ACCT125

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3 of 37Visit UMT online at www.umtweb.edu© South-Western 2004Survey of Accounting, 2/e Chapter 15,

ACCT125

Chapter 15Chapter 15

Capital Investment AnalysisCapital Investment Analysis


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After studying this After studying this chapter, you should chapter, you should

be able to:be able to:

After studying this After studying this chapter, you should chapter, you should

be able to:be able to:

ContinuedContinuedContinuedContinued

Learning ObjectivesLearning Objectives

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.

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


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Learning ObjectivesLearning Objectives

4. Diagram the capital rationing process.


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1Explain the nature and

importance of capital

investment analysis.

Learning ObjectiveLearning Objective


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Nature of Capital Investment DecisionsNature of Capital Investment Decisions

1. Management plans, evaluates, and controls investments in fixed assets.

2. Capital investments involve a long-term commitment of funds.

3. Investments must earn a reasonable rate of return.

4. Should include a plan for encouraging and rewarding employees for submitting proposals.


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

2Learning ObjectiveLearning Objective


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Methods of Evaluating Capital InvestmentsMethods of Evaluating Capital Investments

Average rate of return method

Cash payback method

Net present value method

Internal rate of return method

Methods that do not use present valuesMethods that do not use present values

Methods that use present valuesMethods that use present values


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Easy to calculate

Considers accounting income (often used to evaluate managers)

Average Rate of ReturnAverage Rate of Return

Cash PaybackCash Payback

Advantages:

Ignores cash flows

Ignores the time value of money

Disadvantages:

Considers cash flows

Shows when funds are available for reinvestment

Advantages: Disadvantages:Ignores profitability (accounting income)

Ignores cash flows after the payback period


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Considers cash flows and the time value of money

Net Present ValueNet Present Value

Internal Rate of ReturnInternal Rate of Return

Advantages:

Assumes that cash received can be reinvested at the rate of return

Disadvantages:

Considers cash flows and the time value of money

Ability to compare projects of unequal size

Advantages: Disadvantages:Requires complex calculations

Assumes that cash can be reinvested at the internal rate of return


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Average Rate of Return MethodAverage Rate of Return Method

Machine cost $500,000Expected useful life 4 yearsResidual value noneExpected total income $200,000

Assumptions:Assumptions:

Average Rate of Return

Estimated AverageAnnual Income

Average Investment=


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Machine cost $500,000Expected useful life 4 yearsResidual value noneExpected total income $200,000




Average Investment=

=$200,000 / 4 yrs.Average Rate

of Return =($500,000 + $0) / 2

20%


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Average annual income $30,000 $36,000Average investment $120,000 $180,000Average rate of return




Average Investment=

Proposal A Proposal B

What is the average rate of return for each proposal?What is the average rate of return for each proposal?


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Average annual income $30,000 $36,000Average investment $120,000 $180,000Average rate of return 25% 20%

Assumptions:Assumptions: Proposal A Proposal B

This method emphasizes accounting income which is commonly used in evaluating management performance.

This method emphasizes accounting income which is commonly used in evaluating management performance.


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Cash Payback MethodCash Payback Method

Investment cost $200,000Expected useful life 8 yearsExpected annual net cash flows (equal) $40,000


CashPayback Period

Total Investment

Annual NetCash Inflows

=

What is the cash payback period?What is the cash payback period?


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Investment cost $200,000Expected useful life 8 yearsExpected annual net cash flows (equal) $40,000


=$200,000Cash

PaybackPeriod

=$40,000

5 years

CashPayback Period

Total Investment

Annual NetCash Inflows

=


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Year 1 $ 60,000 $ 60,000Year 2 80,000 140,000Year 3 105,000 245,000Year 4 155,000 400,000Year 5 100,000 500,000Year 6 90,000 590,000

Assumptions:Assumptions:Net Cash Cumulative

Flow Net Cash Flow


If the proposed investment is $400,000, what is the payback period?



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Year 1 $ 60,000 $ 60,000Year 2 80,000 140,000Year 3 105,000 245,000Year 4 155,000 400,000Year 5 100,000 500,000Year 6 90,000 590,000





Net Cash CumulativeFlow Net Cash Flow


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The Time Value of Money – Future ValueThe Time Value of Money – Future Value

The time value of money concept is used in many business decisions. This concept is an important consideration in capital investment analysis.

PresentValue

FutureValue

$1,000

$ ????

What is the future value of $1,000 invested today (present value) at 8% per year?



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The Time Value of Money – Future ValueThe Time Value of Money – Future Value


PresentValue

FutureValue

$1,000

= $1,000 + ($1,000 x 8%)= $1,000 x 108% or 1.08



$1,080


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The Time Value of Money – Present ValueThe Time Value of Money – Present Value


PresentValue

FutureValue

$ ????

What is the present value of $1,000 to be received one year from today at 8% per year?


$1,000


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The Time Value of Money – Present ValueThe Time Value of Money – Present Value


PresentValue

FutureValue

$ 925.93 = $1,000 / 108% or 1.08



$1,000


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Calculating Present ValuesCalculating Present Values

Present values can be determined using present value tables, mathematical formulas, calculators or computers.

Present Value of $1 with Compound Interest

1 .9434 = $1.0000 / 1.06

CalculatorPV Table

Period 6%

One dollar at the end of one period at 6% per period is equal to $.9434 today (present value).


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PV Table

Period 6%

One dollar at the end of two periods at 6% per period is equal to $.8900 today (present value).

To use the value from the prior period as the starting point, don’t clear your calculator.

1 .9434.9434 = $1.0000 / 1.06

2 .8900 = $$ .9434.9434 / 1.06

Calculator


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PV Table

Period 6%

One dollar at the end of three periods at 6% per period is equal to $.8396 today (present value).

1 .9434 = $1.0000 / 1.06

2 .8900.8900 = $ .9434 / 1.06

3 .8396 = $ .8900$ .8900 / 1.06

Calculator


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1 .9434 = $1.0000 / 1.06

2 .8900 = $ .9434 / 1.06

3 .8396 = $ .8900 / 1.06

4 .7921 = $ .8396 / 1.06

5 .7432 = $ .7921 / 1.06

6 .7050 = $ .7432 / 1.06

PV Table

Period 6%

When using a calculator, learn to use constant division. You will then enter $1 and 1.06 the first time, pressing only the equal (=) key for each successive answer.

Calculator


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Calculating Present Values of AnnuitiesCalculating Present Values of Annuities

Present Value of $1 — Annuity of 1$

PV Table Annuity

Period 6% 6%

CalculationSum of Periods

1 .9434.9434 .9434 = Period 1

2 .8900.8900 1.8334 = Periods 1–2

3 .8396 2.6730 = Periods 1–3

4 .7921 3.4651 = Periods 1–4

5 .7432 4.2124 = Periods 1–5

4.2124

The PV of an annuity of $1 to be received each year for two years is $1.8334. This is the sum of the PV of the two amounts for periods 1 and 2.

Annuities represent a series of equal amounts to be paid or received in the future over equal periods.


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PV Table Annuity

Period 6% 6%


1 .9434.9434 .9434 = Period 1

2 .8900.8900 1.8334 = Periods 1–2

3 .8396.8396 2.6730 = Periods 1–3

4 .7921 3.4651 = Periods 1–4

5 .7432 4.2124 = Periods 1–5

4.2124

The PV of an annuity of $1 to be received each year for three years is $2.6730. This is the sum of the PV of the three amounts for periods 1–3.



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PV Table Annuity

Period 6% 6%


1 .9434 .9434 = Period 1

2 .8900 1.8334 = Periods 1–2

3 .8396 2.6730 = Periods 1–3

4 .7921 3.4651 = Periods 1–4

5 .7473 4.2124 = Periods 1–5

4.2124Total


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= $ 63,636.36 = 49,586.78

= 37,565.74= 27,320.54= 24,836.85

$202,946.27 200,000.00 $ 2,946.27

1.015

Year 1 $70,000 / 1.10 (1 time) = Year 2 60,000 / 1.10 (2 times) = Year 3 50,000 / 1.10 (3 times) = Year 4 40,000 / 1.10 (4 times) = Year 5 40,000 / 1.10 (5 times) = Total present value Less investment Net present value

Present value index


Cash Flow Present Value

Net Present Value MethodNet Present Value Method

Investment $200,000Useful life 5 yearsResidual value noneMinimum rate of return 10%


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Total present value $107,000 $86,400 $93,600Total investment 100,000 80,000 90,000Net present value $ 7,000 $ 6,400 $ 3,600

Present value index 1.07 1.08 1.04

Assumptions:Assumptions: ProposalsA B C

What is the meaning of an index over 1.0?What is the meaning of an index over 1.0?

Net Present Value MethodNet Present Value Method


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Internal Rate of Return MethodInternal Rate of Return Method

Assume a rate of return and calculate the present value. Modify the rate of return and calculate a new present value. Continue until the present value approximates the investment cost.

Use a computer function to calculate exactly the expected rate of return.

The internal rate of return method uses the net cash flows to determine the rate of return expected from the proposal. The following approaches may be used:

Trial and ErrorTrial and Error

Computer FunctionComputer Function


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List and describe factors that complicate capital investment analysis.3



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Qualitative ConsiderationsQualitative Considerations

1. Improve product quality?

2. Reduce defects and manufacturing cycle time?

3. Increase manufacturing flexibility?

4. Reduce inventories and need for inspection?

5. Eliminate non-value-added activities?

Improvements that increase competitiveness and quality are difficult to quantify. The following qualitative factors are important considerations.


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Diagram the capital rationing process.4



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The Capital Rationing ProcessThe Capital Rationing Process

1. Identify potential projects.

2. Eliminate projects that do not meet minimum cash payback or average rate of return expectations.

3. Evaluate the remaining projects, using present value methods.

4. Consider the qualitative benefits of all projects.

5. Rank the projects and allocate available funds.

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