Chapter 14

Capital InvestmentsLong Term in nature covering many

yearsLarge amounts of capitalInvestments are not easily or quickly

disposedCritical to long-term profitabilityAffect human resources needs and

composition

Prior to sending out requests1. Determination of dollars available for

capital investments

2. Determine the cost of capital (minimum rate of return)

Cost of CapitalAlso called Desired Rate of Return

Type Loan $ % Interest %

%

Time Share

30,000 6.6 13% .9

Auto 20,000 4.4 4% .2

Rental 200,000 44.5 6% 2.7

Residence

200,000 44.5 5% 2.2

TOTAL 450,000 100%

6.0

Steps in choosing a proposalStep 1: Identification of capital investment needsStep 2: Formal requests for capital investmentsStep 3: Preliminary screening (remove those that

are not appropriate for the project)Step 4: Evaluate the proposal based on

Acceptance – rejection standards previously determined

Step 5: Rank the proposalsStep 6: Choose the best proposal (s).

Capital Investment Analysis MethodsNet Present Value Internal Rate of ReturnPayback Period MethodSimple (Acctg) Rate of Return

TermsCash InFlows

Increase in Net cash inflowsCost SavingsReduce Costs

Undiscounted Cash Inflows Rate of Return X Cash InflowsDiscounted Cash Inflows Adjusted for the loss of value over time

Present Value Multiplier X Cash Inflows

NET PRESENT VALUE METHOD Uses PRESENT VALUE Table

Columns: % ReturnRows: Number of Period

Multiplier or factor is where the rate intersects the period.

Periods (Not just years) Can be Semi Annual, Quarterly, Monthly

% - estimate return rate

Based on the number of periods 10% for yearly 5% for seimannual 2.5% for quarterly

Present Value of Cash InFlows ( How much is the money received in following years worth today)

What Present Value TablePresent Value of $1

Received at the end of a period of time Uneven cash inflows

Present Value of a Ordinary Annuity of $1Received the same amount every periodEven Cash Inflows

PRACTICE READING TABLE1. What multiplier do you use if you receive

$100,000 at the end of 10 years assuming a return of 7%? What is its present value?

.508 $100,000 * .508 = $50,800

2. What multiplier do you use if you receive $10,000 every year for 10 years assuming a return of 7%. What is it’s present value?

7.024 $10,000* 7.024 = $70,240

ApplicationExercise 14-1 Compare discounted cash

flow with undiscounted cash flow

Exercise 14-9 Evaluating projects based on PV concept

Is 16% reasonable?

Project Profitability IndexNet Present Value of Project

Investment requiredHelpful to decide what project to select.The higher the betterAmount of cash inflow generated for

each dollar of investment

Internal Rate of Return Investment Required Annual Cash inflow

Rate that causes the PV of the project’s cash inflows to equal the PV of the investment

How much interest you need to receive to pay it backDo not know the rate of return %. Divide Investment required by Annual Cash Inflows Gives you the multiplier factor.Go to the number of periods and find this multiplier Go to the top of the column to get the % = IRR

Excercise 14-2Only 1 and 2

Apply NPV and IRRExercise 14-11

Payback Method Investment Required Net Annual Cash InflowsTime it takes for the investment to

pay for itself.In years.Same as IRRUse formula only if even cash

inflows

Payback Period con’tUneven cash inflows – Use following table

Year

Investment

Cash Inflows Unrecovered

1 4,000 1,000 3,000

2 -0- 3,000

3 2,000 1,000

4 2,000 1,000 2,000

5 500 1,500

6 3,000 0

7 2,000 0

ApplicationExercise 14-5 EVEN OR UNEVEN?

Simple Rate of Return Annual Incremental Net Income Initial InvestmentNot Cash InflowIncludes depreciationAnnual Revenue-Annual

expenses/Invest.Easier than Acctg rate of return but not

accurateNo present value considered

Exercise 14-6

Both Payback period and SRRExercise 14-13

Ranking of investmentsProblem 14-26 pg 672Rank based on NPV (inferior to PPI) 1,2,4,3Rank based on PPI (most dependable) 3,2,1,4Rank based on IRR (payback) 4,3,2,1

Application of NPV ConceptProblem 14-27 pg 672

SRR, IRR and payback methodsProblem 14-28