Capital Investment DecisionsManagement Accounting: The Cornerstone for Business DecisionsCopyright 2006 by South-Western, a division of Thomson Learning. All rights reserved.

Learning ObjectivesExplain what a capital investment decision is and distinguish between independent and mutually exclusive capital investment decisions.Compute the payback period and accounting rate of return for a proposed investment and explain their roles in capital investment decisions.Use net present value analysis for capital investment decisions involving independent projects.

Learning ObjectivesUse the internal rate of return to assess the acceptability of independent projects.Explain the role and value of post audits.Explain why NPV is better than IRR for capital investments decisions involving mutually exclusive projects.

How to calculate payback.Payback period = original investment / annual cash flowSuppose that an new car wash facility requires an investment of $120,000 and has either:Even cash flows of $40,000 per year or The following annual cash flows $20,000, $40,000, $40,000, $50,000, and $30,000REQUIRED: Calculate the payback period for each case.Calculation:

13-1

How to calculate payback.b. 13-1

List Four Ways Payback Can be Used by Managers

How to calculate the accounting rate of return (ARR).ARR = Average Income / Initial InvestmentAssume that an investment requires an investment requires an initial outlay of $140,000. The life of the investment is 5 years with following income stream: $30,000, $40,000, $40,000 $50,000, and $40,000.REQUIRED: Calculate the accounting rate of return.Calculation:13-2

How to assess cash flows and calculate NPV.A market study revealed expected annual revenues of $320,000 for the new cordless headset. Equipment to produce the cordless headset would cost $350,000. After five years, the equipment can be sold for $50,000. In addition, to the equipment, working capital is expected to increase $40,000 because of increases in inventories and receivables. The firm expects to recover the investment in working capital at the end of the projects life. Annual cash operating expenses are estimated at $175,000. The required rate of return is 12%.REQUIRED: Estimate the annual cash flows and calculate the NPV.13-3

How to assess cash flows and calculate NPV.Step 1. Cash- Flow IdentificationYearItemCash Flow0EquipmentWorking capital Total1-4RevenuesOperating expenses TotalRevenuesOperating expensesSalvage valueRecovery of working capital Total13-3

How to assess cash flows and calculate NPV.Step 2A NPV AnalysisYear Cash FlowDiscount FactorPresent Value012345Net Present Value13-3

How to assess cash flows and calculate NPV.Step 2B NPV AnalysisYearCash FlowDiscount FactorPresent Value01-45Net Present Value13-3

How to calculate IRR with Uniform Cash flows.Assume that a hospital has the opportunity to invest $160,000 in a blood analyzer that will produce a net cash flow of $57,184 in each of the next four years.REQUIRED: Calculate the IRR for the blood analyzer.Calculation:13-4

Multiple Period Settings With Uneven Cash FlowsThe simple truth is performing IRR is one of the easiest tasks there is in Excel. It is a matter of listing outflows in a column as negative amounts and then in the same column inflows as positive amounts. Simply follow the directions in the Excel drop down box and it will take less than a couple of seconds to get a precise answer.

Define and Describe a Post Audit

What are the benefits of a post audit?

Compare NPV to IRR

How to calculate NPV & IRR for mutually exclusive projects.Consider two pollution prevention projects. Design Papa and Oscar. Both have a project life of 7 years. Design Papa requires an outlay of $140,000 and has a net after-tax inflow of $40,000 (revenues of $180,000 minus costs of $140,000). Design Oscar, with an initial outlay of $300,000 has a net annual cash inflow of $50,000 ($240,000 - $190,000). The after-tax cash flows are summarized as follows:13-5

How to calculate NPV & IRR for mutually exclusive projects.Cash Flow PatternYearDesign PapaDesign Oscar0$(240,000)$(300,000)140,00050,000240,00050,000340,00050,000440,00050,000540,00050,000640,00050,000740,00050,000The cost of capital for the company is 12%.REQUIRED: Calculate the NPV & the IRR for each.13-5

How to calculate NPV & IRR for mutually exclusive projects.Calculation:Design Papa: NPV Analysis13-5

How to calculate NPV & IRR for mutually exclusive projects.Design Oscar: NPV Analysis13-5