Capital Investment Analysis

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Capital Investment Analysis
Revised by Judy Beebe, Western Oregon University

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Capital Investment Analysis
Capital investment analysis (or capital
budgeting) is the process by which management
plans, evaluates, and controls investments in
fixed assets.
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Nature of Capital Investment Analysis

• 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. The program should
include a plan for encouraging and rewarding
employees for submitting proposals.
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Methods of Evaluating Capital Investment Proposals
Methods that ignore present values

• The average rate of return method
• The cash payback method

Methods that use present values

• The net present value method
• The internal rate of return method

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Percentage of Respondents Reporting the Use of
the Method as Always or Often
Average rate of return Cash payback method Net
present value method Internal rate of return
method
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53
85
76
0 10 20 30 40 50 60 70 80 90
Source Patricia A. Ryan and Glenn P. Ryan.
Capital Budgeting Practices of the Fortune
1,000. How Have Things Changed? Journal of
Business and Management (Winter 2002).
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Average Rate of Return Method
Advantages

• Easy to calculate
• Considers accounting income (often used to
  evaluate managers)

Disadvantages

• Ignores cash flows
• Ignores the time value of money

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Purchase of Machine Example
Assumptions

• Machine cost 500,000
• Expected useful life 4 years
• Residual value none
• Expected total income 200,000

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Proposal A Proposal B

• Estimated average annual income 30,000
  36,000
• Average investment 120,000 180,000

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Proposal A Proposal B
Estimated average annual income 30,000
36,000 Average investment 120,000 180,000
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Proposal A would be preferred over Proposal B.
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Determine the average rate of return for a
project that is estimated to yield total income
of 273,600 over three years, cost 690,000, and
has a 70,000 residual value.
Est. average annual income 91,200 (273,600/3
years) Average investment 380,000 (690,000
70,000)/2 Average rate of return 24
(91,200/380,000)
For Practice PE 25-1A, PE 25-1B
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Cash Payback Method
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 is the cash payback period.
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The excess of cash flowing in from revenue over
the cash flowing out for expenses is termed net
cash flow.
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Assumptions
Investment cost 200,000 Expected annual net
cash flow (equal) 40,000
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If the proposed investment is 400,000, the
payback period is at the end of Year 4.
Net Cash Cumulative Flow Net Cash Flow

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

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Proposed Investment of 400,000
Cumulative Net Cash Net Cash Year Flow Flow
1 60,000 60,000 2 80,000 140,000 3 105,00
0 245,000 4 155,000 400,000 5 100,000 500,000 6
90,000 590,000
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Advantages and Disadvantages of the Cash Payback
Method
Advantages

• Considers cash flows
• Shows when funds are available for reinvestment

Disadvantages

• Ignores profitability (accounting income)
• Ignores cash flows after the payback period

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A project has estimated annual net cash flows of
30,000. It is estimated to cost 105,000.
Determine the cash payback period.
3.5 years (105,000/30,000)
For Practice PE 25-2A, PE 25-2B
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Present Value Concepts
Present value concepts can be divided into

• the present value of an amount and
• the present value of an annuity.

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Present Value of an Amount
On January 1, 2008, you invest 1 in an account
that earns 12 interest compounded annually.
Interest earning interest is called compounding.
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Present Value Concepts
1.00 x 1.12
1.12 x 1.12
1.254 x 1.12
1.12
1.254
1.404
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Assume that today is January 1, 2008 and the
current interest rate is 12 percent. What is the
present value of 1,404 to be received on January
1, 2011? To determine the answer, we need to go
to Exhibit 1 (Slide 22) and find the table value
for three years at 12 percent.
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Partial Present Value of 1 Table
Present Value of 1 with Compound Interest
Year 6 10 12
15 20
1 0.943 0.909 0.893 0.870 0.833 2 0.890 0.826 0.7
97 0.756 0.694 3 0.840 0.751 0.712 0.658 0.579 4 0
.792 0.683 0.636 0.572 0.482 5 0.747 0.621 0.567 0
.497 0.402 6 0.705 0.564 0.507 0.432 0.335
0.712
22
Left click the mouse for solution.
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Amount to be received on January 1, 2011
Table value
x
Present value
Summary If the interest rate is 12, then
1,404 in three years is worth 1,000 today.
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Present Value of an Annuity
An annuity is a series of equal net cash flows at
fixed time intervals. The present value of an
annuity is the amount of cash needed today to
yield a series of equal net cash flows at fixed
time intervals in the future.
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Net Present Value Method
The net present value method (also called the
discounted cash flow method) analyzes capital
investment proposals by comparing the initial
cash investment with the present value of the net
cash flows.
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Equipment Example
At the beginning of 2008, equipment with an
expected life of five years can be purchased for
200,000. At the end of five years it is
anticipated that the equipment will have no
residual value.
(Continued)
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Equipment Example
A net cash flow of 70,000 is expected at the end
of 2008. This net cash flow is expected to
decline 10,000 each year (except 2012) until the
machine is retired. The firm expects a minimum
rate of return of 10. Should the equipment be
purchased?
(Continued)
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Equipment Example
(200,000) 70,000 60,000
50,000 40,000 40,000
63,630
70,000 x 0.909 (n 1 i 10)
(Continued)
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Equipment Example
(200,000) 70,000 60,000
50,000 40,000 40,000
63,630
49,560
60,000 x 0.826 (n 2 i 10)
(Continued)
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Equipment Example
(200,000) 70,000 60,000
50,000 40,000 40,000
63,630
49,560
37,550
50,000 x 0.751 (n 3 i 10)
(Continued)
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Equipment Example
(200,000) 70,000 60,000
50,000 40,000 40,000
63,630
49,560
40,000 x 0.683 (n 4 i 10)
37,550
27,320
(Continued)
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Equipment Example
(200,000) 70,000 60,000
50,000 40,000 40,000
63,630
49,560
37,550
40,000 x 0.621 (n 5 i 10)
27,320
24,840
(Continued)
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Equipment Example
(200,000) 70,000 60,000
50,000 40,000 40,000
63,630
The equipment should be purchased because the net
present value is positive.
49,560
37,550
27,320
24,840 2,900
Net present value
Total present value of the net cash flow is
202,900
(Concluded)
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Present Value Index
When capital investment funds are limited and the
alternative proposals involve different amounts
of investment, it is useful to prepare a ranking
of the proposals by using a present value index.
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Total present value of net cash flow
Present value index
Amount to be invested
Refer to Slide 33. You may go there now by
clicking this button . To return to this
slide, type 35 and press Enter. The sum of
the present values from December 31, 2008 through
December 31, 2012 is 202,900.
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Ranking Various Proposals Using a Present Value
Index
Proposal A Proposal B Proposal C

• Total present value of net cash
  flow 107,000 86,400 86,400
• Amount to be invested 100,000 80,000 90,000
• Net present value 7,000 6,400 3,600
• Present value index

1.07
107,000 100,000
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Proposal A Proposal B Proposal C
Total present value of net cash
flow 107,000 86,400 86,400 Amount to be
invested 100,000 80,000 90,000 Net present
value 7,000 6,400 3,600 Present value
index
1.07
1.08
86,400 80,000
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Proposal A Proposal B Proposal C
Total present value of net cash
flow 107,000 86,400 86,400 Amount to be
invested 100,000 80,000 90,000 Net present
value 7,000 6,400 3,600 Present value
index
1.07
1.08
0.96
86,400 90,000
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Proposal B has the best present value index.
Management should consider the possible use of
the 20,000 difference between Proposal A and
Proposal B before making a decision.
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A proposal is made to acquire 200,000 of
equipment with an expected useful life of five
years (no residual value) and a minimum desired
rate of return of 10. The new equipment is
expected to generate a net cash inflow of
50,000 each year. Should the firm acquire the
equipment?
Note This illustration is not in the textbook.
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Refer to Exhibit 2 (the present value of an
annuity of 1 table) by pressing the button
below. To return to this slide, type 41 and
press Enter.
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Partial Present Value of an Annuity Table
Present Value of an Annuity of 1 at Compound
Interest
Year 6 10 12 15
20

• 1 0.943 0.909 0.893 0.870 0.833
• 2 1.833 1.736 1.690 1.626 1.528
• 3 2.673 2.487 2.402 2.283 2.106
• 4 3.465 3.170 3.037 2.855 2.589
• 5 4.212 3.791 3.605 3.353 2.991
• 4.917 4.355 4.111 3.785 3.326
• 5.582 4.868 4.564 4.160 3.605
• 6.210 5.335 4.968 4.487 3.837

3.791
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Present Value of an Annuity of 1
50,000 x 3.791

0.948
The proposal should be rejected because the
present value index is less than one.
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Advantage and Disadvantage of Net Present Value
Method
Advantage

• Considers cash flows and the time value of money

Disadvantage

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

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A project has estimated annual net cash flows of
50,000 for seven years and is estimated to cost
240,000. Assume a minimum acceptable rate of
return of 12. Using Exhibit 2, determine the
(a) net present value of the project and (b) the
present value index, rounded to two decimal
places.
Click the button to go to Exhibit 2. To return
to this slide, type 45 and press Enter.
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• (11,800) (50,000 x 4.564) 240,000
• 0.95 (228,200/240,000)

For Practice PE 25-3A, PE 25-3B
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Internal Rate of Return Method
The internal rate of return (IRR) method
(sometimes called the time-adjusted rate of
return method) uses present value concepts to
compute the rate of return from the net cash
flows expected from capital investment proposals.
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Management is evaluating a proposal to acquire
equipment costing 33,530. The equipment is
expected to provide annual net cash flows of
10,000 per year for five years. Assume a rate
of return of 12. Should the equipment be
purchased?
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Net Present Value Analysis at 12
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Using a Trial-and-Error Procedure
Jan. 1 2008
Dec. 31 2008
Dec. 31 2009
Dec. 31 2010
Dec. 31 2011
Dec. 31 2012
(33,530) 10,000 10,000
10,000 10,000 10,000
33,530
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Using a Simpler Procedure to Find the Internal
Rate of Return
Such trial-and-error procedures are
time-consuming. To illustrate a simpler
procedure, assume that management is considering
a proposal to acquire equipment costing 97,360.
The equipment is expected to provide equal annual
net cash flows of 20,000 for seven years.
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Determine the table value using the formula
below
Step 1
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Find the seven year line on Exhibit 2 (the
present value of an annuity of 1 at compound
interest). Then, go across the seven-year line
until the closest amount to 4.868 is located.
Step 2
Click on this button to go to the present value
of an annuity of 1 table. To return to this
illustration, type 53 and press Enter.
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Present Value of an Annuity of 1
Year 6 10 12 15

• 1 0.943 0.909 0.893 0.870
• 2 1.833 1.736 1.690 1.626
• 3 2.673 2.487 2.402 2.283
• 4 3.465 3.170 3.037 2.855
• 5 4.212 3.791 3.605 3.353
• 6 4.917 4.355 4.111 3.785
• 5.582 4.868 4.564 4.160
• 6.210 5.335 4.968 4.487

4.868
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Now that you have located 4.868 on the seven year
line, go vertically to the top of the table to
determine the interest rate.
Step 3
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Present Value of an Annuity of 1
10
Year 6 10 12 15

• 1 0.943 0.909 0.893 0.870
• 2 1.833 1.736 1.690 1.626
• 3 2.673 2.487 2.402 2.283
• 4 3.465 3.170 3.037 2.855
• 5 4.212 3.791 3.605 3.353
• 6 4.917 4.355 4.111 3.785
• 5.582 4.868 4.564 4.160
• 6.210 5.335 4.968 4.487

4.868
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If the minimum acceptable rate of return for
similar proposals is 10 or less, then the
proposed investment should be considered
acceptable.
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Advantages and Disadvantages of Internal Rate of
Return
Advantages

• Considers cash flows and the time value of money
• Ability to compare projects on a common basis

Disadvantages

• Computations are more complex than for some of
  the other methods
• Assumes that cash can be reinvested at the
  internal rate of return

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A project is estimated to cost 208,175 and
provide annual net cash flows of 55,000 for six
years. Determine the internal rate of return for
this project, using Exhibit 2 (or click this
button ). To return to this exercise, type
59 and press Enter.
15 (208,175/55,000) 3.785, the present
value of an annuity factor for six periods at 15.
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For Practice PE 25-4A, PE 25-4B
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Factors that Complicate Capital Investment
Analysis

• Income tax

• Unequal proposal lives
• Lease versus capital investment
• Uncertainty
• Changes in price levels
• Qualitative considerations

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Unequal Proposal Lives
Alternative investments, a truck and computers,
are being compared. The truck has a useful life
of 8 years, and the computer network has a useful
life of 5 years. Each proposal requires an
initial investment of 100,000 and the company
desires a rate of return of 10.
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Net Present Value Analysis Unequal Lives of
Proposals
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Net Present Value Analysis Unequal Lives of
Proposals
(Continued)
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Net present Value Analysis Equalized Lives of
Proposals
Truck NPV greater than Computer Network NPV by
1,835
(Concluded)
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Project 1 requires an original investment of
50,000. The project will yield cash flows of
12,000 per year for seven years. Project 2 has
a calculated net present value of 8,900 over a
five-year life. Project 1 could be sold at the
end of five years for a price of 30,000.
(continued)
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(a) Determine the net present value of Project 1
over a five-year life (remember to include the
salvage value in your determination) assuming a
minimum rate of return of 12. (b) Which project
provides the greatest net present value? Click
the blue button for the present value of 1 table
or the red button for the present value of
annuity of 1 table. Type 66 and press Enter
to return to this slide.
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b. Project 1s net present value of 10,270 is
greater than Project 2s net present value of
8,900.
For Practice PE 25-5A, PE 25-5B
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Qualitative Considerations
Improvements that increase competitiveness and
quality are difficult to quantify. The following
qualitative factors are important 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

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Capital Rationing
Capital rationing is the process by which
management allocates funds among competing
capital investment proposals.
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End of slide show. Slides 71 and 72 are for
reference, and are connected to earlier slides.
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Present Value of 1 Table
Present Value of 1 with Compound Interest
Year 6 10 12
15 20
1 0.943 0.909 0.893 0.870 0.833 2 0.890 0.826 0.7
97 0.756 0.694 3 0.840 0.751 0.712 0.658 0.579 4 0
.792 0.683 0.636 0.572 0.482 5 0.747 0.621 0.567 0
.497 0.402 6 0.705 0.564 0.507 0.432 0.335
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Present Value of an Annuity of 1
Present Value of an Annuity of 1 at Compound
Interest
Year 6 10 12 15
20

• 1 0.943 0.909 0.893 0.870 0.833
• 2 1.833 1.736 1.690 1.626 1.528
• 3 2.673 2.487 2.402 2.283 2.106
• 4 3.465 3.170 3.037 2.855 2.589
• 5 4.212 3.791 3.605 3.353 2.991
• 4.917 4.355 4.111 3.785 3.326
• 5.582 4.868 4.564 4.160 3.605
• 6.210 5.335 4.968 4.487 3.837