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1. Explain the nature and importance of capital investment analysis.

Chapter 24 - Capital Investment Analysis. 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.

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1. Explain the nature and importance of capital investment analysis.

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  1. Chapter 24 - Capital Investment Analysis 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.

  2. Nature of Capital Investment Analysis Capital budgeting is the process by which management plans, evaluates, and controls long-term investments in fixed assets. 1. Management plans, evaluates, and controlsinvestments in fixed assets. 2. Capital investments involve a long-termcommitmentof funds. 3. Investments must earn a reasonable rate ofreturn. 4. The process should include a plan forencouraging and rewarding employees for submitting proposals.

  3. Methods of Evaluating Capital Investment Proposals Here’s a survey of business practices in a variety of industries. It reports the capital investment analysis methods used by large U.S. companies.

  4. Average rate of return Cash payback method Net present value method Internal rate of return method 15% 53% 85% 76% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% Journal of Business and Management (Winter 2002)

  5. Methods that Ignore Present Value Average Rate of Return Method • Easy to calculate • Considers accounting income (often used to evaluate managers) Advantages: Disadvantages: • Ignores cash flows • Ignores the time value of money

  6. $200,000 ÷ 4 years = = ($500,000 + $0) / 2 Average Rate of Return Method Assumptions: Machine cost $500,000 Expected useful life 4 years Residual value none Expected total income $200,000 Estimated Average Annual Income Average Rate of Return = Average Investment Average Rate of Return 20%

  7. $30,000 $120,000 = 25% Average Rate of Return Method Assumptions: Proposal A Proposal B Average annual income $ 30,000 $ 36,000 Average investment $120,000 $180,000

  8. $36,000 $180,000 = 20% Average Rate of Return Method Assumptions: Proposal A Proposal B Average annual income $ 30,000 $ 36,000 Average investment $120,000 $180,000

  9. Methods that Ignore Present Value 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

  10. Cash Payback Period Total Investment = Annual Net Cash Inflows $200,000 = 5 years = $40,000 Cash Payback Method Assumptions: Investment cost $200,000 Expected useful life 8 years Expected annual net cash flows (equal) $40,000 Cash Payback Period

  11. Cash Payback Method 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 If the proposed investment is $400,000, the payback period is at the end of Year 4.

  12. = $1,000 ÷ 1.08 $ 925.93 Present Value Methods The time value of moneyconcept is used in many business decisions. This concept is an important consideration in capital investment analysis. Present Value $ ???? What is the present valueof $1,000 to be received one year from today at 8% per year?

  13. Present Value Methods How much would have to be invested on February 1, 2006 in order to receive $1,000 on February 1, 2009 if the interest rate compounded annually is 12%?

  14. Present Value Methods Refer to the partial present value table in Slide 18 to answer the question. $1,000, 3 years, 12% compounded annually

  15. Calculating Present Values Present values can be determined using present value tables, mathematical formulas, a calculator or a computer. 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 0.797 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 $1,000 x .712 = $712

  16. Present Value of an Amount If $712 is invested on February 1, 2006 at an annual rate of 12 percent, $1,000 will accumulate by February 1, 2009. $1,000 x .712 = $712

  17. Feb. 1 2006 Feb. 1 2007 Feb. 1 2008 Feb. 1 2009 Present Value of an Amount $712 x 1.12 $797 x 1.12 $893 x 1.12 $1,000

  18. 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 sum of the present values of each cash flows. What would be the present value of a $100 annuity for five periods at 12?

  19. Calculating Present Values of Annuities Present Value of an Annuity of $1 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 6 4.917 4.355 4.111 3.785 3.326 3.605 3.605 x $100 = $360.50

  20. The net present valuemethod analyzes capital investment proposals by comparing the initial cash investment with the present value of the net cash flows. Net Present Value Method

  21. 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

  22. Net Present Value Method At the beginning of 2006, 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. Cash Flow Present Value A net cash flow of $70,000 is expected at the end of 2006. This net cash flow is expected to decline $10,000 each year (except 2010) until the machine is retired. The firm expects a minimum rate of return of 10%. Should the equipment be purchased?

  23. Net Present Value Method First, we must determine which table to use… the present value of $1 or the present value of an annuity of $1.

  24. Net Present Value Method Because there are multiple years of net cash flows, shouldn’t we use the present value of an annuity of $1?

  25. Net Present Value Method That would be true if the net cash flows remained constant from 2006 through 2010. Note that the net cash flows are $70,000, $60,000, $50,000, $40,000, and $40,000, respectively. So, we have to use the present value of $1 for each of the five years.

  26. Jan. 1 2006 Dec. 31 2006 Dec. 31 2007 Dec. 31 2008 Dec. 31 2009 Dec. 31 2010 Net Present Value Method $<200,000> $70,000 $60,000 $50,000 $40,000 $40,000 $ 63,630 $70,000 x 0.909 (n = 1; i = 10%) $ 49,560 $60,000 x 0.826 (n = 2; i = 10%) $50,000 x 0.751 (n = 3; i = 10%) $ 37,550 $40,000 x 0.683 (n = 4; i = 10%) $ 27,320 $ 24,840 $40,000 x 0.621 (n = 5; i = 10%)

  27. Jan. 1 2006 Dec. 31 2006 Dec. 31 2007 Dec. 31 2008 Dec. 31 2009 Dec. 31 2010 The equipment should be purchased because the net present value is positive. Net Present Value Method $<200,000> $70,000 $60,000 $50,000 $40,000 $40,000 $ 63,630 $ 49,560 $ 37,550 $ 27,320 $ 24,840 $ 2,900

  28. Net Present Value Method 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 using a present value index. (a.k.a. profitability index)

  29. Net Present Value Method Proposals A B C Assumptions: Total present value $107,000 $86,400 $93,600 Total investment 100,000 80,000 90,000 Net present value $ 7,000 $ 6,400 $ 3,600 Present value index 1.07 1.08 1.04 $86,400 ÷ $80,000 $93,600 ÷ $90,000 $107,000 ÷ $100,000 The best

  30. Internal Rate of Return Method Advantages: • Considers cash flows and the time value of money • Ability to compare projects of unequal size Disadvantages: • Requires complex calculations • Assumes that cash can be reinvested at the internal rate of return

  31. Internal Rate of Return Method 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: 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. Trial and Error Computer Function Use a computer function to calculate exactly the expected rate of return.

  32. Determine the table value using the present value for an annuity of $1 table. Step 1: Amount to be invested Equal annual cash flow $97,360 $20,000 = 4.868 Internal Rate of Return Method Management is evaluating a proposal to acquire equipment costing $97,360. The equipment is expected to provide annual net cash flows of $20,000 per year for seven years.

  33. Internal Rate of Return Method Find the seven year line on the table. Then, go across the 7-year line until the closest amount to 4.868 is located. 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 7 5.582 4.868 4.564 4.160 10% 4.868 Move vertically to the top of the table to determine the interest rate

  34. Factors That Complicate Capital Investment Analysis • Income tax • Unequal proposal lives • Lease versus capital investment • Uncertainty • Changes in price levels • Qualitative considerations

  35. 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

  36. Capital Rationing 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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