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Gail B. WrightGail B. WrightProfessor of AccountingProfessor of AccountingBryant UniversityBryant University

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CARL S. WARRENCARL S. WARREN

SURVEY OF ACCOUNTINGSURVEY OF ACCOUNTING

Chapter 15

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LEARNING OBJECTIVES

When you finish this chapter, you should be able to

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

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

3. List, describe factors that complicate capital investment analysis

4. Diagram capital rationing process.

LEARNING OBJECTIVESLEARNING OBJECTIVES

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LEARNING OBJECTIVELEARNING OBJECTIVE

1Explain nature, importance of capital investment analysis.

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CAPTIAL INVESTMENT ANALYSIS

Capital investment analysis (capital budgeting) is the process by which managersPlanEvaluateControl

investments in fixed assets

LO 1

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LEARNING OBJECTIVELEARNING OBJECTIVE

2 Evaluate capital investment proposals.

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EVALUATION METHODS

Methods not using present valuesAverage rate of returnPayback

Methods that do use present valuesNet present valueInternal rate of return

LO 2

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AVERAGE RATE OF RETURN

LO 2

Measure of average income as a percent of average investment in fixed assets.

Average rate of return =

Estimated average income / Average investment

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AVERAGE RATE OF RETURN:Example

LO 2

Purchase of machine for $500,000 expected to generate $200,000 profit over 4 years.

Average rate of return =

($200,000/4) / ($500,000/2) =

$50,000 / $250,000

20%

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AVERAGE RATE OF RETURN:Analysis

LO 2

Purchase of the machine will help generate an average return of 20% per year for 4 years

after taking into consideration its depreciation. However, it does not consider the present

value of money.

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PAYBACK PERIOD

LO 2

Expected time between investment and recapture of cash outlay.

Payback period =

Cost / (Expected revenues – expenses)

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PAYBACK PERIOD:Example

LO 2

Purchase of machine for $200,000 with 8 year life expected to generate $40,000 net profit annually.

Payback period =

$200,000 / ($50,000 – 10,000) =

$200,000 / $40,000

5 years

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PAYBACK PERIOD:Analysis

LO 2

It will take 5 years to pay for the machine, assuming $40,000 net profit and with no consideration for alternative uses for the

money or the time value of money.

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LO 2

Present value methods employ the time value of money to determine the

return on purchase of a long term asset.

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PRESENT VALUE $1

LO 2

Present value of $1 measures the cost in today’s dollars of a single investment to be

withdrawn at a point in the future.

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PRESENT VALUE: Annuity

LO 2

Present value of an annuity measures the cost in today’s dollars of a series of investments to

be withdrawn at a point in the future.

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LO 2

Net present value (discounted cash flow) compares initial cash

investment with present value of net cash flows.

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NET PRESENT VALUE:Example

LO 2

Purchase of machine for $200,000 with 5 year life, 10% minimum rate of return.

NPV =

$200,000 – 3.605 ($70,000) =

$200,000 - $202,900

$2,900

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NET PRESENT VALUE: Analysis

LO 2

Return from investment in a long term asset costing $200,000 exceeds its cost by a positive

$2,209, after considering the time value of money.

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LO 2

Internal rate of return uses present value concepts to compute the rate of return

expected from capital investment proposals.

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INTERNAL RATE OF RETURN:Example

LO 2

A machine costing $33,530 must generate a 12% return to be viable. The expected annual return is $10,000 each

year for 5 years.

($10,000 * 3.605) - $33,000 = $2,520

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INTERNAL RATE OF RETURN: Analysis

LO 2

Return from investment in a long term asset costing $33,530 exceeds its cost by a positive

$2,520, after considering the time value of money. This equates to an internal rate of

return of 15%.

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LEARNING OBJECTIVELEARNING OBJECTIVE

3List, describe factors that complicate capital investment analysis.

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COMPLICATING FACTORS

Income taxProposals with unequal livesLease vs. capital investmentUncertaintyChanges in price levelsQualitative considerations

LO 3

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LEARNING OBJECTIVELEARNING OBJECTIVE

4Diagram capital

rationing process.

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LO 4

What is capital rationing?

Capital rationing is the process by which managers

allocate funds among competing proposals.

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LO 4

EX

HIB

IT

EX

HIB

IT 66

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CAPITAL RATIONING: Analysis

LO 4

Capital rationing proposes an analytical process to choose among competing proposals.

Those proposals that meet all quantitative (financial) and qualitative tests should be ranked for funding along with rejected

proposals that change outcomes because of qualitative tests.

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THE END

CHAPTER 15