Accounting - Capital Investment Analysis
Cash Payback Period is calculated by
dividing the initial investment cost by the calculated expected annual net cash flow (if the annual net cash flows are expected to be the same each year)
A Present Value Index is calculated by
dividing the total present value of the net cash flow by the amount to be invested.
The uncertainty associated with the need to forecast cash flows and make other assumptions about the future of a capital investment increases when
these investments have long lives, which they relatively do.
Strategic investments may have less __________________________________________ and more ________________________________________________
"hard" cost savings affects on future revenues, which are more difficult to estimate.
Uncertainty cannot be eliminated but it can be reduced by
(1) Analyzing its effects (2) Incorporating the best available information into analyses (3) Subjecting capital investment analyses to sensitivity analysis
Disadvantages of Net Present Value Method
(1) Computations are more complex than those for the methods that ignore present value. (2) Assumes the cash received from the proposal during its useful life can be reinvested at the rate of return used in computing the present value of the proposal - due to changing economic conditions, this may not always be the case.
Advantages of the Average Rate of Return Method:
(1) Easy to compute (2) includes the amount of income earned over the entire life of the proposal. (3) Emphasizes accounting income (which is often used by investors and creditors in evaluating management performance)
Leasing fixed assets in some industries is common because
(1) Leasing allows a business to use fixed assets without tying up large amounts of cash that would be needed to purchase them (2) Leasing is particularly attractive when a certain fixed asset has a higher risk of beccoming obsolete. (3) Certain provisons of tax law can also make leasing assets more attractive
Capital investment evaluation methods can be grouped into the following categories:
(1) Methods that do not use present values (2) Methods that use present values
Advantages of the internal rate of return method:
(1) The present values of the net cash flows over the entire useful life of the proposal are considered. (2) Determining a rate of return for each proposal means all proposals are compared on a common basis (3) Application of this method does not require an assumption about a minumum rate of return.
Two methods that do not use present values are These two methods are often used to initially screen proposals and are useful for proposals with
(1) average rate of return method (2) cash payback method relatively short useful lives because the timing of cash flows is less important.
In many cases, despite higher costs of leasing, it makes sense to consider leasing assets before purchasing because the leasing could affect:
(1) deducting lease payments from taxable income (2) Costs of borrowing (3) other factors that can affect the economics of lease vs buy
Additional factors that may complicate the outcome of a capital investment decision are
(1) income tax (2) proposals with unequal lives (3) lease vs capital investment (4) uncertainty (5) changes in price levels (6) qualitative considerations
Funding for capital projects may be obtained from:
(1) issuing stock (2) borrowing (3) operating cash
Two methods that DO use present values are These methods consider the time value of money - that is, the time value of money concept recognizes that
(1) net present value method (2) internal rate of return method an amount of cash invested today will earn interest/income and , therefore, has value over time.
Qualitative considerations that may influence capital investment analysis include:
(1) product quality (2) reduction in the number of defective units (3) manufacturing flexibility (4) reduced inventories needed to operate efficiently (5) employee morale (6) manufacturing productivity (7) reduction or elimination of the need for inspection to determine product quality (8) market opportunity
Final steps in capital rationing process are
(1) ranking proposals according to management's criteria (2) comparing the proposals with the funds available (3) selecting the proposals which are to be funded
Disadvantages of the internal rate of return method:
(1) the complexity of the computations relative to those required for some other methods (however, spreadsheets software does have IRR functions that simplify the calculation) (2) Assumes that the cash received from a proposal during its useful life will be reinvested at the internal rate of return - due to changing economic conditions this may not always be the case.
Present value concepts can be divided into
(1) the present value of an amount (2) the present value of an annuity
A short payback period is desirable because:
(1) the sooner the cash invested is recovered, the sooner it becomes available for reinvestment in other projects. (2) there is less risk of loss due to obsolescence, changing economic conditions, etc.
What is an Annuity?
A series of equal cash flows at fixed time intervals. Examples: monthly rental, salary, and bond interest cash flows
Present Value of an Amount Example:
Choice 1: Get $1 today Choice 2: Get $1 three years from now Take the first choice because you could invest $1 today and earn interest for 3 years, making the amount you would have after three years greater than $1
Advantage of the Net Present Value Method is that it
Considers the time value of money!
Ignoring differences in the useful lives of alternative investments can
distort the present value analysis and adversely affect decisions.
When equal annual net cash flows are expected from a proposal, we can calculate the internal rate of return simply by determining a present value factor for an annuity of $1 by
Dividing the amount to be invested by the euqal annual net cash flows.
Main Disadvantage of Average Rate of Return Method:
Does not directly consider the expected cash flows from the proposal and the timing of these cash flows.
Simplified Version of Average Rate of Return Calculation:
Estimated Average Annual income (total expected income divided by life of investment) OVER Average Investment (total cost + residual value divided by 2)
Disadvantage of the Cash Payback Method:
It ignores cash flows occurring after the payback period and the time value of money
Example of adjusting cash flow assumptions of proposals to end at the same time:
Proposal #1: truck has useful life of 8 years Proposal #2: computer network has useful life of 5 years Assume truck will be sold at the end of 5 years, the residual value of the truck is estimated at the end of 5 years, and this value is included as a cash flow at that date. Both investments then have 5 year lives, and net present value analysis can be used to compare the proposals over the same 5-year period.
The average rate of return is computed by
Taking the average of the annual income expected to be earned from the investment over the investment life as the numerator While the denominator is the average book value of the investment over the investment life. Ex: ((average annual income expected to be earned)/(investment life))/((average book value of the investment)/(investment life))
Net Cash Flow is
The excess of cash flowing in from revenue over the cash flowing out for expenses
The Cash Payback Period is
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.
Present Value of an Annuity
The sum of the present values of each cash flow. In other words, the amount of cash that could be invested today to yield a series of equal net cash flows at fixed time intervals in the future.
What is the residual value of an asset?
This value reflects how much you can sell an asset for after the firm has finished using it or once the asset-generated cash flows can no longer be accurately predicted.
The total cost subjected to depreciation is the same for tax and book purposes, but rules for tax depreciation often result in the Thus, depreciation for tax purposes often exceeds
acceleration of depreciation. the depreciation for financial statement purposes in the early years of an asset's use.
The average rate of return method focuses on
accounting income rather than cash flows.
If the annual cash flows are not equal every year, the cash payback period is determined by
adding the annual net cash flows until the cumulative sum equals the amount of the proposed investment.
The difference in useful lives of investment proposals can be addressed by
adjusting the cash flow assumptions of the proposals to end at the same time.
Since depreciation is deductible in determining taxable income, accelerated depreciation allowed under tax regulations can
affect a project's expected cash flows.
Funded proposals are included in the
capital expenditures budget to assist planning and financing for operations.
The timing of the cash outflows for income taxes can have a significant impact on
capital investment analysis.
A Present Value Index is used to rank proposals when
capital investment funds are limited and the alternative proposals involve different amounts of investment.
The Net Present Value Method (sometimes called the discounted cash flow method) analyzes
capital investment proposals by comparing the initial cash investment with the present value of the expected net cash flows generated by the investment.
Normally leasing assets can be more costly than purchasing because the lessor must
charge a rental price that includes not only the costs associated with owning the assets but also a profit.
The Internal Rate of Return Method uses present value concepts to
compute the expected rate of return for capital investment proposals.
When several proposals are considered they are ranked by their internal rate of returns, and the proposal with the highest rate is
considered the most desirable.
Strategic investments are those that are
designed to affect a company's long-term ability to generate profits.
The higher the present value indexes, the more
desirable a proposal is.
When several capital investment proposals are being considered, the higher the average rate of return of a project, the more
desirable the proposal.
Comparing results of analysis that incorporate assumptions that are more and less conservative than the manager's best estimate will help
determine how sensitive the investment analysis is to uncertainty and the assumptions used.
Many qualitative factors are as important, if not more so, than results of quantitative analysis - therefore, considering both
economic analysis and qualitative factors is often appropriate when making strategic decisions on capital investments.
In capital rationing, alternative proposals are screened by
establishing minimum standards for the cash payback and the average rate of return.
While general prices are rising, the returns on an investment must
exceed the rising price level or else the cash returned on the investment becomes less valuable over time.
Unfunded proposals may be reconsidered if
funds become available later.
Price levels may change for a number of reasons including inflation, which occurs when
general price levels are rising.
Companies use capital investment analysis (or capital budgeting) to
help evaluate long-term investments and compare alternatives investment options.
Improvements that _________________________ ________________________________ are often difficult to quantify
increase competitiveness
Analyzing capital investments requires assumptions and estimates; although necessary, regardless of skill and knowledge they also
introduce uncertainty, and therefore risk, to a companie's investment choices.
Capital Rationing is the process by which
management makes choices and allocates available funds among competing capital investment proposals
Since these qualitative factors cannot be readily incorporated into methods used to evaluate investment alternatives, they will be ignored if
managers do not take an additional step to consider possible qualitative factors.
Some benefits of capital investments are qualitative in nature and cannot be easily
measured or expressed in terms of dollars.
Average rate of return and cash payback method are often used for the initial assessment of a proposal to see if it
meets the minimim standards for accepting proposals set by management. Those that meet the standards are analyzed further; those that do not are dropped from consideration.
Tax reductions in early years of an asset's life are offset by higher taxes in the later years when depreciation is lower. Thus, accelerated depreciation does not
result in a long-run saving in taxes, but it can affect the timing of cash flows.
Capital investment uses cash and must, therefore,
return cash in the future in order to be successful
The more rapidly an investment generates enough cash to cover its cost, the less
risky the investment is.
In determining depreciation for federal income tax purpose, statutory useful lives are often much
shorter than actual useful lives.
Throughout capital rationing process, qualitative factors relating to each proposal
should be/are also considered.
Qualitative considerations in capital investment analysis are most appropriate for
strategic investments.
Even if the expected amount of the foreign currency returned on the investment is realized, the change in exchange rates would mean
that fewer U.S. dollars could be purchased.
Present Value Methods use both
the amount and the timing of net cash flows in evaluating an investment.
The average rate of return, sometimes called the accounting rate of return, is a measure of
the average income as a percent of the average investment in fixed assets.
The residual value of an asset is calculated as
the difference between profits and the cost of capital
If the amount of foreign currency that must be exchanged for one U.S dollar increases, then Thus, if a U.S. company made an investment in another country where the local currency was weakening, the return on investment expressed in U.S. dollars would be
the foreign currency is said to be weakening to the dollar. adversely affected.
If the present value of the cash flows expected from a proposed investment exceeds the amount of the initial investment, then
the investment will generate a return that is greater than the hurdle rate, and the proposal is deemed desirable.
The proposals that survive the initial screening based on the minimum return standards are further analyzed using
the net present value and internal rate of return methods.
If the present value of the cash flows, based on a particular rate of return, is greater than the original investment amount, then we know the internal rate of return must be higher than
the particular rate of return that the present cash flow values were calculated on.
If the average rate of return MEETS or EXCEEDS the minimum return rate established by management, then
the project should be purchased or at least analyzed further using additional methods.
Price levels may also change for foreign investments, as the result of currency exchange rates, which are
the rates at which a foreign currency can be exchanged for U.S. dollars.
The Payback Period is found as
the time required for the net cash flow to equal the initial outlay for the fixed asset
The cash payback period is especially important to bankers and other creditors whose main concern is liquidity because:
they depend on net cash flow for repayment of debt used to fund the investment - the sooner the cash is recovered, the sooner debt and other liabilities can be paid
The interest rate (minimum desired rate of return) used in net present value analysis is set by management. This rate, sometimes called the hurdle rate, is
typically based on such factors as the nature of the business, the purpose of the investment, the cost of securing funds for the investment, and the minimum desired rate of return.
Rather than establishing a minimum return on the investment, the internal rate of return method starts with the net cash flows and
works backwards to determine the rate of return expected from the proposal.
