Chapter 10

The net present value method has the following two disadvantages:

1)It has more complex computations than methods that don't use present value. 2)It assumes the cash flows can be reinvested at the minimum desired rate of return, which may not be valid

The average rate of return has the following three advantages:

1)It is easy to compute. 2)It includes the entire amount of income earned over the life of the proposal. 3)It emphasizes accounting income.

The cash payback method has the following two advantages:

1)It is simple to use and understand. 2)It analyzes cash flows.

Income tax

For federal income tax purposes, depreciation on fixed assets can be much shorter than the actual useful lives. Also, depreciation for tax purposes often differs from depreciation for financial statement purposes.

Changes in price levels

General price levels often increase in a rapidly growing economy, which is called inflation. Price levels may change for foreign investments. This occurs as currency exchange rates change. Currency exchange rates are the rates at which currency in another country can be exchanged for U.S. dollars.

Present value index =

Present value index = total present value of net cash flow / amount to be invested

• Teach yourself what Present Value really means

Present value methods use amount and timing of net cash flows in evaluating an investment. These are evaluating capital investment using values are net present value method and internal rate of return method.

Qualitative factors

- Improvements that increase quality and competitiveness are difficult to quantify. The following qualitative factors are important considerations. 1)Product quality 2)Manufacturing flexibility 3)Employee morale 4)Manufacturing productivity 5)Market (strategic) opportunities

Both the net present value and the internal rate of return methods use the following two present value concepts:

-Present value of an amount -Present value of an annuity

The cash payback method has the following two disadvantages:

1) It ignores cash flows occurring after the payback period. 2) It does not use present value concepts in valuing cash flows occurring in different periods.

The net present value method has the following three advantages:

1)It considers the cash flows of the investment. 2)It considers the time value of money. 3)It can rank equal lived projects using the present value index.

The average rate of return has the following two disadvantages:

1)It does not directly consider the expected cash flows from the proposal. 2)It does not directly consider the timing of the expected cash flows.

• Teach yourself which of the four main methods of capital appraisal use Present Value Methods that use present values:

1)Net present value method - The net present value method compares the amount to be invested with the present value of the net cash inflows. It is sometimes called the discounted cash flow method. 2) Internal rate of return method - The internal rate of return (IRR) method uses present value concepts to compute the rate of return from a capital investment proposal based on its expected net cash flows. This method, sometimes called the time-adjusted rate of return method, starts with the proposal's net cash flows and works backward to estimate the proposal's expected rate of return. -The two methods that use present values consider the time value of money. The time value of money concept recognizes that a dollar today is worth more than a dollar tomorrow because today's dollar can earn interest.

• Teach yourself the main 6 complications to capital appraisal methodologies

1)income tax 2)proposals 3)leasing versus purchasing 4)uncertainty 5)changes 6)qualitative factors

Uncertainty

All capital investment analyses rely on factors that are uncertain. -Estimates of revenue and expenses -The amount of cash flows

Average investment =

Average investment = (initial cost + residual value) / 2

Average rate of return =

Average rate of return = estimated average annual income / average investment

• Teach yourself what Capital Rationing is

Capital rationing is the process by which management allocates funds among competing capital investment proposals.

Cash payback period =

Cash payback period = initial cost / annual net cash inflow

Leasing versus purchasing

Some advantages of leasing a fixed asset include the following: -The company has use of the fixed asset without spending large amounts of cash to purchase the asset. -The company eliminates the risk of owning an obsolete asset. -The company may deduct the annual lease payments for income tax purposes. One disadvantage of leasing a fixed asset is the following: The leasing arrangement normally is more costly than the outright purchase of the asset.

• Teach yourself the Average Rate of Return Method

The average rate of return, sometimes called the accounting rate of return, measures the average income as a percent of the average investment

• Teach yourself the Cash Payback Method

The expected period of time that will pass between the date of an investment and the complete recovery in cash of the amount invested is the cash payback period. When annual net cash inflows are equal.

• Teach yourself what Net Present Value is

The net present value method compares the amount to be invested with the present value of the net cash inflows. It is sometimes called the discounted cash flow method. Capital investment proposals can be ranked by using a present value index