Mowen ch12

Chapter 12
Capital Investment
Decisions
Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7th Edition. © 2018 Cengage.
All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part
Learning Objectives (1 of 2)
1. Explain the meaning of capital investment decisions, and distinguish
between independent and mutually exclusive capital investment decisions
2. Compute the payback period and accounting rate of return for a proposed
investment, and explain their roles in capital investment decisions
3. Use net present value analysis for capital investment decisions involving
independent projects
Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7th Edition. © 2018 Cengage. All
Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part
Learning Objectives (2 of 2)
4. Use the internal rate of return to assess the acceptability of independent
projects
5. Explain the role and value of postaudits
6. Explain why net present value is better than internal rate of return for capital
investment decisions involving mutually exclusive projects
7. (Appendix 12A) Explain the relationship between current and future dollars
Types of Capital Investment Decisions (1 of 2)
• Capital investment decisions are concerned with the process of planning,
setting goals and priorities, arranging financing, and using certain criteria to
select long-term assets
• The process of making capital investment decisions often is referred to as
capital budgeting
Types of Capital Investment Decisions (2 of 2)
• Two types of capital budgeting projects will be considered: independent
projects and mutually exclusive projects
o Independent projects are projects that, if accepted or rejected, do not affect the
cash flows of other projects
o Mutually exclusive projects are those projects that, if accepted, preclude the
acceptance of all other competing projects
Making Capital Investment Decisions (1 of 2)
• A sound capital investment will earn back its original capital outlay over its
life and, at the same time, provide a reasonable return on the original
investment
• Managers must decide on the acceptability of independent projects and
compare competing projects on the basis of their economic merits
Making Capital Investment Decisions (2 of 2)
• To make a capital investment decision, a manager must
o estimate the quantity and timing of cash flows
o assess the risk of the investment
o consider the impact of the project on the firm’s profits
Basic Capital Investment Decision Models
• The basic capital investment decision models can be classified into two
major categories:
o Nondiscounting models ignore the time value of money
o Discounting models explicitly consider the time value of money
Nondiscounting Models: Payback Period (1 of 3)
• The payback period is a nondiscounting model that presents the time
required for a firm to recover its original investment
• It is often used to assess things such as
o financial risk
o impact of an investment on liquidity
o obsolescence risk
o impact of investment on performance measures
• If the cash flows of a project are an equal amount each period, the payback
period is computed as follows:
OriginalInvestment
Payback Period =
AnnualCashFlow
• If the cash flows are unequal, the payback period is computed by adding the
annual cash flows until such time as the original investment is recovered
• If a fraction of a year is needed, it is assumed that cash flows occur evenly
within each year
Example 12.1: How to Calculate Payback (1 of 3)
Suppose that a new car wash facility requires an investment of $100,000 and
either has (a) even cash flows of $50,000 per year or (b) the following expected
annual cash flows: $30,000, $40,000, $50,000, $60,000, and $70,000.
Required:
Calculate the payback period for each case.
Solution:
Original Investment $ 100,000
a. Payback Period = = = 2 years
Annual CashFlow $ 50,000
b. year Unrecovered Investment Annual Cash Time Needed for

(beginning of year) Flow Payback (years)
1 $100,000 $30,000 1.0
2 70,000 40,000 1.0
3 30,000 50,000 0.6*
4 0 60,000 0.0
5 0 70,000 0.0
2.6
* At the beginning of Year 3, $30,000 is needed to recover the investment.
 $30,000 
Since a net cash flow of $50,000 is expected, only 0.6 year  
 $50,000 
is needed to recover the remaining $30,000, assuming a uniform cash inflow
throughout the year.
Using the Payback Period to Assess Risk (1 of 2)
• One way to use the payback period is to set a maximum payback period for
all projects and to reject any project that exceeds this level
• Some analysts suggest that the payback period can be used as a rough
measure of risk, with the notion that the longer it takes for a project to pay for
itself, the riskier it is
Using the Payback Period to Assess Risk (2 of 2)
• Firms with riskier cash flows in general could require a shorter payback
period than normal
• Firms with liquidity problems would be more interested in projects with quick
paybacks
• Another critical concern is obsolescence
o Firms with a higher risk of obsolescence, such as computer and MP3 player
manufacturers, would be interested in recovering funds rapidly
Using the Payback Period to Choose Among
Alternatives
• The payback period can be used to choose among competing alternatives
• The investment with the shortest payback period is preferred over
investments with longer payback periods
• This measure suffers from two major deficiencies:
o It ignores the cash flow performance of the investments beyond the payback
period
o It ignores the time value of money
Nondiscounting Models: Accounting Rate of
Return (1 of 2)
• The accounting rate of return (ARR) measures the return on a project in
terms of income, as opposed to using a project’s cash flow
• It may be useful as a screening measure to ensure that a new investment
does not adversely affect debt covenants (covenants may use accounting
ratios that can be affected by the income reported and the level of long-term
assets)
Nondiscounting Models: Accounting Rate of
Return (2 of 2)
• The accounting rate of return is computed by the following formula:
Average Income
Accounting Rate of Return =
Initial Investment
Example 12.2: How to Calculate the Accounting
Rate of Return (1 of 3)
An investment requires an initial outlay of $100,000 and has a 5-year life with
no salvage value. The yearly cash flows are $50,000, $50,000, $60,000,
$50,000, and $70,000.
Required:
1. Calculate the annual net income for each of the 5 years.
2. Calculate the accounting rate of return.
Solution:
1. Yearly Depreciation Expense =
( $100,000 – $0 )
= $20,000
5 years
Annual Net Income = Net Cash Flow – Depreciation Expense
Year 1 Net Income = $50,000 − $20,000 = $30,000
Year 2 Net Income = $50,000 − $20,000 = $30,000
Year 3 Net Income = $60,000 − $20,000 = $40,000
Year 4 Net Income = $50,000 − $20,000 = $30,000
Year 5 Net Income = $70,000 − $20,000 = $50,000
2. Total Net Income (5 Years) = $180,000
$180,000
Average Net Income = = $36,000
5
$36,000
Accounting Rate of Return = = 0.36
100,000
Here’s How It’s Used: IN YOUR LIFE (1 of 6)
Kent Shorts just graduated from pharmacy school and has accepted a position
that requires him to travel to three different pharmacies, located in different
communities. He expects to average about 24,000 miles per year. He is
considering converting his new truck (which averages 15 miles per gallon) so
that it can run on either compressed natural gas (CNG) or conventional fuel (a
bi-fuel conversion). One of the incentives for conversion for Kent is the
favorable impact that CNG usage would have on the environment. CNG is a
cleaner fuel than gasoline and would reduce greenhouse emissions by 30 to
40%.
Kent also hopes to save money on his fuel costs. The cost of CNG would be
about half the cost of gasoline. He estimates that the cost for gasoline would
average about $3.40 per gallon over the next 5 years and that the cost per
gallon for CNG would be $1.65.
However, the cost of conversion is about $8,000. The mechanic offering the
conversion package also tells Kent that the state offers a $2,400 tax credit for
alternative fuels. Intrigued, Kent wonders whether the conversion would be
economical. He decides to consult with Lisa Powell, his fiancée and a CPA.
She offers Kent the following analysis:
“Kent, at 15 mpg, you would use 1,600 gallons per year. CNG would save you
$1.75 per gallon or $2,800 per year. With the tax credit, your net cost of
conversion would be $5,600 ($8,000 − $2,400). It only takes 2 years
 $5,600 
 $2,800  to recover your conversion cost from the fuel cost savings. That is not a
 
bad payback period. Not only do you benefit the environment, but after the first
2 years, you pocket $2,800 per year in savings.”
Limitations of Accounting Rate of Return (1 of 2)
• Unlike the payback period, the ARR does consider a project’s profitability
• ARR has other potential drawbacks, including the following:
o Ignoring Time Value of Money: Like the payback period, it ignores the time
value of money. The ARR and payback model are referred to as nondiscounting
models because they ignore the time value of money
Limitations of Accounting Rate of Return (2 of 2)
o Dependency on Net Income: ARR is dependent upon net income, which
is the financial measure most likely to be manipulated by managers
o Managers’ Incentive: Because bonuses to managers often are based on
accounting income or return on assets, managers may have a personal
interest in selecting investments that provide the highest net income in the
short term rather than ones that produce the greatest cash flows and
returns in the long term
Discounting Models: The Net Present Value
Method (1 of 2)
• Discounting models use discounted cash flows, which are future cash
flows expressed in terms of their present value
• One discounting model is the net present value (NPV) method
• Net present value (NPV) is the difference between the present value of the
cash inflows and outflows associated with a project
Discounting Models: The Net Present Value
Method (2 of 2)
  CF 
NPV =  t
t  −1
 (1 + i ) 
=   CFt dft  −`1
= P −1
Where:
I = The present value of the project’s cost (usually the initial cash outlay)
CFt = The cash inflow to be received in period t, with t = 1 … n
i = The required rate of return
t = The time period
P = The present value of the project’s future cash inflows
dft = 1(1 + i ) ? , the discount factor
t
Net Present Value (1 of 4)
• NPV measures the profitability of an investment
• A positive NPV indicates that the investment increases the firm’s wealth
• To use the NPV method, a required rate of return must be defined
• The required rate of return is the minimum acceptable rate of return
• It also is referred to as the discount rate, hurdle rate, and cost of capital
• If future cash flows are known with certainty, then the correct required rate of
return is the firm’s cost of capital
• Managers often choose a discount rate higher than the cost of capital to deal
with the uncertainty
• If the rate chosen is excessively high, it will bias the selection process toward
short-term investments
• Once the NPV for a project is computed, it can be used to determine whether
or not to accept an investment
o If the NPV is greater than zero the investment is profitable and, therefore,
acceptable. A positive NPV signals that (1) the initial investment has been
recovered, (2) the required rate of return has been recovered, and (3) a return in
excess of (1) and (2) has been received
o If the NPV equals zero, the decision maker will find acceptance or rejection of the
investment equal
o If the NPV is less than zero, the investment should be rejected. In this case, it is
earning less than the required rate of return
Example 12.3: How to Assess Cash Flows and Calculate
A detailed market study revealed expected annual revenues of $300,000 for
new earphones. Equipment to produce the earphones will cost $320,000. After
5 years, the equipment can be sold for $40,000. In addition to equipment,
working capital is expected to increase by $40,000 because of increases in
inventories and receivables. The firm expects to recover the investment in
working capital at the end of the project’s life. Annual cash operating expenses
are estimated at $180,000. The required rate of return is 12%.
Required:
Estimate the annual cash flows, and calculate the NPV .
Example 12.3: How to Assess Cash Flows and
Calculate Net Present Value (2 of 4)
Solution: STEP 1. CASH FLOW IDENTIFICATION
Year Item Cash Flow
0 Equipment $ (320,000)
Working capital (40,000)
Total $ (360,000)
1–4 Revenues $ 300,000
Operating expenses (180,000)
Total $ 120,000
5 Revenues $ 300,000
Operating expenses (180,000)
Salvage 40,000
Recovery of working capital 40,000
Total $ 200,000
STEP 2A. NPV ANALYSIS
Year Cash Flowa Discount Factorb Present Value
0 $(360,000) 1.00000 $(360,000)
1 120,000 0.89286 107,143
2 120,000 0.79719 95,663
3 120,000 0.71178 85,414
4 120,000 0.63552 76,262
5 200,000 0.56743 113,486
Net present value $ 117,968
STEP 2B. NPV ANALYSIS
Year Cash Flow Discount Factorc Present Value

0 $(360,000) 1.00000 $(360,000)
1–4 120,000 3.03735 364,482
5 200,000 0.56743 113,486
aFrom Step 1.
bFrom Exhibit 12B.1.
cYears 1–4 from Exhibit 12B.2; Year 5 from Exhibit 12B.1.
NPV, Discount Rates, and Cash Flows (1 of 2)
• It is common to provide pessimistic and most likely cash flow scenarios to
help assess a project’s risk
• As the discount rate increases, the present value of future cash flows
decreases, making it harder for a project to achieve a positive NPV
• Plotting the NPV as the discount rate varies provides good insight into the
risk and economic viability of the proposed project
NPV, Discount Rates, and Cash Flows (2 of 2)
Kent Shorts is still considering the investment in a CNG conversion for his
truck. His fiancée, Lisa Powell, calculated the cash flows and the payback
period for him and recommended the investment. He has one additional
concern—he knows the $5,600 net investment could earn 5% annually in his
savings account. At the end of 5 years, he would have the $5,600 plus the
interest earned. Before making a final decision, he decides to consult with Lisa
once again to see what she thinks.
Below is the text message she sends him in response:
NPV analysis answers your question. The CNG conversion costs $5,600 and
produces $2,800 savings per year in fuel costs. If your required rate of return is
5%, then using the same 5-year horizon we used for the payback analysis, you
would have a net increase in your current financial wealth of about $6,523. This
number is called the net present value. It is the value of the 5-year stream of
savings (what you would have to invest at 5% to get the $2,800 per year for 5
years) less the $5,600 actually needed to produce those savings.
In other words, in effect, you get back your $5,600 plus an additional $6,523.
This CNG conversion is a great deal for you!
Internal Rate of Return (1 of 4)
• Another discounting model is the internal rate of return method
• The internal rate of return (IRR) is defined as the interest rate that sets the
present value of a project’s cash inflows equal to the present value of the
project’s cost
• The IRR is the interest rate (discount rate) where NPV = 0
• Acceptable investments should have an IRR greater than the required rate of
return (cost of capital)
• The following equation can be used to determine a project’s IRR:
CF 
I =  t
t
 (1 + i ) 
o where t = 1, …, n
• The right side of this equation is the present value of future cash flows
• The left side is the investment
• I, CFt, and t are known
• Thus, the IRR (the interest rate, i, in the equation) can be found using trial
and error
• Once the IRR for a project is computed, it is compared with the firm’s
required rate of return:
o If the IRR is greater than the required rate of return, the project is deemed
acceptable
o If the IRR is less than the required rate of return, the project is rejected
o If the IRR is equal to the required rate of return, the firm is indifferent between
accepting or rejecting the investment proposal
• The IRR is the most widely used of the capital investment techniques
Internal Rate of Return: Multiple Period
• If the investment produces a series of uniform cash flows, a single discount
factor from the present value table can be used to compute the present value
of the annuity
• If the cash flows are not uniform, then the IRR equation must be used
• For a multiple-period setting, this equation can be solved by trial and error or
by using a business calculator or a spreadsheet program
Example 12.4: How to Calculate Internal Rate of
Return with Uniform Cash Flows (1 of 2)
Assume that a hospital has the opportunity to invest $205,570.50 in a new
ultrasound system that will produce net cash inflows of $50,000 at the end of
each of the next 6 years.
Required:
Calculate the IRR for the ultrasound system.
Solution:
I
df =
CF
$205,570.50
=
$50,000
= 4.11141
Example 12.4: How to Calculate Internal Rate of
Return with Uniform Cash Flows (2 of 2)
Since the life of the investment is 6 years, find the sixth row in Exhibit 12B.2
and then move across this row until df = 4.11141 is found. The interest rate
corresponding to 4.11141 is 12%, which is the IRR.
Here’s How It’s Used: SUSTAINABILITY, IRR, AND
UNCERTAINTY (1 of 7)
As a manager of a plant producing cooking oils and margarines, you are
concerned about the emission of contaminated water effluents. On a regular
basis, your plant violates its discharge permit and dumps many times the
allowable waste (organic solids) into a local river. This practice is beginning to
draw increased attention and criticism from the state environmental agency.
You are considering the acquisition and installation of a zero-discharge, closed-
loop system with an expected life of 10 years and a required investment of
$250,000.
The closed-loop system is expected to produce the following expected annual
savings:
Water (from the ability to recycle the water) $20,000
Materials (from the ability to use extracted materials) 5,000
Avoidance of fines and penalties 15,000
Reduction in demand for laboratory analysis 10,000
Total savings $50,000
To accept any project, the IRR must be greater than the cost of capital, which is
10%. Upon calculating the IRR, you find that it is about 15%, significantly
greater than the 10% benchmark rate. However, upon seeking approval for the
project from the divisional manager, he asks you how certain you are about the
projected cash savings. He also questions the estimated life, arguing that
based on his experience the expected life of the particular closed-loop system
is usually closer to 8 years than 10.
How would you address the divisional manager’s concerns about
projected cash savings and estimated life?
The concerns of the divisional manager relate to the uncertainty surrounding
both the cash flow and project life estimates. The savings from recycling water
and the fines and penalties probably have very little uncertainty attached to
them. The same may also be true of the lab costs, especially if the analysis is
outsourced. The major source of uncertainty probably is attached to the
quantity of organic solids that once extracted can be used to produce additional
margarines and cooking oils.
Assuming that the extraction process does not produce any usable organic
solids, the annual savings would be $45,000 ($50,000 − $5,000), yielding the
worst-case scenario for cash flows. This uncertainty in the cash flows can be
dealt with by first calculating the minimum annual cash savings that must be
realized to earn a rate equal to the firm’s cost of capital and then comparing
this minimum cash savings with the cash flows of the worst-case scenario
($45,000). Calculating this minimum cash flow for an 8-year life simultaneously
addresses the project life issue.
The minimum cash flow is calculated as follows (where df is the discount factor
for 8 years and 10%, from Exhibit 12B.2, p. 671):
I = CF ( df )
I
CF =
df
$250,000
=
5.33493
= $46,861(rounded )
In the worst-case scenario, the project will not meet the minimum cash savings
requirement. The cash savings from the extraction of organic solids can only be
off by about 20% to retain project viability.
As a plant manager, you might argue that there is a likely underestimation of
future fines and penalties resulting from the increased political attention to
polluting of the local river. Also, there may be a positive benefit, not included in
the savings, of a more favorable public image (e.g., increased sales because of
the favorable environmental action). Taken together, you should have a strong
position for winning approval of the project.
Sensitivity analysis thus provides a powerful tool for assessing the
impact of uncertainty in capital investment analysis.
Postaudit of Capital Projects
• A key element in the capital investment process is a follow-up analysis of a
capital project once it is implemented
• A postaudit compares the actual benefits with the estimated benefits and
actual operating costs with estimated operating costs
• It evaluates the overall outcome of the investment and proposes corrective
action if needed
Postaudit Benefits (1 of 2)
• Firms that perform postaudits of capital projects experience a number of
benefits, including the following:
o Resource Allocation: By evaluating profitability, postaudits ensure that
resources are used wisely
o Positive Impact on Managers’ Behavior: If managers are held accountable for
the results of a capital investment decision, they are more likely to make such
decisions in the best interests of the firm
o Independent Perspective: A postaudit by an independent party ensures more
objective results
Postaudit Benefits (2 of 2)
• Postaudits are costly
• The assumptions driving the original analysis may often be invalidated by
changes in the actual operating environment
• Accountability must be qualified to some extent by the impossibility of
foreseeing every possible eventuality
Mutually Exclusive Projects
• Up to this point, we have focused on independent projects
o NPV and IRR both yield the same decision for independent projects
• However, many capital investment decisions deal with mutually exclusive
projects
o For competing projects, the two methods can produce different results
o Choosing the project with the highest NPV or the highest IRR is consistent with
maximizing the wealth of shareholders
Net Present Value Compared with Internal Rate of
Return (1 of 4)
• NPV differs from IRR in two major ways:
o The NPV method assumes that each cash inflow received is reinvested at the
required rate of return
• The IRR method assumes that each cash inflow is reinvested at the computed IRR
• Reinvesting at the required rate of return is more realistic and produces more reliable
results when comparing mutually exclusive projects
Return (2 of 4)
• The NPV method measures profitability in absolute terms
o The IRR method measures it in relative terms
o NPV measures the amount by which the value of the firm changes
Return (3 of 4)
Return (4 of 4)
• When choosing between projects, what counts are the total dollars earned—
the absolute profits—not the relative profits
• Accordingly, NPV , not IRR , should be used for choosing among competing,
mutually exclusive projects or competing projects when capital funds are
limited
NPV Analysis for Mutually Exclusive Projects
• There are three steps in selecting the best project (with the largest NPV)
from several competing projects:
o Step 1: Assess the cash flow pattern for each project
o Step 2: Compute the NPV for each project
o Step 3: Identify the project with the greatest NPV
Example 12.5: How to Calculate Net Present Value and
Internal Rate of Return for Mutually Exclusive Projects (1 of 4)
Consider two pollution prevention designs: Design A and Design B. Both
designs have a project life of 5 years. Design A requires an initial outlay of
$180,000 and has a net annual after-tax cash inflow of $60,000 (revenues of
$180,000 minus cash expenses of $120,000). Design B, with an initial outlay of
$210,000, has a net annual cash inflow of $70,000 ($240,000 − $170,000). The
after-tax cash flows are summarized as follows:
CASH FLOW PATTERN
Year Design A Design B
0 $(180,000) $(210,000)
1 60,000 70,000
2 60,000 70,000
3 60,000 70,000
4 60,000 70,000
5 60,000 70,000
The cost of capital for the company is 12%.

Required:
Calculate the NPV and the IRR for each project.
Solution: DESIGN A: NPV ANALYSIS
Year Cash Flow Discount Factor* Present Value
0 $(180,000) 1,00000 $(180,000)
1-5 60,000 3,60478 216,287
DESIGN A: IRR ANALYSIS

Initial Investment
Discount Factor =
Annual Cash Flow
$180,000
=
$60,000
= 3.00000
From Exhibit 12B.2 (p. 671), df = 3.00000 for 5 years implies that IRR ≈ 20%.
DESIGN B: NPV ANALYSIS
Year Cash Flow Discount Factor* Present Value
0 $(210,000) 1.00000 $(210,000)
1-5 70,000 3.60478 252,335
DESIGN B: IRR ANALYSIS

Initial Investment
Discount Factor =
Annual Cash Flow
$210,000
=
$70,000
= 3.00000
From Exhibit 12B.2, df =3.00000 for 5 years implies that IRR ≈ 20%.
*From Exhibit 12B.2.
Here’s How It’s Used: At Kicker (1 of 4)
During the period of 2001–2003, Stillwater Designs experienced high sales of
its Kicker products. As a result, the levels of inventory filled all storage areas to
capacity. Consequently, Stillwater Designs began plans to add another building
on existing property with 50,000 square feet of capacity. This new facility had
an estimated construction cost between $1 and $1.5 million. During this
preliminary planning phase, a shipping strike placed extra storage demands on
existing facilities, and Stillwater Designs began looking for a warehousing
facility that could be leased on a short-term basis.
It identified a 250,000-square-foot facility on 22 acres that was owned by
Moore Business Forms. This facility was an attractive leasing option, and it
quickly became a competing alternative to adding the 50,000-square-foot
facility to Stillwater’s current complex. In fact, the company began looking at
the possibility of buying and renovating the Moore facility and moving all of its
operations into the one facility.
Renovation required such actions as installing a new HVAC system, bringing
the building up to current fire codes, painting and resealing the floor, and
adding a large number of offices. After careful financial analysis, Stillwater
Designs decided that the buy-and-renovate option was more profitable than
adding the 50,000-square-foot building to its current complex.
Two economic factors affecting the decision were (1) selling the current
complex of five buildings would help pay for the needed renovations and (2)
the purchase cost of the nonrenovated Moore facility was less than the cost of
building the 50,000-square-foot facility.
Special Considerations for Advanced Manufacturing
Environment (1 of 2)
• For advanced manufacturing environments, like those using automated
systems, capital investment decisions can be more complex because they
must take special considerations into account
• Great care must be exercised to assess the actual cost of an automated
system because it is easy to overlook substantial peripheral costs such as
software, engineering, and training
Special Considerations for Advanced Manufacturing
Environment (2 of 2)
• More effort is needed to measure intangible and indirect benefits, like
reduced lead time, reliability, and customer satisfaction, in order to assess
more accurately the potential value of investments
Appendix 12A: Present Value Concepts (1 of 2)
• An important feature of money is that it can be invested and can earn interest
• A dollar today is not the same as a dollar tomorrow
• This fundamental principle is the backbone of discounting methods
• Future value is expressed as F = P(1 + i), where F is the future amount, P is
the initial or current outlay, and i is the interest rate
Appendix 12A: Present Value Concepts (2 of 2)
• The earning of interest on interest is referred to as compounding of
interest, expressed as follows for n periods into the future:
F = P (1 + i )
n
Present Value (1 of 3)
• A manager needs to compute not the future value but the amount that must
be invested now in order to yield some given future value
• The amount that must be invested now to produce the future value is known
as the present value of the future amount
• To compute the present value of a future outlay, all we need to do is solve the
compounding interest equation for P:
P= F
(1+i)n
• The process of computing the present value of future cash flows is often
referred to as discounting
• The interest rate used to discount the future cash flow is the discount rate.
1
The expression in the present value equation is the discount factor
(1 + i )
n
Annuities (1 of 2)
• An annuity is a series of future cash flows
• If the annuity has uneven cash flows, then each future cash flow must be
discounted using individual discount factors (the present value for each cash
flow is calculated separately and then summed), as shown here
Year Cash Receipt Discount Factor Present Value*
1 $110.00 0.90909 $100.00
2 121.00 0.82645 100.00
3 133.10 0.75131 100.00
2.48685 $300.00
*Rounded.
Annuities (2 of 2)
• For even cash flows, a single discount rate, which is the sum of each
discount rate for each cash flow, can be used
o In the example shown here, the factors sum to 2.48685
Year Cash Receipt* Discount Factor Present Value
1 $100 0.90909 $90.91

2 100 0.82645 82.65
3 100 0.75131 75.13
2.48685 $248.69
*The annual cash flow of $100 can be multiplied by the sum of the discount
factors (2.48685) to obtain the present value of the uniform series ($248.69).
Annuities (3 of 3)
• This sum is found in the table of discount factors for an annuity, as found in
Exhibit 12B.2, for 3 periods at 10%
o For simplicity, the factors from the present value of an annuity table can be used
for an annuity of uniform cash flows

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Chapter 12

b. year Unrecovered Investment Annual Cash Time Needed for

Year Cash Flow Discount Factorc Present Value

cYears 1–4 from Exhibit 12B.2; Year 5 from Exhibit 12B.1.

The cost of capital for the company is 12%.

0 $(180,000) 1,00000 $(180,000)

1-5 60,000 3,60478 216,287

Net present value $ 36,287

DESIGN A: IRR ANALYSIS

DESIGN B: IRR ANALYSIS

Year Cash Receipt Discount Factor Present Value*

1 $110.00 0.90909 $100.00

2 121.00 0.82645 100.00

3 133.10 0.75131 100.00

1 $100 0.90909 $90.91

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