MANAGEMENT

PowerPoint Presentation by ACCOUNTING

Gail B. Wright
Professor Emeritus of Accounting 8th EDITION
Bryant University
BY
Copyright 2007 Thomson South-Western, a part of The
Thomson Corporation. Thomson, the Star Logo, and
South-Western are trademarks used herein under license.
HANSEN & MOWEN

13 CAPITAL INVESTMENT DECISIONS

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LEARNING OBJECTIVES
LEARNING GOALS

After studying this

chapter, you should be
able to:

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 LEARNING OBJECTIVES
1. Explain what a capital investment decision
is; distinguish between independent &
mutually exclusive decisions.
2. Compute payback period, accounting rate
of return for proposed investment; explain
their roles.
3. Use net present value analysis for capital
investment decision of independent
projects.
Continued
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 LEARNING OBJECTIVES
4. Use internal rate of return to assess
acceptability of independent projects.
5. Discuss the role and value of postaudits.
6. Explain why NPV is better than IRR for
capital investment decisions of mutually
exclusive projects.

Continued
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 LEARNING OBJECTIVES
7. Convert gross cash flows to after-tax flows.
8. Describe capital investment in advanced
manufacturing environment.

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Questions to Think About
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QUESTIONS TO THINK ABOUT:
Honley Medical

What role, if any, should

qualitative factors play in
capital budgeting decisions?

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QUESTIONS TO THINK ABOUT:
Honley Medical

How do we measure the

financial benefits of long-term
investments?

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QUESTIONS TO THINK ABOUT:
Honley Medical

Why are cash flows important

for assessing the financial
merits of an investment?

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QUESTIONS TO THINK ABOUT:
Honley Medical

What role doe taxes & inflation

play in assessing cash flows?
Should cash flows of intangible
factors be estimated?

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LEARNING OBJECTIVE

Explain what a capital

1
investment decision is;
distinguish between
independent & mutually
exclusive decisions.

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 LO 1

CAPITAL INVESTMENT
DECISIONS: Definition

Are concerned with the process

of planning, setting goals &
priorities, arranging financing,
& using certain criteria to select
longterm assets.

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 LO 1

How do the 2 types of

capital budgeting differ?

In capital budgeting, decisions to

accept/reject an independent project
does not affect decisions about another
project whereas acceptance of a
mutually exclusive project precludes
other projects.
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 LO 1

What is a reasonable
return on a capital
investment?

A capital investment must earn

back its original cost and cover
opportunity cost of funds invested.

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 LO 1

CAPITAL INVESTMENT
METHODS
Methods used to guide managers
investment decisions are:
Nondiscounting
Payback period
Accounting rate of return
Discounting
Net present value (NPV)
Internal rate of return (IRR)

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LEARNING OBJECTIVE

Compute payback

2
period, accounting rate
of return for proposed
investment; explain
their roles.

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 LO 2

PAYBACK PERIOD: Definition

Is the time required for a firm

to recover its original
investment.

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 LO 2

HONLEY MEDICAL: Background

Honley Medical invests $1,000,000 in a new
RV generator. The investment is
expected to generate net cash flows of
$500,000 per year. How long will it take
for the project to break even?

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 LO 2

FORMULA: Payback Period

Payback period tells how long it will take a
project to break even.

Payback period
= Original investment Annual cash flows
= $1,000,000 / $500,000
= 2 years
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 LO 2

PAYBACK PERIOD: Uses

Sets maximum payback period for all projects;

rejects any that exceed payback period
Measures of risk
Riskier firms use shorter payback period
In liquidity problems, use shorter payback period
Avoids obsolescence

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 LO 2

PAYBACK PERIOD: Deficiencies

Ignores performance of investment beyond

payback period
Ignores time value of money

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 LO 2

HONLEY MEDICAL: Background

Honley Medical is choosing between 2
different types of computer-aided design
systems (CAD). Each system requires a
$150,000 initial outlay and has a 5-year
life. Will using payback period help
make the right choice?

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 LO 2

CAD DECISION
Payback period
Investment Year 1 Year 2 Year 3 Year 4 Year 5
CAD A $ 90,000 $ 60,000 $ 50,000 $ 50,000 $ 50,000
CAD - B }40,000 110,000 25,000 25,000 25,000

Payback period does not

distinguish between the 2
investments because the
payback periods are equal
but the return after payback
is different.

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 LO 2

PAYBACK PERIOD: Summary

Payback period provides information that can
be used to help
Control risks of uncertain future cash flows
Minimize impact of investment on liquidity
problems
Control risk of obsolescence
Control effects of investment on performance
measures

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 LO 2

HONLEY MEDICAL: Background

Honley Medicals IV Division is considering
investing in a special tooling with a 5
year life that requires an initial outlay of
$100,000. Average cash flow is $36,000
& depreciation is $20,000. Will the
investment earn an acceptable
accounting rate of return?

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 LO 2

FORMULA: Accounting Rate of

Return
Accounting rate of return is a nondiscounting
model of return on a project.

Accounting rate of return

= Average income Original investment (or
Average investment)
= ($36,000 - $20,000) / $100,000 = 16% or
= ($36,000 - $20,000) / $50,000 = 32%
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 LO 2

What are similarities and

differences between payback
period & accounting rate of
return?

Payback period & accounting rate of

return are similar because they
ignore time value of money but
different because accounting rate of
return considers profitability.

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LEARNING OBJECTIVE

Use net present value

3 analysis for capital

investment decision of
independent projects.

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 LO 3

NET PRESENT VALUE (NPV):

Definition

Is the difference between the

present value of the cash inflows
& outflows associated with a
project.

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 LO 3

NPV: What You Need to Know

Present value of projects cost
Cash inflow to be received in each period
Useful life of project
Required rate of return (hurdle rate)
Time period
Present value of projects future cash inflows
Discount factor

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 LO 3

ANALYZING NPV
When NPV is positive:
The initial investment has been recovered
The required rate of return has been
achieved
A return in excess of (1) & (2) has been
received

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 LO 3

HONLEY MEDICAL: Background

Honley Medical is considering producing a home
blood pressure instrument. Equipment
costing $320,000 plus $40,000 increase in
working capital would be required for the
project. Annual net cash flows of $120,000
are expected and Honley requires a 12% rate
of return. Should Honley produce the new
product?
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 LO 3

CASH FLOW: Step 1

The first step in
calculating the
NPV is to
determine the total
cash flows of the
project.

EXHIBIT 13.2
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 LO 3

CASH FLOW: Step 2

The second step is
to calculate the
present value of the
annual cash flows.

EXHIBIT 13.2
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LEARNING OBJECTIVE

Use internal rate of

4 return to assess
acceptability of
independent projects.

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 LO 4

INTERNAL RATE OF RETURN

(IRR): Definition

Is the interest rate that sets the

present value of a projects cash
inflows equal to the present
value of a projects cost.

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 LO 4

HONLEY MEDICAL: Background

Honley Medical is considering investing

$1,200,000 in a new ultrasound system
product. Net annual cash inflows of
$499,500 will occur for 3 years. Should
Honley invest in the new product?

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 LO 4

FORMULA: IRR
IRR measures a projects rate of return against
a hurdle rate for accepting projects.

IRR
= Investment Annual cash flows
= $1,200,000 / $499,500
= 2.402 (12%)
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 LO 4

Can IRR be calculated if

the cash flows are uneven?

Yes. But you must use trial &

error, a business calculator, or a
spreadsheet.

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LEARNING OBJECTIVE

5 Discuss the role and

value of postaudits.

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 LO 5

POSTAUDIT: Definition

Compares actual benefits to

estimated benefits & actual
operating costs to estimated
operating costs.

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 LO 5

What happens as a result of

a postaudit?

Evaluation may conclude the

investment worked as expected
or might propose corrective
action.

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 LO 5

POSTAUDIT RESULTS
In the case of Honley Medicals investment in
RF, the postaudit concluded that the
investment was a poor decision. Benefits:
Complaints decreased
Fewer rejections
Direct labor & materials costs decreased
Costs:
Investment & operating costs higher
Costs outweighed benefits
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 LO 5

POSTAUDIT Cost-Benefit Analysis

Benefits
Ensures resources are used wisely
Additional funds for profitable projects
Corrective action when needed
Impacts managerial behavior
Managers held accountable for decisions
Decisions made in best interest of firm
Costs
Costly
Operating environment different from original assumptions

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LEARNING OBJECTIVE

Explain why NPV is

better than IRR for

6 capital investment
decisions of mutually
exclusive projects.

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 LO 6

COMPARING NPV & IRR

Similarities
NPV & IRR yield same decision for independent projects
Differences
Cash inflows: NPV assumes reinvested at same rate but
IRR assumes reinvested at IRR rate
NPV measures profitability in absolute terms but IRR
measures in relative terms
Choosing projects: NPV consistent with maximizing
shareholder wealth while IRR does not always provide
results that will maximize wealth

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 LO 6

SELECTING BEST PROJECTS

Selection process
Assess cash flow pattern for each project
Compute NPV for each project
Identify project with greatest NPV

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 LO 6

HONLEY MEDICAL: Background

Honley Medical is choosing between 2
different processes to prevent production
of contaminants. Design A requires
initial outlay of $180,000 while Design
B requires an initial outlay of $210,000.
Honley Medical has a 12% cost of
capital. Which process should be
selected?
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 LO 6

POLUTION CONTROL
Investment Design A Design B
Annual revenues $179,460 $239,280
Annual operating costs 119,460 169,280
Equipment (before Y1) 180,000 210,000
Project life 5 years 5 years

While both projects offer a 20% return

evaluated by IRR, Design B offers a
NPV of $42,350 while Design A
offers a NPV of $36,300.

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 LO 6

CASH FLOW PATTERNS: Panel A

Cash flow patterns are
even but different as are
investment costs.

EXHIBIT 13.3
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 LO 6

IRR ANALYSIS: Panel B

IRR produces same
result for both
designs.

Design A
EXHIBIT 13.3

Design B
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 LO 6

NPV ANALYSIS: Panel C

Design A
NPV shows that
Design B is best.
EXHIBIT 13.3

Design B

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LEARNING OBJECTIVE

Convert gross cash

7 flows to after-tax
flows.

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 LO 7

COMPUTING CASH FLOWS

To compute project cash flows,

First forecast revenues, expenses, & capital
outlays
Then adjust gross cash flows for inflation & tax
effects

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 LO 7

CASH FLOWS & INFLATION

The project will not

be accepted unless
an inflation
adjustment is done.

EXHIBIT 13-4
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 LO 7

FORMULA: After-Tax Cash

Flows
After-tax cash flows help evaluate project
acceptability.

After-tax cash flows

= After-tax net income + Noncash expenses
= $90,000 + $200,000
= $290,000
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LEARNING OBJECTIVE

Describe capital

8 investment in advanced
manufacturing
environment.

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 LO 8

Is financial information the

only information used to set
criteria for project
evaluation?

NO. Both financial and nonfinancial

information are used to set criteria in
an advanced manufacturing
environment.

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CHAPTER 13

THE END

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