chapter
25(11)
Capital Investment Analysis
______________________________________________
OPENING COMMENTS
Although accounting and finance may be treated as two distinct disciplines in academia, there is no clear
After studying the chapter, your students should be able to:
1. Describe the nature and importance of capital investment analysis.
2. Evaluate capital investment proposals, using the average rate of return and cash payback methods.
3. Evaluate capital investment proposals, using the net present value and internal rate of return methods.
4. Describe factors that complicate capital investment analysis.
5. Describe and diagram the capital rationing process.
ADM: Describe and illustrate the use of capital investment analysis in evaluating a sustainability
investment.
KEY TERMS
annuity
average rate of return
capital investment analysis
capital rationing
Chapter 25(11) Capital Investment Analysis 448
cash payback period
currency exchange rate
inflation
internal rate of return (IRR) method
net present value method
present value concepts
present value index
present value of an annuity
time value of money concept
STUDENT FAQS
Why does capital investment seem to be so important and affect several years?
Which method of evaluating capital investment is the best to use?
Should we apply all formulas used in this chapter, then evaluate from there? Or should we just use
present value method?
How does management decide the minimum rate of return in capital investment?
Which factors complicate capital investment analysis?
OBJECTIVE 1
Describe the nature and importance of capital investment analysis.
SYNOPSIS
The process by which management plans, evaluates, and controls investments in fixed assets is called
capital investment analysis. Capital investments use funds and affect operations for many years and must
earn a reasonable rate of return. Capital investments can be evaluated using methods that use present
values or by methods that do not use present values. Both methods consider the time value of money; this
recognizes that a dollar today is worth more than a dollar tomorrow.
Key Terms and Definitions
Capital Investment Analysis—The process by which management plans, evaluates, and controls
long-term capital investments involving property, plant, and equipment.
Time Value of Money Concept—The concept that an amount of money invested today will earn
income.
SUGGESTED APPROACH
Capital investment analysis is the process by which management plans, evaluates, and controls
investments in fixed assets. Explain that capital investment decisions are some of the most important
decisions made by management because they (1) frequently involve large sums of money and (2) affect
Chapter 25(11) Capital Investment Analysis 449
operations for many years. Students can view the costs they spend in attending college as a capital
investment in their careers.
OBJECTIVE 2
Evaluate capital investment proposals, using the average rate of return and cash payback
methods.
SYNOPSIS
If the capital investment has a relatively short life span, methods not using the present value are useful.
The average rate of return method is computed as average rate of return = estimated average annual
income/average investment where average investment is calculated as: average investment = (initial cost
+ residual value)/2. The average rate of return from this calculation should be compared to the minimum
cash is recovered, the sooner the cash can be invested in other projects. In addition, there is less chance of
losses from changing economic or business conditions.
Key Terms and Definitions
Average Rate of Return—A method of evaluating capital investment proposals that measures
Relevant Check Up Corner and Exhibits
Check Up Corner 25(11)-1 – Capital Investment Analysis Not Using Present Value
SUGGESTED APPROACH
The text presents four methods of evaluating investment proposals. Data on two potential capital
investments follow [Transparency Master (TM) 25(11)-1]. Use these data to illustrate the various methods
of investment analysis:
Project A Project B
Cost $560,000 $900,000
Expected life 4 years 4 years
Expected residual value $0 $0
Chapter 25(11) Capital Investment Analysis 450
Project A Project B
Expected Net Net
Returns Income Cash Flow Income Cash Flow
Year 1 $10,000 $150,000 $100,000 $325,000
Year 2 50,000 190,000 100,000 325,000
Year 3 80,000 220,000 100,000 325,000
Year 4 84,000 224,000 100,000 325,000
DEMONSTRATION PROBLEM—Average Rate of Return
Average rate of return measures the profitability of an investment. The formula for average rate of return
is as follows:
Estimated Average Annual Income
Average Rate of Return Average Investment
$10,000 + $50,000 + $80,000 + $84,000
Estimated Average Annual Income 4
$56,000
$560,000 + 0
Average Investment = = $280,000
2
$56,000
Average Rate of Return = 20%
$280,000
(Answer: $100,000/$450,000 = 22%).
DEMONSTRATION PROBLEM—Cash Payback Method
Explain that the cash payback period is the amount of time (in years) it takes to recover the cash invested
in a project. A project’s annual cash flows are used to determine the cash payback period.
For example, the cash payback period for Project A would be calculated as follows:
Annual Cash Flow Cumulative Cash Flow
Year 1 $150,000 $150,000
Year 2 190,000 340,000
Year 3 220,000 560,000
Chapter 25(11) Capital Investment Analysis 451
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The $560,000 investment is recovered in three years.
Ask your students to calculate the payback period for Project B and write it in their notes. (Answer:
$900,000/325,000 = 2.8 yrs.)
OBJECTIVE 3
Evaluate capital investment proposals, using the net present value and internal rate of
return methods.
SYNOPSIS
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. The interest rate used in net present value
analysis is the company’s minimum desired rate of return, called the hurdle rate. The net present value
method is demonstrated in Exhibit 6. Multiple investments can be ranked using the present value index.
their internal rate of return. The proposal with the highest rate of return is the most desirable. This method
has three advantages: it considers the cash flows of the investment, it considers the time value of money,
and it ranks proposals based on the cash flows from their complete useful life. This method also has two
disadvantages: it involves complex computations and it assumes the cash received from a proposal can be
reinvested at the internal rate of return.
Key Terms and Definitions
from the investment.
Net Present Value Method—A method of analysis of proposed capital investments that focuses
on the present value of the cash flows expected from the investments.
Present Value Concept—Cash to be received (or paid) in the future is not the equivalent of the
same amount of money received at an earlier date.
Chapter 25(11) Capital Investment Analysis 452
Present Value of an Annuity—The sum of the present values of a series of equal cash flows to
be received at fixed intervals.
Relevant Check Up Corner and Exhibits
Exhibit 2—Partial Present Value of $1 Table
Exhibit 3—Present Value of an Amount of $1.404
Exhibit 4—Present Value of a $100 Amount for Five Consecutive Periods
Exhibit 5—Partial Present Value of an Annuity Table
Exhibit 6—Present Value of Equipment Cash Flows
Exhibit 7—Net Present Value Analysis at 12%
GROUP LEARNING ACTIVITY—Present Value Concepts
Prior to covering the net present value and internal rate of return methods of evaluating capital
investments, you may want to briefly review present value concepts. These concepts were introduced in
Chapter 12 when covering the accounting for bonds.
displayed on TM 25(11)-3.
DEMONSTRATION PROBLEM—Net Present Value
Under the net present value method, the present values of the cash flows from a project are compared to
the amount that must be invested in the project.
Present Present Value of
Cash Flow Value Factor Project’s Cash Flows
Year 1 $150,000 .870 $130,500
Year 2 190,000 .756 143,640
Year 3 220,000 .658 144,760
Year 4 224,000 .572 128,128
Total $547,028
Amount to be invested 560,000
Net present value $ (12,972)
Chapter 25(11) Capital Investment Analysis 453
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Because the net present value of this project is negative, its cash flows are not providing the minimum 15
percent return required by the company. Therefore, the project should be rejected.
Ask your students to determine the net present value of Project B and write it in their notes. Remind them
that Project B has equal cash flow amounts in each of the four years of the project. Therefore, it may be
valued as an annuity using the present value table in Exhibit 5 of the text. After giving your students a
couple of minutes to work, review the following calculations:
Annual Present Value Present Value of
$325,000 2.855 $927,875
Amount to be invested 900,000
Net present value $ 27,875
Because the net present value of this project is positive, it is providing a return above 15 percent.
Your students may find the following notation useful:
If NPV > 0, invest
If NPV = 0, invest where NPV = net present value
If NPV < 0, reject
WRITING EXERCISE—Minimum Rate of Return
What are some of the factors that management would consider in setting the minimum rate
of return for investments?
Possible response: In setting the rate of return on investments, management should consider the market
cost, providing a competitive advantage.
You can use this writing exercise to stimulate a discussion on the cost of capital and the relationship
between risk and return.
DEMONSTRATION PROBLEM—Present Value Index