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Chapter 25(11) Capital Investment Analysis 454
Under Case II, each project requires a different initial investment. Therefore, a present value index is
helpful in choosing the most attractive investment from this group. Ask your students to calculate the
present value index for each project using the following formula:
Total Present Value of Net Cash Flows
Present Value Index = Amount to be Invested
The correct present value indexes are shown on TM 25(11)-6. Stress that Project B has the highest net
present value but the lowest net present value index. This occurs because of the relatively high investment
required by Project B.
DEMONSTRATION PROBLEM—Internal Rate of Return
Internal rate of return (IRR) uses present value concepts to determine the rate earned on an investment.
Under the internal rate of return method, students “work backwards” to find the discount rate where a
project’s net present value is zero. For projects that have cash flows that vary from year to year, the
For example, you previously demonstrated that the return on Project A [from TM 25(11)-1] is less than
15 percent, because the project’s net present value was negative when discounted at 15 percent. Ask your
students to determine the net present value of the project using a 12 percent discount rate. After allowing
a couple of minutes for them to work, share the following calculation:
Present Present Value of
Year 1 $150,000 .893 $133,950
Year 2 190,000 .797 151,430
Year 3 220,000 .712 156,640
Year 4 224,000 .636 142,464
Total $584,484
Amount to be invested 560,000
Net present value $ 24,484
and 15 percent.
With the present value table in text Exhibit 2, that is as close as you can get in estimating Project A’s
internal rate of return. This range could be narrowed using a present value table that contains more
interest rate possibilities, a computer, or a calculator that includes present value capabilities.
Chapter 25(11) Capital Investment Analysis 455
For example, Project B costs $900,000 and has cash flows of $325,000 per year. Previous calculations
Therefore, if
Annual Net Present Value Factor Present Value of
Cash Flow for an Annuity Project's Cash Flows
then
Present Value of Project's Cash Flows
Present Value Factor for an Annuity = Annual Net Cash Flow
Using data from Project B:
$900,000
Present Value Factor for an Annuity = = 2.769
$325,000
5. Because 2.769 is between 2.855 (15 percent) and 2.589 (20 percent), the internal rate of return is
between 15 and 20 percent.
LECTURE AID—Comparing Methods to Evaluate Capital Investments
TMs 25(11)-7 and 25(11)-8 summarize the advantages and disadvantages of these four methods of
evaluating capital investments. As you review this TM, emphasize that non-present value methods are
often used to screen proposals. They also are appropriate for investments that have short lives.
OBJECTIVE 4
Describe factors that complicate capital investment analysis.
SYNOPSIS
Besides the prior methods used to evaluate capital investments in the chapter, there are many other
factors. These factors include income tax, proposals with unequal lives, leasing versus purchasing,
uncertainty, changes in price levels, and qualitative factors. The impact of income tax can be material if
the business is paying the corporate rate of 35%. Unequal lives of the investments make it difficult to
compare them. Leasing assets versus buying has several cash flow and tax implications. Many of the
assumptions that are factored into the decisions making process are uncertain. Price level changes and
inflation affect return on investment. Also, exchange rate of foreign currency may change the cash flows
of the investment. There are also qualitative factors that may have an impact on the investment.
Chapter 25(11) Capital Investment Analysis 456
Key Terms and Definitions
Currency Exchange Rate—The rate at which currency in another country can be exchanged for
local currency.
Inflation—A period when prices in general are rising and the purchasing power of money is
declining.
Relevant Check Up Corner and Exhibits
Exhibit 10—Net Present Value Analysis—Unequal Lives of Proposals
Exhibit 11—Net Present Value Analysis—Equalized Lives of Proposals
Check Up Corner 25(11)-3 – Net Present Value-Unequal Lives
SUGGESTED APPROACH
Remind students that Chapter 25(11) is only an introduction to capital budgeting. The factors that
complicate capital budgeting, which were ignored in previous examples, include income taxes; the effect
of unequal proposal lives; the possibility of leasing, rather than purchasing, assets; uncertainty related to
cash flows and interest rates; and changes in price levels due to inflation.
Emphasize that capital investment analysis uses estimates of future costs to make decisions. In response
to the uncertainties of estimates, including the impact of inflation, many accountants perform sensitivity
analyses using microcomputers. Such analyses can examine the impact of varying different assumptions
about future revenues, costs, investment life, or inflation.
Because income taxes can have a profound influence on capital investment analysis, you may want to
share an example of their impact using the following demonstration problem.
DEMONSTRATION PROBLEM—Income Taxes in Capital Investment
Analysis
TM 25(11)-1 presented two projects that were used to illustrate capital investment analysis. Some of the
relevant information from Project A is recapped as follows:
Cost: $560,000
Life: 4 years
Depreciation per year: $140,000 (straight line)
Net cash flow—year 1: $150,000
Net income—year 1: $10,000
The difference between the project’s net cash flow and net income was explained as the yearly
depreciation charge, which is a noncash expense.
Income taxes were ignored in this example. In reality, the $150,000 net cash flow was a pre-tax net cash
flow. To show the cash flows on an after-tax basis, income taxes must be subtracted.
Chapter 25(11) Capital Investment Analysis 457
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Assume that this company was in a 30 percent tax bracket. The after-tax net cash flows would be
calculated as follows:
Taxes paid (based on the company’s net income):
$10,000 30% = $3,000
After-tax net cash flow:
Before-tax net cash flow $150,000
Less taxes paid 3,000
$147,000
Emphasize that depreciation is deductible for tax purposes. Therefore, the company pays taxes on its net
income, not its net cash flow. Because taxes would have been $45,000 without this deduction ($150,000
30% = $45,000), the depreciation deduction saves $42,000 in taxes ($140,000 30%).
LECTURE AID—Qualitative Factors in Evaluating Capital Investments
TM 25(11)-9 lists several qualitative factors that are important in today’s technology driven
manufacturing environment. The “competitive squeeze” felt by many companies is forcing business to
look beyond the numbers and consider investments based on their ability to help the firm compete in a
global marketplace. TM 25(11)-9 lists many of the important qualitative issues to consider before
investing in factory automation.
OBJECTIVE 5
Describe and diagram the capital rationing process.
SYNOPSIS
capital expenditure budget.
Key Terms and Definitions
Capital Rationing—The process by which management plans, evaluates, and controls long-term
capital investments involving fixed assets.
Chapter 25(11) Capital Investment Analysis 458
Relevant Check Up Corner and Exhibits
Exhibit 12—Capital Rationing Decision Process
SUGGESTED APPROACH
Capital rationing occurs whenever limited funds force management to choose only a few of the capital
investment projects under consideration. The capital rationing process is outlined on TM 25(11)-10.
Review this TM with your class.
GROUP LEARNING ACTIVITY—Capital Rationing
Handout 25(11)-1 is a capital rationing problem. It asks your students to evaluate five capital budgeting
proposals. These proposals are to be ranked in the order they should be funded based on each project’s net
present value, internal rate of return, and qualitative value to the company. Average rate of return and
cash payback period are used to screen the five proposals.
ADM OBJECTIVE
Describe and illustrate the use of capital investment analysis in evaluating a sustainability
investment.
SYNOPSIS
Sustainability is the practice of operating a business to maximize profits while attempting to preserve the
Relevant Check Up Corner and Exhibits
Exhibit 13—Examples of Sustainability Capital Investments
Make A Decision – Capital Investment for Sustainability
Handout 25(11)-1
Capital Rationing
Plasticon manufactures plastic containers used to package a variety of liquid consumer
Plasticon has received five proposals for capital investment projects. Your job is to evaluate
these proposals and rank them in the order in which they should be funded. Begin your analysis
by computing the average rate of return and cash payback period for each proposal. Any project
that has an average rate of return of less than 15 percent or a cash payback period of longer
corporation (qualitative factors).
Projects: A B C D E
Cost $200,000 $250,000 $325,000 $500,000 $400,000
Life (in years) 8 10 10 10 8
Residual value $0 $0 $0 $0 $0
Annual project income $17,000 $18,000 $33,000 $55,000 $45,000
Annual net cash flows $42,000 $43,000 $65,500 $105,000 $95,000
containers that are larger than three gallons.
Project C: This proposal requests funds for equipment to make stick-on labels that are applied
to the plastic containers. Currently, all stick-on labels are ordered from another company. This
supplier has not proven very reliable in meeting delivery deadlines.
allow engineers to complete manufacturing instructions on special orders more quickly. This
equipment should reduce Plasticon’s cycle time from seven to five days.
Present Value of an Annuity of $1 at Compound Interest
Period 12% 13% 14% 15% 16% 17% 18%
8 4.968 4.799 4.639 4.487 4.344 4.207 4.078
10 5.650 5.426 5.216 5.019 4.833 4.659 4.494
Type Item Description Video Excel CLGL LO(s) Difficulty Time Est BUSPROG AICPA
ACBSP - Primary Bloom's ADM Service Real World
Writing
Ethics
MC 1 1 Easy 5 min. Analytic FN - Measurement NPV/IRR Methods Applying
MC 2 2 Easy 5 min. Analytic FN - Measurement NPV/IRR Methods Applying
MC 3 2 Easy 5 min. Analytic FN - Measurement NPV/IRR Methods Applying
MC 4 3 Easy 5 min. Analytic FN - Measurement NPV/IRR Methods Applying
PP Problem n/a Moderate 1 hour Analytic FN - Measurement NPV/IRR Methods Applying
DQ 1 n/a Easy 5 min. Analytic FN - Measurement Payback/ARR Methods Remembering
DQ 2 n/a Easy 5 min. Analytic FN - Measurement Payback/ARR Methods Remembering
DQ 3 n/a Easy 5 min. Analytic FN - Measurement Payback/ARR Methods Remembering
DQ 10 n/a Easy 5 min. Analytic FN - Measurement NPV/IRR Methods Remembering
DQ 11 n/a Easy 5 min. Analytic FN - Measurement NPV/IRR Methods Remembering
DQ 12 n/a Easy 5 min. Analytic FN - Measurement NPV/IRR Methods Remembering
BE 1 Average rate of return x 2 Easy 5 min. Analytic FN - Measurement Payback/ARR Methods Applying
EX 3 Average rate of return - new product x 2 Easy 10 min. Analytic FN - Measurement Payback/ARR Methods Applying
EX 4 Calculate cash flow s x 2 Easy 10 min. Analytic FN - Measurement Payback/ARR Methods Applying
EX 5 Cash payback period for a service company x 2 Easy 15 min. Analytic FN - Measurement Payback/ARR Methods Applying x
EX 6 Cash payback method x 2 Easy 15 min. Analytic FN - Measurement Payback/ARR Methods Applying x
EX 13 Net present value method and present value index 3 Moderate 20 min. Analytic FN - Measurement NPV/IRR Methods Applying x
EX 14
Average rate of return, cash payback period, net present value me
x 2,3 Moderate 20 min. Analytic FN - Measurement NPV/IRR Methods Applying x
EX 15 Cash payback period, net present value analysis, and qualitative considerations 2,3,4 Easy 15 min. Analytic FN - Measurement NPV/IRR Methods Applying x
EX 16 Internal rate of return method x 3 Easy 15 min. Analytic FN - Measurement NPV/IRR Methods Applying
EX 18 Internal rate of return method - two projects 3 Easy 15 min. Analytic FN - Measurement NPV/IRR Methods Applying x
EX 19 Net present value method and internal rate of return method for a service company 3 Moderate 20 min. Analytic FN - Measurement NPV/IRR Methods Applying x x
EX 20 Identify error in capital investment analysis calculations 3 Easy 10 min. Analytic FN - Measurement NPV/IRR Methods Applying x
PR 5A Alternative capital investments x 3,4 Moderate 1.5 hours Analytic FN - Measurement NPV/IRR Methods Applying x
PR 6A
Capital rationing decision for a service company involving four proposals
x 2,3,5 Challenging 1.5 hours Analytic FN - Measurement Payback/ARR Methods Applying x
PR 1B
Average rate of return method, net present value method, and an
x x 2,3 Moderate 1.5 hours Analytic FN - Measurement Payback/ARR Methods Applying x
PR 2B
Cash payback period, net present value method, and analysis for a servic
x 2,3 Moderate 1.5 hours Analytic FN - Measurement Payback/ARR Methods Applying x x
PR 3B
Net present value method, present value index, and analysis for a service
x 3 Moderate 1 hour Analytic FN - Measurement Payback/ARR Methods Applying x x
PR 5B Alternative capital investments x 3,4 Moderate 1.5 hours Analytic FN - Measurement NPV/IRR Methods Applying x
ADM 1 Wind turbine capital investment analysis ADM Moderate 20 min. Analytic FN - Measurement NPV/IRR Methods Applying
TIF 1 Ethics in action n/a Easy 15 min. Ethics FN - Reporting NPV/IRR Methods Analyzing x x
TIF 2 Team activity n/a Moderate 1.5 hours Analytic FN - Measurement NPV/IRR Methods Applying x x
TIF 3 Communication n/a Moderate 30 min. Analytic FN - Measurement NPV/IRR Methods Analyzing x
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