chapter
25(10)
Capital Investment Analysis
______________________________________________
OPENING COMMENTS
Capital investment analysis is a topic that usually receives detailed coverage in introductory finance
courses and/or intermediate accounting. The purpose of this chapter is to give students a brief introduction
Although accounting and finance may be treated as two distinct disciplines in academia, there is no clear
dividing line in today’s business world. Accountants must understand principles of finance in order to
analyze company performance and make recommendations to management. Capital investment analysis is
one of the most important techniques used to plan and control expenditures for fixed assets.
After studying the chapter, your students should be able to:
2. Evaluate capital investment proposals, using the average rate of return and cash payback methods.
4. List and describe factors that complicate capital investment analysis.
5. Diagram the capital rationing process.
KEY TERMS
annuity
average rate of return
capital investment analysis
capital rationing
cash payback period
currency exchange rate
448 Chapter 25(10) Capital Investment Analysis
inflation
internal rate of return (IRR) method
net present value method
present value concept
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?
OBJECTIVE 1
Explain 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
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
operations for many years. Students can view the costs they spend in attending college as a capital
investment in their careers.
Chapter 25(10) Capital Investment Analysis 449
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
rate of return required by management. If the average rate of return exceeds the minimum requirement,
losses from changing economic or business conditions.
Key Terms and Definitions
• Average Rate of Return – A method of evaluating capital investment proposals that focuses on
the expected profitability of the investment.
Relevant Example Exercises and Exhibits
• Example Exercise 25(10)-1 Average Rate of Return
• Example Exercise 25(10)-2 Cash Payback Period
SUGGESTED APPROACH
The text presents four methods of evaluating investment proposals. Data on two potential capital
investments follow [Transparency Master (TM) 25(10)-1]. Use these data to illustrate the various methods
of investment analysis:
Project A Project B
Cost $560,000 $900,000
450 Chapter 25(10) Capital Investment Analysis
Project A Project B
Expected Net Net
Returns Income Cash Flow Income Cash Flow
Year 1 $10,000 $150,000 $100,000 $325,000
Stress that the difference between the annual income and annual cash flows from each project is the
depreciation expense ($140,000 per year for Project A and $225,000 per year for Project B using straight–
line depreciation and ignoring the effect of income taxes).
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
=
Demonstrate the average rate of return for Project A as follows:
$10,000 + $50,000 + $80,000 + $84,000
Estimated Average Annual Income 4
$56,000
=
=
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
Chapter 25(10) Capital Investment Analysis 451
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
An investment in fixed assets may be viewed as purchasing a series of net cash flows over a period of
time. Present value methods use the amount and timing of the net cash flows in evaluating the investment.
Exhibit 2 contains the table for present values. An annuity is a series of equal net cash flows at fixed time
intervals. Cash payments for rent and salaries are both examples of annuities. The present value of an
annuity is the amount of cash needed today to yield a series of equal net cash flows at fixed intervals in
the future. The table in Exhibit 4 demonstrates how to figure the present value of an annuity. 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. The interest rate used in net present value
Key Terms and Definitions
• Annuity – A series of equal cash flows at fixed intervals.
• Internal Rate of Return (IRR) Method – A method of analysis of proposed capital investments
that uses present value concepts to compute the rate of return from the net cash flows expected
from the investment.
• Net Present Value Method – A method of analysis of proposed capital investments that focuses
452 Chapter 25(10) Capital Investment Analysis
• 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 Example Exercises and Exhibits
• Example Exercise 25(10)-3 Net Present Value
• Example Exercise 25(10)-4 Internal Rate of Return
• Exhibit 1 – Compound Amount of $1 for Three Periods at 12%
• Exhibit 2 – Partial Present Value of $1 Table
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.
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.
For example, assume the company considering Projects A and B wants a 15 percent return on any
investment. The present value of Project A’s cash flows would be determined using the present value
table in Exhibit 1 of the text, as follows:
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
Chapter 25(10) Capital Investment Analysis 453
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 2 of the text. After giving your students a
couple of minutes to work, review the following calculations:
Annual Present Value Present Value of
Cash Flow Factor—Annuity Project’s Cash Flows
Because the net present value of this project is positive, it is providing a return above 15 percent.
Therefore, the company should invest in project B.
Your students may find the following notation useful:
If NPV < 0, reject
WRITING EXERCISE—Minimum Rate of Return
Ask your students to write an answer to the following question [TM 25(10)-4]:
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
rate of return expected by investing in similar available opportunities. Additionally, management should
DEMONSTRATION PROBLEM—Present Value Index
TM 25(10)-5 presents six investment alternatives. Under Case I, you will find the net present values for
454 Chapter 25(10) Capital Investment Analysis
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:
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
internal rate of return must be found through trial and error.
Present Present Value of
Cash Flow Value Factor Project’s Cash Flows
Year 1 $150,000 .893 $133,950
Year 2 190,000 .797 151,430
Chapter 25(10) Capital Investment Analysis 455
then
Present Value of Project’s Cash Flows
Present Value Factor for an Annuity = Annual Net Cash Flow
Using data from Project B:
LECTURE AID—Comparing Methods to Evaluate Capital Investments
TMs 25(10)-7 and 25(10)-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
List and 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
456 Chapter 25(10) Capital Investment Analysis
Key Terms and Definitions
• Currency Exchange Rate – The rate at which currency in another country can be exchanged for
Relevant Example Exercises and Exhibits
• Exercise Example 25(10)-5 Net Present Value—Unequal Lives
SUGGESTED APPROACH
Remind students that Chapter 25(10) 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.
DEMONSTRATION PROBLEM—Income Taxes in Capital Investment
Analysis
TM 25(10)-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
Chapter 25(10) Capital Investment Analysis 457
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
LECTURE AID—Qualitative Factors in Evaluating Capital Investments
Capital investment decisions must consider qualitative factors in addition to quantitative analysis. The
group learning activity under Objective 5 will provide your students with an opportunity to consider
qualitative factors in choosing between investment alternatives.
OBJECTIVE 5
Diagram the capital rationing process.
SYNOPSIS
Capital rationing is the process by which management allocate funds among competitive capital
investments. Each potential investment is screened and analyzed using the analysis from this chapter. At
the end of this period, they are ranked and compared for suitability. Selected proposals are put in the
capital expenditure budget.
Key Terms and Definitions
458 Chapter 25(10) Capital Investment Analysis
Relevant Example Exercises 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(10)-10.
Review this TM with your class.
GROUP LEARNING ACTIVITY—Capital Rationing
Handout 25(10)-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.
Handout 25(10)-1
Capital Rationing
Plasticon manufactures plastic containers used to package a variety of liquid consumer
products (such as fabric softener, cleaners, shampoo, hair spray, and liquid soap). The
containers are manufactured on a job-order basis to customer specifications.
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
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
Project A: This proposal requests funds to purchase hardware and software that will allow the
accounting department to process payroll in-house. Paychecks are currently processed by an
outside payroll service company. The annual increase in net income and cash flows will result
from cost savings if the payroll function is no longer contracted to an outside company.
Project D: This proposal requests funds for automated manufacturing equipment that will reduce
the cycle time from receipt of a customer order to delivery of that order. Plasticon’s cycle time is
currently seven days. The automated equipment will reduce that time to four days while saving
costs due to the elimination of five jobs. It will also make Plasticon more competitive; the
company’s major competitor currently has a cycle time of five days.
Project E: This proposal requests funds for computerized drafting and design equipment that will
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%
Type Item Description LO(s) Difficulty Time Est BUSPROG AICPA ACBSP – APC Bloom’s EE Excel GL SMH FAI Service Real World Writing Ethics Internet Group
DQ 1 1 Easy 5 min. Analytic Measurement Payback/ARR Methods Knowledge
DQ 2 2 Easy 5 min. Analytic Measurement Payback/ARR Methods Knowledge
DQ 3 2 Easy 5 min. Analytic Measurement Payback/ARR Methods Knowledge
DQ 4 2 Easy 5 min. Analytic Measurement Payback/ARR Methods Knowledge
DQ 5 2 Easy 5 min. Analytic Measurement Payback/ARR Methods Knowledge
DQ 6 2 Easy 5 min. Analytic Measurement NPV/IRR Methods Knowledge
DQ 7 2 Easy 5 min. Analytic Measurement NPV/IRR Methods Knowledge
DQ 8 2 Easy 5 min. Analytic Measurement NPV/IRR Methods Knowledge
DQ 9 2 Easy 5 min. Analytic Measurement NPV/IRR Methods Knowledge
DQ 10 2 Easy 5 min. Analytic Measurement NPV/IRR Methods Knowledge
DQ 11 3 Easy 5 min. Analytic Measurement NPV/IRR Methods Knowledge
DQ 12 4 Easy 5 min. Analytic Measurement NPV/IRR Methods Knowledge
PE 1A Average rate of return 2 Easy 5 min. Analytic Measurement Payback/ARR Methods Application x
PE 1B Average rate of return 2 Easy 5 min. Analytic Measurement Payback/ARR Methods Application x
PE 2A Cash payback period 2 Easy 5 min. Analytic Measurement Payback/ARR Methods Application x
PE 2B Cash payback period 2 Easy 5 min. Analytic Measurement Payback/ARR Methods Application x
PE 3A Net present value 3 Easy 5 min. Analytic Measurement NPV/IRR Methods Application x
PE 3B Net present value 3 Easy 10 min. Analytic Measurement NPV/IRR Methods Application x
PE 4A Internal rate of return 3 Easy 10 min. Analytic Measurement NPV/IRR Methods Application x
PE 4B Internal rate of return 3 Easy 5 min. Analytic Measurement NPV/IRR Methods Application x
PE 5A Net present value – unequal lives 4 Easy 10 min. Analytic Measurement NPV/IRR Methods Application x
EX 1 Average rate of return 2 Easy 10 min. Analytic Measurement Payback/ARR Methods Application x
EX 2 Average rate of return – cost savings 2 Easy 10 min. Analytic Measurement Payback/ARR Methods Application
EX 3 Average rate of return – new product 2 Easy 10 min. Analytic Measurement Payback/ARR Methods Application x
EX 4 Calculate cash flows 2 Easy 10 min. Analytic Measurement Payback/ARR Methods Application x
EX 5 Cash payback period for a service company 2 Easy 15 min. Analytic Measurement Payback/ARR Methods Application x x
EX 6 Cash payback method 2 Easy 15 min. Analytic Measurement Payback/ARR Methods Application x x
EX 7 Net present value method 3 Easy 15 min. Analytic Measurement NPV/IRR Methods Application x x
EX 8 Net present value method for a service company 3 Moderate 20 min. Analytic Measurement NPV/IRR Methods Application x x
EX 9 Net present value method – annuity for a service company 3 Moderate 20 min. Analytic Measurement NPV/IRR Methods Application x x x
EX 10 Net present value method – annuity 3 Moderate 20 min. Analytic Measurement NPV/IRR Methods Application x
EX 11 Net present value method for a service company 3 Moderate 30 min. Analytic Measurement NPV/IRR Methods Application x x
EX 12 Present value index 3 Easy 15 min. Analytic Measurement NPV/IRR Methods Application x
EX 14 Average rate of return, cash payback period, net present value method for a service company 2,3 Moderate 20 min. Analytic Measurement NPV/IRR Methods Application x x
EX 15 Cash payback period, net present value analysis, and qualitative considerations 2,3,4 Easy 15 min. Analytic Measurement NPV/IRR Methods Application x
EX 16 Internal rate of return method 3 Easy 15 min. Analytic Measurement NPV/IRR Methods Application x
EX 17 Internal rate of return method for a service company 3,4 Easy 10 min. Analytic Measurement NPV/IRR Methods Application x x x
EX 18 Internal rate of return method – two projects 3 Easy 15 min. Analytic Measurement NPV/IRR Methods Application x
EX 19 Net present value method and internal rate of return method for a service company 3 Moderate 20 min. Analytic Measurement NPV/IRR Methods Application x x
EX 20 Identify error in capital investment analysis calculations 3 Easy 10 min. Analytic Measurement NPV/IRR Methods Application x
EX 21 Net present value – unequal lives 3,4 Moderate 20 min. Analytic Measurement NPV/IRR Methods Application x
EX 22 Net present value – unequal lives 3,4 Easy 10 min. Analytic Measurement NPV/IRR Methods Application
PR 1A Average rate of return method, net present value method, and analysis for a service company 2,3 Moderate 1.5 hours Analytic Measurement Payback/ARR Methods Application x x x x
PR 2A Cash payback period, net present value method, and analysis 2,3 Moderate 1.5 hours Analytic Measurement Payback/ARR Methods Application x x
PR 3A Net present value method, present value index, and analysis for a service company 3 Moderate 1 hour Analytic Measurement Payback/ARR Methods Application x x x
PR 4A Net present value method, internal rate of return method, and analysis for a service company 3 Moderate 1.5 hours Analytic Measurement NPV/IRR Methods Application x x
PR 5A Alternative capital investments 3,4 Moderate 1.5 hours Analytic Measurement NPV/IRR Methods Application x x
PR 6A Capital rationing decision for a service company involving four proposals 2,3,5 Challenging 1.5 hours Analytic Measurement Payback/ARR Methods Application x x x
PR 1B Average rate of return method, net present value method, and analysis for a service company 2,3 Moderate 1.5 hours Analytic Measurement Payback/ARR Methods Application x x x x
PR 2B Cash payback period, net present value method, and analysis for a service company 2,3 Moderate 1.5 hours Analytic Measurement Payback/ARR Methods Application x x x
PR 3B Net present value method, present value index, and analysis for a service company 3 Moderate 1 hour Analytic Measurement Payback/ARR Methods Application x x x
PR 4B Net present value method, internal rate of return method, and analysis for a service company 3 Moderate 1.5 hours Analytic Measurement NPV/IRR Methods Application x x
PR 5B Alternative capital investments 3,4 Moderate 1.5 hours Analytic Measurement NPV/IRR Methods Application x x
PR 6B Capital rationing decision for a service company involving four proposals 2,3,5 Challenging 1.5 hours Analytic Measurement Payback/ARR Methods Application x x x
CP 1 Ethics and professional conduct in business 1 Easy 15 min. Ethics Measurement NPV/IRR Methods Analysis x x
CP 2 Personal investment analysis for a service company 2 Moderate 30 min. Analytic Measurement NPV/IRR Methods Application x x
CP 3 Changing prices 3 Moderate 30 min. Analytic Measurement NPV/IRR Methods Analysis x
CP 4 Qualitative issues in investment analysis 3 Moderate 30 min. Analytic Measurement NPV/IRR Methods Analysis x x
CP 5 Net present value method for a service company 2,3 Moderate 30 min. Analytic Measurement NPV/IRR Methods Application x x x x
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