chapter
26
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
to the basics of capital investment analysis using the following methods: average rate of return, cash
payback, net present value, and internal rate of return.
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.
STUDENT FAQS
126 Chapter 26 Capital Investment Analysis
• 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
Explain the nature and importance of capital investment analysis.
KEY TERMS
Capital Investment Analysis Time Value of Money Concept
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.
OBJECTIVE 2
Evaluate capital investment proposals using the average rate of return and cash payback
methods.
KEY TERMS
Average Rate of Return Cash Payback Period
SUGGESTED APPROACH
The text presents four methods of evaluating investment proposals. Data on two potential capital
investments follow (Transparency Master [TM] 26-1). Use these data to illustrate the various methods of
investment analysis:
Chapter 26 Capital Investment Analysis 127
Project A Project B
Cost $560,000 $900,000
Expected life 4 years 4 years
Expected residual value $0 $0
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
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
=
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:
128 Chapter 26 Capital Investment Analysis
Annual Cash Flow Cumulative Cash Flow
Year 1 $150,000 $150,000
OBJECTIVE 3
Evaluate capital investment proposals using the net present value and internal rate of
return methods.
KEY TERMS
Annuity Present Value Concept
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 14 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.
Chapter 26 Capital Investment Analysis 129
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
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
$325,000 2.855 $927,875
Your students may find the following notation useful:
If NPV > 0, invest
WRITING EXERCISE — Minimum Rate of Return
Ask your students to write an answer to the following question (TM 26-4):
What are some of the factors that management would consider in setting the minimum rate
of return for investments?
130 Chapter 26 Capital Investment Analysis
Possible response: In setting the rate of return on investments, management should consider the market
DEMONSTRATION PROBLEM — Present Value Index
TM 26-5 presents six investment alternatives. Under Case I, you will find the net present values for three
projects that all require the same initial investment. If a company evaluating these projects could invest in
only one, it should choose the project with the highest net present value.
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.
For example, you previously demonstrated that the return on Project A (from TM 26-1) 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
Cash Flow Value Factor Project’s Cash Flows
Chapter 26 Capital Investment Analysis 131
Because the net present value of Project A is positive when discounted at 12 percent, its rate of return is
greater than 12 percent. Therefore, you can conclude that Project A’s internal rate of return is between 12
and 15 percent.
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
LECTURE AID — Comparing Methods to Evaluate Capital Investments
TMs 26-7 and 26-8 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.
132 Chapter 26 Capital Investment Analysis
OBJECTIVE 4
List and describe factors that complicate capital investment analysis.
KEY TERMS
Currency Exchange Rate Inflation
SUGGESTED APPROACH
Remind students that Chapter 26 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 26-1 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
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):
Chapter 26 Capital Investment Analysis 133
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.
KEY TERM
Capital Rationing
SUGGESTED APPROACH
134 Chapter 26 Capital Investment Analysis
GROUP LEARNING ACTIVITY — Capital Rationing
Handout 26-1 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
Handout 26-1
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
that has an average rate of return of less than 15 percent or a cash payback period of longer
than five years should be eliminated from further consideration. After this initial screening,
compute the net present value (using a 15 percent discount rate) and internal rate of return for
the remaining projects. Rank the projects based on both their profitability and overall merit to the
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
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 B: This proposal requests funds for new manufacturing equipment. This equipment will
allow Plasticon to make containers as large as ten gallons. Currently, Plasticon can not make
containers that are larger than three gallons.
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
DIFFICULTY BUSPROG ACBSP ACBSP IMA BLOOM’S TIME
Problem
Learning
Objective
Description Primary Primary Secondary
Managerial
Only
Spread-
sheet
DQ26-1 26-1 Easy Analytic Payback/ARR Methods
Investment
Decisions
Knowledge 5 min.
DQ26-2 26-2 Easy Analytic Payback/ARR Methods
Investment
Decisions
Knowledge 5 min.
Investment
DQ26-3 26-2 Easy Analytic Payback/ARR Methods
Decisions
Knowledge 5 min.
DQ26-4 26-2 Easy Analytic Payback/ARR Methods
Decisions
Knowledge 5 min.
Investment
Investment
DQ26-5 26-2 Easy Analytic Payback/ARR Methods
Decisions
Knowledge 5 min.
DQ26-6 26-2 Easy Analytic NPV/IRR Methods
Decisions
Knowledge 5 min.
Investment
Investment
DQ26-7 26-2 Easy Analytic NPV/IRR Methods
Decisions
Knowledge 5 min.
DQ26-8 26-2 Easy Analytic NPV/IRR Methods
Investment
Decisions
Knowledge 5 min.
DQ26-9 26-2 Easy Analytic NPV/IRR Methods
Decisions
Knowledge 5 min.
DQ26-10 26-2 Easy Analytic NPV/IRR Methods
Investment
Decisions
Knowledge 5 min.
DQ26-11 26-3 Easy Analytic NPV/IRR Methods
Decisions
Knowledge 5 min.
DQ26-12 26-4 Easy Analytic NPV/IRR Methods
Investment
Decisions
Knowledge 5 min.
Investment
PE26-1A 26-2 Average rate of return Easy Analytic Payback/ARR Methods
Decisions
Application 5 min.
PE26-1B 26-2 Average rate of return Easy Analytic Payback/ARR Methods
Investment
Decisions
Application 5 min.
PE26-2A 26-2 Cash payback period Easy Analytic Payback/ARR Methods
Decisions
Application 5 min.
PE26-2B 26-2 Cash payback period Easy Analytic Payback/ARR Methods
Decisions
Application 5 min.
PE26-3A 26-3 Net present value Easy Analytic NPV/IRR Methods
Decisions
Application 5 min.
PE26-3B 26-3 Net present value Easy Analytic NPV/IRR Methods
Investment
Decisions
Application 10 min.
HOMEWORK CHART WITH LEARNING OUTCOMES TAGGING
DIFFICULTY BUSPROG ACBSP ACBSP IMA BLOOM’S TIME
Problem
Learning
Objective
Description Primary Primary Secondary
Managerial
Only
Spread-
sheet
PE26-4A 26-3 Internal rate of return Easy Analytic NPV/IRR Methods
Investment
Decisions
Application 10 min.
Investment
PE26-4B 26-3 Internal rate of return Easy Analytic NPV/IRR Methods
Decisions
Application 5 min.
PE26-5A 26-4 Net present value—unequal lives Easy Analytic NPV/IRR Methods
Investment
Decisions
Application 10 min.
PE26-5B 26-4 Net present value—unequal lives Easy Analytic NPV/IRR Methods
Decisions
Application 10 min.
Ex26-1 26-2 Average rate of return Easy Analytic Payback/ARR Methods
Investment
Decisions
Application 10 min.
Ex26-2 26-2
Average rate of return— cost
savings Easy Analytic Payback/ARR Methods
Investment
Decisions
Application 10 min.
Ex26-3 26-2 Average rate of return—new product Easy Analytic Payback/ARR Methods
Investment
Decisions
Application 10 min.
Ex26-4 26-2 Calculate cash flows Easy Analytic Payback/ARR Methods
Decisions
Application 10 min.
Ex26-5 26-2 Cash payback period Easy Analytic Payback/ARR Methods
Investment
Decisions
Application 15 min.
Investment
Ex26-6 26-2 Cash payback method Easy Analytic Payback/ARR Methods
Decisions
Application 15 min. X
Ex26-7 26-3 Net present value method Easy Analytic NPV/IRR Methods
Decisions
Application 15 min.
Ex26-8 26-3 Net present value method Moderate Analytic NPV/IRR Methods
Decisions
Application 20 min.
Ex26-9 26-3 Net present value method-annuity Moderate Analytic NPV/IRR Methods
Investment
Decisions
Application 20 min.
Ex26-10 26-3 Net present value method-annuity Moderate Analytic NPV/IRR Methods
Investment
Decisions
Application 20 min.
Investment
Ex26-12 26-3 Present value index Easy Analytic NPV/IRR Methods
Decisions
Application 15 min.
Ex26-13 26-3
Net present value method and
present value index
Moderate Analytic NPV/IRR Methods
Investment
Decisions
Application 20 min.
Ex26-14 26-2, 26-3
method
Moderate Analytic NPV/IRR Methods
Decisions
Application 20 min.
DIFFICULTY BUSPROG ACBSP ACBSP IMA BLOOM‘S TIME
Problem
Learning
Objective
Description Primary Primary Secondary
Managerial
Only
Spread-
sheet
Ex26-15
26-2, 26-3,
analysis, and qualitative
Investment
26-4
considerations
Easy Analytic NPV/IRR Methods
Decisions
Application 15 min.
Investment
Investment
Ex26-17 26-3, 26-4 Internal rate of return of method Easy Analytic NPV/IRR Methods
Decisions
Application 10 min.
Ex26-18 26-3
Internal rate of return method- two
projects
Easy Analytic NPV/IRR Methods
Investment
Decisions
Application 15 min.
Ex26-19 26-3
Net present value method and
internal rate of return method
Moderate Analytic NPV/IRR Methods
Investment
Decisions
Application 20 min.
Ex26-20 26-3
Identify error in capital investment
analysis calculations
Easy Analytic NPV/IRR Methods
Investment
Decisions
Application 10 min.
Investment
Ex26-21 26-3, 26-4 Net present value-unequal lines Moderate Analytic NPV/IRR Methods
Decisions
Application 20 min. X
Ex26-22 26-3, 26-4 Net present value-unequal lines Easy Analytic NPV/IRR Methods
Investment
Decisions
Application 10 min.
Average rate of return method, net
Investment
Pr26-1A 26-2, 26-3
present value method, and analysis
Moderate Analytic Payback/ARR Methods NPV/IRR Methods
Decisions
Application 1.5 hours X
Pr26-2A 26-2, 26-3
Cash payback period, net present
value method, and analysis
Moderate Analytic Payback/ARR Methods NPV/IRR Methods
Investment
Decisions
Application 1.5 hours X
Pr26-3A 26-3
Net present value method, present
value index, and analysis
Moderate Analytic Payback/ARR Methods NPV/IRR Methods
Investment
Decisions
Application 1 hour X
Pr26-4A 26-3
Net present value method, internal
rate of return method, and analysis
Moderate Analytic NPV/IRR Methods
Investment
Decisions
Application 1.5 hours
Evaluate alternative capital
Investment
Pr26-5A 26-3, 26-4
investment decisions
Moderate Analytic NPV/IRR Methods
Decisions
Application 1.5 hours X
Pr26-6A
26-2, 26-3,
26-5
Capital rationing decision involving
four proposals
Challenging Analytic Payback/ARR Methods NPV/IRR Methods
Investment
Decisions
Application 1.5 hours X
Pr26-1B 26-2, 26-3
Average rate of return method, net
present value method, and analysis
Moderate Analytic Payback/ARR Methods NPV/IRR Methods
Investment
Decisions
Application 1.5 hours X
Pr26-2B 26-2, 26-3
Cash payback period, net present
value method, and analysis
Moderate Analytic Payback/ARR Methods NPV/IRR Methods
Investment
Decisions
Application 1.5 hours X
Pr26-3B 26-3
value index, and analysis
Moderate Analytic Payback/ARR Methods NPV/IRR Methods
Decisions
Application 1 hour X
Net present value method, present
Investment
Pr26-4B 26-3
rate of return method, and analysis
Moderate Analytic NPV/IRR Methods
Decisions
Application 1.5 hours
DIFFICULTY BUSPROG ACBSP ACBSP IMA BLOOM’S TIME
Problem
Learning
Objective
Description Primary Primary Secondary
Managerial
Only
Spread-
sheet
Pr26-5B 26-3, 26-4
Evaluate alternative capital
investment decisions
Moderate Analytic NPV/IRR Methods
Investment
Decisions
Application 1.5 hours X
Pr26-6B
26-3, 26-3,
26-5
Capital rationing decision involving
four proposals
Challenging Analytic Payback/ARR Methods NPV/IRR Methods
Investment
Decisions
Application 1.5 hours X
CP26-1 26-1
business
Decisions
Analysis 15 min.
Investment
Ethics and professional conduct in
Investment
CP26-2 26-2 Personal investment analysis Moderate Analytic NPV/IRR Methods
Decisions
Application 30 min.
CP26-3 26-3 Changing prices Moderate Analytic NPV/IRR Methods
Decisions
Analysis 30 min.
Qualitative issues in investment
Investment
Investment
CP26-4 26-3
analysis
Moderate Analytic NPV/IRR Methods
Methods
Decisions
Analysis 30 min.
CP26-5 26-2, 26-3 Net present value method Moderate Analytic NPV/IRR Methods
Decisions
Application 30 min.
Investment
CP26-6 26-3 Capital investment analysis Moderate Analytic NPV/IRR Methods
Decisions
Analysis 1.5 hours