planning for capital investments chapter 16 mcgraw-hill/irwin copyright 2012 by the mcgraw-hill...
DESCRIPTION
16-3 Capital Investment Decisions Purchases of long-term operational assets are capital investments. Once a company purchases operational assets, it is committed to these investments for an extended period of time. Understanding the time value of money concept will help you make rational capital investment decisions.TRANSCRIPT
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Planning for Capital
InvestmentsChapter
16
McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
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16-2
Learning Objectives1.Explain the time value of money concept and
apply it to capital investment decisions.2.Determine the present value of future cash flows.3.Determine and interpret the net present value of
an investment opportunity.4.Determine and interpret the internal rate of
return of an investment opportunity.5. Identify cash flows associated with an investment
opportunity.6.Compare capital investment alternatives.7.Determine the payback period for an investment
opportunity.8.Determine the unadjusted rate of return for an
investment opportunity.9.Conduct a postaudit of a completed investment.
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16-3
Capital Investment Decisions
Purchases of long-term operational assets are capital investments. Once a company purchases operational assets, it is committed to these investments for
an extended period of time. Understanding the time value of money
concept will help you make rational capital investment decisions.
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Time Value of MoneyThis concept recognizes that the present value of a dollar received in the future is
less than today’s dollar. The further into the future the receipt is expected to occur, the
smaller its present value.When a company When a company invests in capital invests in capital
assets, it sacrifices assets, it sacrifices present dollars in present dollars in exchange for the exchange for the
opportunity to receive opportunity to receive future dollars.future dollars.
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Minimum Rate of ReturnMost companies consider the cost of capital to be the minimum expected return on investment opportunities. Creditors expect interest payments; in most companies, owners expect dividends and increased stock value. The blend of creditors and owners costs is considered the cost of capital for an organization.
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Capital Investment ProposalsNet Present Value
Subtracting the cost of the investment from the present value of future cash
inflows determines the net present value of the investment opportunity. A positive net present value indicates the investment will
yield a rate of return higher than the required return. A negative net present value means the return is less than the
required return.
Let’s look at an example.
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16-7
Internal Rate of ReturnThe internal rate of return is the rate at The internal rate of return is the rate at which the present value of cash inflows which the present value of cash inflows
equalsequals cash outflows. cash outflows.We compute a present value factor by dividing the cost of the
investment by the annual cash inflow, in our case:
$582,742 ÷ $200,000 = 2.913712Period 8% 10% 12% 14%
1 0.925926 0.909091 0.892857 0.877193 2 1.783265 1.735537 1.690051 1.646661 3 2.577097 2.486852 2.401831 2.321632 4 3.312127 3.169865 3.037349 2.913712 5 3.992710 3.790787 3.604776 3.433081
Present Value Factor for an Annuity of $1
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16-8
Measuring Investment Cash Flows
Cash Cash InflowsInflows
IncrementalIncrementalRevenuesRevenues
CostCostSavingsSavings
SalvageSalvageValueValue
Reduction in Reduction in Working CapitalWorking Capital
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16-9
Measuring Investment Cash Flows
Cash Cash OutflowsOutflows
WorkingWorkingCapitalCapital
RequiremenRequirementsts
Increases inIncreases inOperatingOperatingExpensesExpenses
InitialInitialInvestmentInvestment
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16-10
Comparing Alternative Capital Investment Opportunities
PV index =PV index = PV of cash inflowsPV of cash inflowsPV of cash PV of cash outflowsoutflows
Alternative 1 = = 1.1081.108$86,414$78,000
Alternative 2 = = 1.0481.048$255,061$243,358
Alternative 1 yields a Alternative 1 yields a higherhigher return than Alternative 2. return than Alternative 2.
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16-11
Internal Rate of ReturnWhen management uses the internal rate of return (IRR), the higher the return, the more
profitable the investment. Calculating IRR can be tedious. Let’s use Excel to make the process
efficient. To use Excel’s special functions, we must know the values involved and make a reasonable
guess as to the IRR. The guess is necessary to help Excel determine the correct IRR.
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16-12
Techniques That Ignore the Time Value of MoneyPayback Method
This is a simple and easy approach to looking at the recovery of an
investment.PaybackPaybackperiodperiod == Net cost of Net cost of
investmentinvestmentAnnual net cash Annual net cash
inflowsinflows
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Unadjusted Rate of ReturnInvestment cash flows are not adjusted to reflect the time value of money. The return is computed as follows:
UnadjustedUnadjustedrate of returnrate of return ==
Average incremental Average incremental increase in annual net increase in annual net
incomeincomeNet cost of original Net cost of original
investmentinvestment
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16-14
PostauditsA postaudit is conducted at the
completion of a capital investment project, using the same analytical
technique that was used to justify the original investment. The focus should be on continuous improvement rather
than punishment in the capital expenditure process.
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End of Chapter Sixteen