Amount investedAccounting rate of returnAccounting rate of returnCh 12 - Capital Investment Decisions andthe Time Value of Money12.1Capital Budgeting - process of making capital investment decisionsCapital Investments Investing in capital assets-assets used for a long period of time-equipment, buildings, vehicles, automatingproduction, improving technology, etc.-usually require large sums of moneyAnalyzing Capital Investments- Desirability of a capital asset depends on its ability to generate NET CASH INFLOWSo Cash inflows minus cash outflows- Most methods use net cash flow rather than accrual accounting net income- Cash flows include:• Future cash net income (no depreciation, amortization, etc)• Any future savings in ongoing cash operating costs • Any future residual (salvage) value of the asset Capital Budgeting ProcessStep 1 Identify potential capital investmentsStep 2 Estimate future net cash inflows Step 3 Analyze potential investments a) screen out undesirable investments using Payback or Accounting Rate of Return b) Further analyze using Net Present Value or Internal Rate of ReturnStep 4 If resources are limited, use capital rationing tools to choose among alternativesStep 5 Perform post-audits to evaluate if investments are going as planned and if estimated cash inflows were reasonable12.2Payback PeriodLength of time it takes to recover the initial cost - Generally, the shorter the payback period , the better- Usually used as a screening toolCalculating:- When the net cash inflows are equal each year:Payback Period = Amount investedExpected annual net cash inflows- When periodic cash flows are unequal, you must accumulate net cash inflows until theamount invested is recoveredMajor Criticism: o focuses only on time, not on profitabilityo considers only those cash flows that occur during the payback period Medley is considering producing Mp3 Players and DVR’s. The products each require aspecialized machine costing $1,000,000. Each machine has a five year life and no residualvalue. The expected cash inflows for each machine are as follows:Year Mp3 Players DVR’s1 $332,000 $500,0002 332,000 380,0003 332,000 320,0004 332,000 280,0005 332,000 25,000Total $1,660,000 $1,505,000Medley must achieve a payback period of 3.5 years and an ARR of 8% for an investment to beacceptable.1) Calculate the Mp3 Players project’s payback period:Payback period =Amount investedExpected annual net cash inflow=If the Mp3 investment had a residual value of $125,000, would the payback period change? Does this investment pass Medley’s screening criteria? 2) Calculate the DVR project’s payback period:Year Annual Net Cash Inflow Cumulative Net Cash Inflow123If the DVR investment had a residual value of $125,000, would the payback period change? Does this investment pass Medley’s screening criteria? Accounting Rate of Return (ARR)Measures the average annual rate of return over the asset’s life- Focuses on OPERATING INCOME, not net cash inflowo If you are given net cash inflows, you must deduct depreciation expense to get operating incomeo If you are given operating income, you must add back depreciation expense to get net cash flows (Payback, NPV, IRR)- ARR is compared to the REQUIRED RATE OF RETURN determined by the companyARR = Average annual operating income Initial Investment3) Calculate the Mp3 Players project’s ARR.Accounting rate of return=Average annual operating income from investmentInitial Investment=Average annual net cash−Annual depreciationinflow from asset on assetInitial Investment If the project had a residual value of $125,000, would the ARR change? How?Does this investment pass Medley’s screening criteria? 4) Calculate the DVR project’s ARR.Accounting rate of return=Average annual operating income from investmentInitial Investment=Average annual net cash−Annual depreciationinflow from asset on assetInitial InvestmentIf the project had a residual value of $125,000, would the ARR change? How?Does this investment pass Medley’s screening criteria? 12.3Time Value of MoneyImportant in long-term capital investment decisions- Invested money earns income over time- Cash received sooner preferred over being received later- Also used for personal financial planning, business valuation, and financing decisions Factors:Principal amount (p) – amount invested or borrowed- Single lump sum- Annuity – series of EQUAL PERIODIC payments Ordinary – payments received at the END of the period Annuity Due – payments received at the BEGINNING of each periodNumber of periods (n)Interest rate (i) –annual rate- Simple interest – compounded only on the principal amount each periodAn investment of $10,000 earns simple interest of 6% every year for five years: P x i x t = Interest 1 $10,000 x .06 $6002 $10,000 x .06 6003 $10,000 x .06 6004 $10,000 x .06 6005 $10,000 x .06 600Total $3,000- Compound interest – compounded on the principal plus accumulated interestAn investment of $10,000 earns compound interest of 6% every year for five years:Interest Balance1 $10,000 x .06 $600 $10,6002 $10,600 x .06 636 11,2363 $11,236 x .06 674 11,9104 $11,912 x .06 715 12,6275 $12,627 x .06 758 13,385Total $3,385$385 more interest is earned in five years by compoundingWe could also solve for the above algebraically as follows: n 5 FV = P x (1 + i) FV = P x (1.06) FV = 10,000 x 1.338 = $13,380FV = Future valueP = Principaln = number of periodsOr 10,000 x (1+ .06) = $10,600i = annual interest rateFuture Value Tables nDeveloped to streamline interest calculations using: (1 + i) to calculate FV factors Future Value of $1 (Lump sum)- Table C below (an in Appendix 12A) gives you the future (compounded) value of $1 for n period, i interest rate- Using our $10,000 for 5 years at 6% from above:FV = $10,000 x 1.338 = $13,380 ($3 off due to rounding)The above table is used to find the future value of a lump sum amountFuture Value of an AnnuityAnnuity – series of EQUAL, PERIODIC payments. The annuity tables we will be using assume all payments are made at the end of each period. This is called an ORDINARY ANNUITY.FV = P x (FV factor i, n)Another table (D in your Appendix 12A) is used when the cash inflows are in the form of an ANNUITY. The periodic payment amount is now the “P” in our equation. Let’s invest $2,000 a year at the end of