Capital Investment AnalysisCapital BudgetingMethodsMethods – not using PVAverage rate of returnExample 1:Average of Rate of ReturnExample 2:Cash Payback PeriodSlide 10Example 3:Example 4:Uneven Cash Flows:Example:Present value methodsPresent value of $1Net Present Value MethodDiscounted Cash Flow MethodPresent Value of an AnnuityPresent value tablesExample 5:Slide 22Example 6: Same as 5 but uneven cash flowsExampleExample 7:Example 7:Present value indexInternal Rate of ReturnFactors complicating capital investment analysisCapital Investment AnalysisACG 2071Module 12Chapter 25Fall 2007Capital BudgetingIs the process by which management plans, evaluates, and controls investments in fixed assetsInvolves long term commitment of fundsMust earn a reasonable rate of returnMethodsMethods – not using present valueAverage rate returnCash payback periodPresent Value MethodsNet present value methodPresent value indexInternal rate of returnMethods – not using PVUsed to screen proposalsMinimum standards are set for accepting or notAverage rate of returnARR = Average annual income Average investmentWhere Average investment is one half of the original costExample 1:Suppose that the company is considering the purchase of a machine at a cost of $500,000. The machine is expected to have a useful life of 4 years, with no residual value and to yield total income of $200,000. Compute the average rate of return.Average of Rate of ReturnAverage Rate of Return = Average annual income Average investmentAverage annual income = $200,000/4 = $50,000Average investment = $500,000/2 = $250,000ARR = 50,000/250,000 = 20%Example 2:Suppose a corporation has an investment with a cost of $400,000 and average annual income of $20,000 what is the ARR?Cash Payback PeriodLooks for project with the shortest period to recover the original investmentNet cash Flow = excess cash flow from revenues – expensesCash payback period = number of years to recover cash investedCash Payback PeriodEVEN cash flows formula: Original investment Net cash flow = number of years to payback investmentExample 3:Suppose that the company is considering the purchase of a machine at a cost of $400,000. The machine is expected to have net cash flow if $100,000. What is the cash payback period? Original investment = $400,000 = 4 years Net cash flow $100,000Example 4:Suppose machine with cost of $500,000 and net cash flow of $75,000 per year. What is the payback period?Uneven Cash Flows:Uneven cash flowsCost is $300,000 then subtract the flowsYear Cash Flows1 $60,0002 80,0003 105,0004 155,0005 100,0006 90,000Example: Year Cash Flows Balance at end of year1 $60,000 $300,000 - $60,000 = $240,0002 80,000 $240,000 - $80,000 = $160,0003 105,000 $160,000 - $105,000 = $55,0004 155,000 $55,000 - $155,000 = end5 100,0005 90,000Present value methodsInvestment in fixed assets may be reviewed as acquiring a series of net cash flows over a period of timeTime is an important factor in determining the value of an investmentPresent value of $1It allows you to compare monies received today to monies received at a future dateDue to the fact that money has a value - interestThe quicker that you receive the money the more it is worthNet Present Value MethodAnalyze capital investment proposals by comparing the initial cash investment with the present value of the net cash flowsCalled discounted cash flow methodRate is set my managementIf Net present value > original investment then go ahead with projectDiscounted Cash Flow MethodTotal present value of net cash flow = Net cash flow x PV of AnnuityThen: Net cash flow X PV of Annuity LESS original investment > 0 then take the projectPresent Value of an AnnuityYear 6% 10% 12% 15% 20%1 0.943 0.909 0.893 0.870 0.8332 1.833 1.736 1.690 1.626 1.5283 2.673 2.487 2.402 2.283 2.1064 3.465 3.170 3.037 2.855 2.5895 4.212 3.791 3.605 3.353 2.9916 4.917 4.355 4.111 3.785 3.3267 5.582 4.868 4.564 4.160 3.6058 6.210 5.335 4.968 4.487 3.8379 6.802 5.759 5.328 4.772 4.03110 7.360 6.145 5.650 5.019 4.192Present value tablesYear 6% 10% 12% 15% 20%1 0.943 0.909 0.893 0.870 0.8332 0.890 0.826 .797 0.756 0.6943 .840 0.751 0.712 0.658 0.5794 0.792 0.683 0.636 0.572 0.4825 0.747 0.621 0.567 0.497 0.4026 0.705 0.564 0.507 0.432 0.3357 0665 0.513 0452 0.376 0.2798 0.627 0.467 0.404 0.327 0.2339 0.592 0.424 0.361 0.284 0.19410 0.558 0.386 0.322 0.247 0.162Example 5:Suppose that a proposal to acquire $200,000 of equipment with an expected useful life of five years and a minimum desired rate of return of 10%. The net cash flow is $70,000. Should we accept the project?Example 5:cash flow x PV of Annuity $70,000 x 3.170 = $221,900Net cash flow $221,900Original investment $200,000Discounted cash flow 21,900Since positive accept the proposalExample 6: Same as 5 but uneven cash flowsYear Cash Flows1 $70,0002 60,0003 40,0004 40,0005 20,0006 20,000NPV$70,000 * 0.893 = 62,510$60,000 * 0.797 = 47,82040,000 * 0.712 = 28,48040,000*.636 = $25,44020,000 * 0.567 = 11,34020,000 * 0.507 = 10,140TOTAL $185,730ExampleAdd the Net present values = $185,730Cost of project is $350,000Since project is more expensive than returnDecline the dealExample 7: Cost of project $200,000 for 4 yearsCash flows are$90,000$60,000$50,000$40,000Rate is 10%Example 7:Cost is $200,000NPV is $212,760Difference is positiveKeep the dealYear Cash FlowNPV1 $90,000 $81,8102 $80,000 66,0803 $50,000 37,5504 $40,000 27,320Total 212,760Present value index= total present value of net cash flow/amount to be investedSelect highest index among the projectsProposal A B CPV cash flows $107,000 $86,400 $93,600Original Investment 100,000 80,000 90,000NPV 7,000 6,400 3,600Index 1.07 1.08 1.04Internal Rate of ReturnUses present value concepts to compute the rate of return from the net cash flowsPV of Cash Flows = Annual cash flows X PV factor NPV = PV cash flows – cost of investmentIf NPV > 0 then accept the proposalFactors complicating capital investment analysisIncome taxUnequal proposal livesLease versus capital investmentUncertaintyInflationQualitative