Chapter 12 Capital Investment Decision and the Time Value of Money A Capital Budgeting process of making capital investment decisions a Focuses on cash flow needs to produce more cash inflows verusus outflows over the assts useful life b Capital Budgeting Process Identify potential Capital investments i ii Estiamate net future cash flows iii Analyze potential Investmetns 1 Screen out undesirable invmnts using payback or ARR 2 Further analyze investments using NPV and or IRR 3 Engage in capital rationing if necessary to choose among alternative investments 4 Perform post audits after making capital investments B Payback Period of the capital outlay How quickly mangers expect to recover their money the length of time it takes to recover in net cash inflows the cost a PayBack Period Amount Invested Expected annual net cash inflows b Does NOT cover profitability C Accounting Rate of Return operating income versus cash flow focuses on profit based on accrual accounting and on a ARR Average annual operating Income from asset Initial Investment ARR Average Annual net csh flow annual depreciation expense initial investment Annual Depreciated Expense Initail cost residual value Useful life of asset b c If expected accounting rate of return ARR exceeds the required rate of return INVEST If expected accounting rate of return is less than the required rate of return DO NOT INVEST D Time Value of Money invested money earns more income over time a Key i P principal amount ii N number of periods iii b Annuity I interest rate is a stream of equal installments made at equal time intervals i Ordinary Annuity ii Future Value Principal Interest Earned iii Present Value Future Value Interest Earned payments occur at the end of each period c Tables i Present Value of 1 Used for Lump sum amounts ii Present Value of Annuity of 1 used for annuities iii Future Value of 41 Used for Lump Sum aMount iv Future Value of Annuities if 1 Used for annuities d Future Value Factors i Future Value principal FV Factor for I n 1 Factor is found from table ii Future Value Amnt of e cash installment Annuity Fv Factor I n 1 Factor fround from table E Managers calculations a Net Present Value the difference between the present value of the investments net cash inflows and the ivestments costs i Discount Rate interst rate used for preent value calculations 1 Required rate or Feturn or Hurdle Rate another name for discount rate ii Present Value Amount of e cash inflows Annuity PV Factor I n 1 then subtract investment If net present value is positive Invest If Net Present Value Is negative do Not Invest iii iv v Unequal distribtuin NOT an Annuity 1 do separate calculations for each year and add all separate years together b Profitability Index PV of Net Cash Inflows Investmetn c Internal Rate of Returen IRR Discounted cash flows the company can expect to earn based on discounted cash flows that a company can expect to earn by investing in the project i NPV O ii iii Investments Cost Present Value of the investments net cash inflows IRR is the interest rate that makes the cost of the investment equal to the present value of the investments net cash inflows iv Annuity PV Factor i n given Investment Cost Amount of each equal net cash inflows IRR required rate of return Invest IRR required rate of return Do NOT Invest v vi vii Unequal Net Cash Inflows 1 do trial error to find what interest rate is until answer is 0 Ignore Time Value of Money Pay Back Period o Simple to compute o Time it takes for company to recover companys cash investment o Ignores cash flow after the payback period including residual value Accounting Rate of Return ARR o Accural Accounting Figures o How Investment will effect operating o Average profitability of asset over income lifetime o Shows risk with longer cash recovery o Ignores Time value of money periods o Ignored Time va lue of money Incorporate Time Value of Money Net Present Value NPV o Incorporates Time Value of Money and Net cash flows over entire life o Indicates whether asset will return minimum required rate of return o Shows excess of Dificency of the Internal Rate of Return IRR o Incorporates Time Value of Money and the assetss net cash inflows o Computes the projects unique rate of return o No additional steps for capital assets present value of the net cash inflows over its initial investment cost o Computed for capital rationing decisions when the asset requires different initial investment rationing decisions
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