Survey of accounting 6e chapter 15

Capital Investment Analysis

Chapter
15

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Learning Objectives
After studying this chapter, you should be able to:
•

Explain the nature and importance of capital investment
analysis.

•

Evaluate capital investment proposals using the average
rate of return and cash payback methods.

•

Evaluate capital investment proposals using the net present
value and internal rate of return methods.

•

List and describe factors that complicate capital investment
analysis.

•

Diagram the capital rationing process.

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Learning
Objective 1
Explain the nature and importance
of capital investment analysis

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Capital Investment Analysis
• The process by which management plans,
evaluates, and controls investments in
_____________.
• Capital investment is very important for the
______________ success of a business.

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Methods of Evaluating Capital
Investment Proposals
• Methods that do not use present value:

• _________________
• _________________

• Methods that use present values

• _________________
• _________________

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Learning
Objective 2
Evaluate capital investment
proposals, using the average rate of
return and cash payback methods

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Methods That Ignore Present
Value
• Often used to initially ________ proposals.
• Useful for proposals with relatively short useful
lives because the _________ of cash flows is
less important.

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Average Rate of Return
• A measure of the average annual income
expected to be earned from the investment over

the investment life, after deducting depreciation.
• Also called the accounting rate of return.

Avg. Rate of Return =

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Average Rate of Return
•
•
•
•

Cost = $500,000
No Residual Value
4-year useful life
Estimated total income - $200,000

Avg. Rate of Return =

$
$

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Average Rate of Return Analysis
• If the average rate of return equals or exceeds
the company’s minimum rate, the project should

be __________.
• Advantages:
• Easy to compute.
• Includes the entire income to be earned over
the life of the proposal.
• Emphasizes accounting income.
• Disadvantage – does not directly consider the
_____________and _______________.
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Cash Payback
• The cash payback period is the expected period
of time between the date of an investment and
the complete recovery in cash (or equivalent) of
the amount invested.
• The excess of cash flowing in from revenue over
the cash flowing out for expenses is called net
cash flow.
Cash Payback Period =
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Cash Payback
• Cost = $200,000
• Estimated cash inflow per year = $50,000
• Estimated cash outflow per year = $10,000
Cash Payback Period =

$

$

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Cash Payback
• If annual cash flows
are not equal, the
payback period is
determined by
adding the
_______________
until the investment
is recovered

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Cash Payback Analysis
• Advantages:
• Used for evaluating ___________ proposals.
• A short payback period is desirable.
•The sooner the cash is recovered, the sooner it can
be reinvested.
•There is less chance of losses from changing
economic conditions.

• Disadvantages:
• Ignores ___________ after the payback period.
• Does not use present value concepts.

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Learning
Objective 3
Evaluate capital investment proposals
using the net present
value and internal rate of return
methods

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Present Value Considerations
• Uses both the amount and timing of _________
to evaluate an investment.
• Present Value of an Amount – $1 today is worth
______ than $1 received in a future date,
because today’s $1 can be invested and earn
interest.
• Present Value of an Annuity – sum of the present
values of a series of equal cash flows at
__________ intervals.

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Time Value of Money

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Present Value Calculations
• Present value tables help us calculate
present values for _________ and
___________.
Exhibit
1: Partial Present Value of $1 Table

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Present Value of an Annuity
Calculations
• Cash Inflow Timeline and Present Value

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Present Value of an Annuity
Calculations
• Present value tables help us calculate present
values for ___________ and __________.
Exhibit 2: Partial Present Value of an Annuity Table

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Net Present Value Method
• Analyzes capital investment proposals by

comparing the initial cash investment with the
_______________ of the net cash flows.
• Also called ____________ cash flow method.
• The return rate is set by management – often
called the _________ rate.
• If the net present value expected from an
investment equals/exceeds the initial investment,
the project is __________.

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Net Present Value Calculation
• Net present value
analysis for the
purchase of a
$200,000 machine
with a 5-year useful
life. Minimum rate of
return is 10%.

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Present Value Index
• If ___________are being considered, use of the
present value index can help determine which
projects to accept.

Present Value Index =

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Internal Rate of Return
• Uses present value concepts to compute the
_____________from the net cash flows
expected from capital investment proposals.
• Also called the ______________________
method.
• Starts with net cash flows and works backward
to determine the ____________expected from
the project.

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Internal Rate of Return
•
•
•
•

Cost = $33,350
Estimated cash inflow = $10,000
Expected life – 5 years
Rate of return – 12%

Exhibit 3: Net Present Value Analysis at 12%

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