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Chapter 14:

Capital Investment
Decisions
Cornerstones of Managerial Accounting,
4e
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Learning Objectives
1. Explain the meaning of capital investment decisions, and
distinguish between independent and mutually exclusive capital
investment decisions.
2. Compute the payback period and accounting rate of return for a
proposed investment, and explain their roles in capital
investment decisions.
3. Use net present value analysis for capital investment decisions
involving independent projects.
4. Use the internal rate of return to assess the acceptability of
independent projects.
5. Explain the role and value of postaudits.
6. Explain why net present value is better than internal rate of
return for capital investment decisions involving mutually
exclusive projects.
7. (Appendix 14A) Explain the relationship between current and
future dollars.
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Types of
1 Capital Investment
Decisions
Capital investment decisions are concerned with the
process of planning, setting goals and priorities,
arranging financing, and using certain criteria to select
long-term assets.
The process of making capital investment decisions
often is referred to as capital budgeting.
Two types of capital budgeting projects will be
considered: independent projects and mutually exclusive
projects.
Independent projects are projects that, if accepted
or rejected, do not affect the cash flows of other
projects.
Mutually exclusive projects are those projects that,
if accepted, preclude the acceptance of all other
competing projects.

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Making
1 Capital Investment
Decisions
In general terms, a sound capital investment will earn
back its original capital outlay over its life and, at the
same time, provide a reasonable return on the original
investment.
After making this assessment, managers must decide
on the acceptability of independent projects and
compare competing projects on the basis of their
economic merits.
To make a capital investment decision, a manager must
estimate the quantity and timing of cash flows
assess the risk of the investment
consider the impact of the project on the firms profits

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Basic Capital Investment
2
Decision Models
The basic capital investment
decision models can be classified into
two major categories:
Nondiscounting models ignore the
time value of money.
Discounting models explicitly
consider the time value of money.

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Nondiscounting Models:
2
Payback Period
The payback period is a nondiscounting model
that presents the time required for a firm to recover
its original investment.
If the cash flows of a project are an equal amount
each period, payback period is computed as follows:

If the cash flows are unequal, the payback period is


computed by adding the annual cash flows until
such time as the original investment is recovered.
If a fraction of a year is needed, it is assumed that
cash flows occur evenly within each year.

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Cornerstone 14-1
2
Calculating Payback

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2 Using Payback Period
to Assess Risk
One way to use the payback period is to set a
maximum payback period for all projects and to
reject any project that exceeds this level.
Some analysts suggest that the payback period can
be used as a rough measure of risk, with the notion
that the longer it takes for a project to pay for itself,
the riskier it is.
Also, firms with riskier cash flows in general could
require a shorter payback period than normal.
Additionally, firms with liquidity problems would be
more interested in projects with quick paybacks.
Another critical concern is obsolescence. Firms with
higher risk of obsolescence such as computer
manufacturers would be interested in recovering
funds rapidly.
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Using the Payback Period
2 to Choose Among
Alternatives
The payback period can be used to choose among
competing alternatives.
Under this approach, the investment with the
shortest payback period is preferred over
investments with longer payback periods.
However, this use of the payback period is less
defensible because this measure suffers from two
major deficiencies:
It ignores the cash flow performance of the
investments beyond the payback period.
It ignores the time value of money.

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2 Nondiscounting Models:
Accounting Rate of Return
The accounting rate of return (ARR)
measures the return on a project in terms of
income, as opposed to using a projects cash
flow.
The accounting rate of return is computed by
the following formula:

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Cornerstone 14-2
2 Calculating the Accounting Rate
of Return

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Limitations of the
2
Accounting Rate of Return
Unlike the payback period, the ARR does consider a
projects profitability.
However, the ARR has other potential drawbacks,
including the following:
Ignoring Time Value of Money: Like the payback period, it
ignores the time value of money.
Dependency on Net Income: ARR is dependent upon net
income, which is the financial measure most likely to be
manipulated by managers.
Managers Incentive: Additionally, because bonuses to
managers often are based on accounting income or return
on assets, managers may have a personal interest in
selecting investments that contribute to net income in the
short-run.

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Discounting Models:
3 The Net Present Value
Method
Discounting models use discounted cash flows
which are future cash flows expressed in terms of
their present value.
One discounting model is the net present value
(NPV), which is the difference between the
present value of the cash inflows and outflows
associated with a project.

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3 Net Present Value
NPV measures the profitability of an investment.
A positive NPV indicates that the investment increases
the firms wealth.
To use the NPV method, a required rate of return must be
defined.
The required rate of return is the minimum
acceptable rate of return.
It also is referred to as the discount rate, hurdle rate, and
cost of capital.
In theory, if future cash flows are known with certainty,
then the correct required rate of return is the firms cost
of capital.

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3
Net Present Value
(continued)
In practice, managers often choose a discount rate higher than the cost
of capital to deal with uncertainty.
However, if the rate chosen is excessively high, it will bias the selection
process toward short-term investments.
Once the NPV for a project is computed, it can be used to determine
whether or not to accept an investment.
If the NPV is greater than zero the investment is profitable and,
therefore, acceptable.
A positive NPV signals that (1) the initial investment has been
recovered, (2) the required rate of return has been recovered, and
(3) a return in excess of (1) and (2) has been received.
If the NPV equals zero, the decision maker will find acceptance or
rejection of the investment equal.
If the NPV is less than zero, the investment should be rejected. In
this case, it is earning less than the required rate of return.

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Cornerstone 14-3
3 Assessing Cash Flows
and Calculating Net Present Value
Information:
A detailed market study revealed expected annual revenues of
$300,000 for new earphones. Equipment to produce the earphones
will cost $320,000. After five years, the equipment can be sold for
$40,000. In addition to equipment, working capital is expected to
increase by $40,000 because of increases in inventories and
receivables. The firm expects to recover the investment in working
capital at the end of the projects life. Annual cash operating expenses
are estimated at $180,000. The required rate of return is 12 percent.
Required:
Estimate the annual cash flows, and calculate the NPV.

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Cornerstone 14-3
3 Assessing Cash Flows
and Calculating Net Present Value
(continued)

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Cornerstone 14-3
3 Assessing Cash Flows
and Calculating Net Present Value
(continued)

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NPV, Discount Rates, and Cash
3 Flows
It is common to provide pessimistic and most likely cash flow
scenarios to help assess a projects risk.
As the discount rate increases, the present value of future cash
flows decreases, making it harder for a project to achieve a positive
NPV.
Plotting the NPV as the discount rate varies provides good insight
into the risk and economic viability of the proposed project.

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4 Internal Rate of Return
The internal rate of return (IRR), another discounting
model, is defined as the interest rate that sets the present
value of a projects cash inflows equal to the present value of
the projects cost.
It is the interest rate that sets the projects NPV at zero.
The following equation can be used to determine a projects
IRR, where t = 1, , n :

The right side of this equation is the present value of future cash flows
The left side is the investment.
I, CFt, and t are known.
Thus, the IRR (the interest rate, i, in the equation) can be found using
trial and error.

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4
Internal Rate of Return
(continued)

Once the IRR for a project is computed, it is


compared with the firms required rate of return:
If the IRR is greater than the required rate, the project
is deemed acceptable.
If the IRR is less than the required rate of return, the
project is rejected.
If the IRR is equal to the required rate of return, the
firm is indifferent between accepting or rejecting the
investment proposal.
The IRR is the most widely used of the capital
investment techniques.

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4 Internal Rate of Return:
Multiple Period
If the investment produces a series of uniform
cash flows, a single discount factor from the
present value table can be used to compute the
present value of the annuity.
If the cash flows are not uniform, then the IRR
equation must be used.
For a multiple-period setting, this equation can be
solved by trial and error or by using a business
calculator or a spreadsheet program.

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Cornerstone 14-4
4 Calculating Internal Rate of
Return
With Uniform Cash Flows

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You Decide
4IRR and Uncertainty in Estimates
of
Cash Savings and Project Life

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You Decide
4IRR and Uncertainty in Estimates
of
Cash Savings and Project Life
(continued)

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5 Postaudit of Capital
Projects
A key element in the capital investment process
is a follow-up analysis of a capital project once it
is implemented.
A postaudit compares the actual benefits with
the estimated benefits and actual operating costs
with estimated operating costs.
It evaluates the overall outcome of the
investment and proposes corrective action if
needed.

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5 Postaudit Benefits
Firms that perform postaudits of capital
projects experience a number of benefits,
including the following:
Resource Allocation: By evaluating profitability,
postaudits ensure that resources are used wisely.
Positive Impact on Managers Behavior: If managers
are held accountable for the results of a capital
investment decision, they are more likely to make
such decisions in the best interests of the firm.
Independent Perspective: Postaudit by an
independent party ensures more objective results.

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5 Postaudit Limitations
Postaudits are costly.
The assumptions driving the original
analysis may often be invalidated by
changes in the actual operating
environment.
Accountability must be qualified to
some extent by the impossibility of
foreseeing every possible eventuality.
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6 Mutually Exclusive Projects
Up to this point, we have focused on
independent projects.
NPV and IRR both yield the same decision for
independent projects.
However, many capital investment decisions
deal with mutually exclusive projects.
For competing projects, the two methods can
produce different results.
Choosing the project with the largest NPV is
consistent with maximizing the wealth of
shareholders.

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Net Present Value
6 Compared
with Internal Rate of
NPV differs from IRRReturn
in two major ways:
The NPV method assumes that each cash inflow
received is reinvested at the required rate of return,
whereas the IRR method assumes that each cash
inflow is reinvested at the computed IRR.
Reinvesting at the required rate of return is more
realistic and produces more reliable results when
comparing mutually exclusive projects.
The NPV method measures profitability in absolute
terms, whereas the IRR method measures it in
relative terms. NPV measures the amount by which
the value of the firm changes.

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Net Present Value
6 Compared with Internal
Rate of Return (continued)

When choosing between projects, what counts are the


total dollars earnedthe absolute profitsnot the
relative profits.
Accordingly, NPV, not IRR, should be used for choosing
among competing, mutually exclusive projects or
competing
2012 projects
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part, except for use as permitted in a
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Net Present Value
6 for Mutually Exclusive
Projects
There are three steps in selecting the best
project (with the largest NPV) from several
competing projects:
Step 1: Assess the cash flow pattern for each
project.
Step 2: Compute the NPV for each project.
Step 3: Identify the project with the greatest
NPV.

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Cornerstone 14-5
6 Calculating Net Present Value and
Internal Rate of Return for Mutually
Exclusive Projects

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Cornerstone 14-5
6 Calculating Net Present Value and
Internal Rate of Return for Mutually
Exclusive Projects (continued)

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Special Considerations for the
6 Advanced Manufacturing
Environment
For advanced manufacturing environments, like those
using automated systems, capital investment
decisions can be more complex because they must
take special considerations into account.
Great care must be exercised to assess the actual cost
of an automated system because it is easy to overlook
substantial peripheral costs like software, engineering,
and training.
More effort is needed to measure intangible and
indirect benefits, like reduced lead time, reliability, and
customer satisfaction, in order to assess more
accurately the potential value of investments.

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Appendix 14A:
7 Present Value Concepts
An important feature of money is that it can be
invested and can earn interest.
A dollar today is not the same as a dollar tomorrow.
This fundamental principle is the backbone of
discounting methods.
Future value is expressed as: F = P(1 + i), where
F is the future amount, P is the initial or current
outlay, and i is the interest rate.
The earning of interest on interest is referred to as
compounding of interest, expressed as follows
for n periods into the future:

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7 Present Value
Often, a manager needs to compute not the future value but
the amount that must be invested now in order to yield some
given future value.
The amount that must be invested now to produce the future
value is known as the present value of the future amount.
To compute the present value of a future outlay, all we need
to do is solve the compounding interest equation for P:

The process of computing the present value of future cash


flows is often referred to as discounting.
The interest rate used to discount the future cash flow is the
discount rate. The expression 1/(1 + i)n in the present value
equation is the discount factor.

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7 Annuities
An annuity is a series of future cash flows.
If the annuity is uneven, then each future
cash flow must be discounted using
individual discount rates (the present value
for each cash flow is calculated separately
and then summed).
For even cash flows, a single discount rate,
which is the sum of each discount rate for
each cash flow, can be used.

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