Management
Accounting: The
Cornerstone for
Business Decisions
Capital Investment
Decisions
Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.
Learning Objectives
1. Explain what a capital investment decision is
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.
Learning Objectives
4. Use the internal rate of return to assess
the acceptability of independent
projects.
5. Explain the role and value of post
audits.
6. Explain why NPV is better than IRR for
capital investments decisions involving
mutually exclusive projects.
How
to
calculate
payback.
13-1
Payback period = original investment / annual cash
flow
Suppose that an new car wash facility requires an
investment of $120,000 and has either:
a. Even cash flows of $40,000 per year or
b. The following annual cash flows $20,000, $40,000,
$40,000, $50,000, and $30,000
REQUIRED: Calculate the payback period for each
case.
Calculation:
a. Even cash flows
Payback period = original investment / annual
cash flow
= $120,000 / $40,000 = 3 years
How
to
calculate
payback.
13-1
b. Uneven cash flows
Unrecovered Investment
Annual Time Needed
Year
(Beginning of the Year) Cash Flow
for Payback
1
$120,000
$20,000
1.0 year
2
100,000
40,000
1.0 year
3
60,000
40,000
1.0 year
4
20,000
50,000
0.4 year
5
0
30,000
0.0 year
Total
3.4 years
At the beginning of year 4, $20,000 is needed to recover the
investment. Since a net cash flow of $50,000 is expected
only 0.4 year ($20,000 / $50,000 is needed to recover the
remaining $20,000 assuming a uniform cash flow
throughout the year).
List Four Ways Payback Can
be Used by Managers
1. To help control the risks associated with
the uncertainty of future cash flows
2. To help minimize the impact of an
investment on a firm’s liquidity
problems
3. To help control the risk of obsolescence
4. To help control the effect the of the
investment on performance measures
13-2
How to calculate the accounting
rate of return (ARR).
ARR = Average Income / Initial Investment
Assume that an investment requires an investment requires
an initial outlay of $140,000. The life of the investment is
5 years with following income stream: $30,000, $40,000,
$40,000 $50,000, and $40,000.
REQUIRED: Calculate the accounting rate of return.
Calculation:
Total net income (five years) = $200,000
Average net income = $200,000 / 5 = $40,000
Accounting rate of return = $40,000 / $140,000 = 0.35 or
35%
How to assess cash flows and
13-3
calculate NPV.
A market study revealed expected annual revenues of
$320,000 for the new cordless headset. Equipment to
produce the cordless headset would cost $350,000. After
five years, the equipment can be sold for $50,000. In
addition, to the equipment, working capital is expected
to increase $40,000 because of increases in inventories
and receivables. The firm expects to recover the
investment in working capital at the end of the project’s
life. Annual cash operating expenses are estimated at
$175,000. The required rate of return is 12%.
REQUIRED: Estimate the annual cash flows and calculate
the NPV.
How to assess cash flows and
13-3
calculate NPV.
Step 1. Cash- Flow Identification
Year
Item
0
Equipment
Working capital
Total
1-4
Revenues
Operating expenses
Total
5
Revenues
Operating expenses
Salvage value
Recovery of working capital
Total
Cash Flow
$(350,000)
(40,000)
$(390,000)
$350,000
(175,000)
$175,000
$350,000
(175,000)
50,000
40,000
$265,000
How to assess cash flows and
13-3
calculate NPV.
Step 2A NPV Analysis
YearCash Flow Discount Factor
Present Value
0
$(390,000)
1.000
$(390,000)
1
175,000
0.893
156,275
2
175,000
0.797
139,475
3
175,000
0.712
124,600
4
175,000
0.636
111,300
5
265,000
0.567
150,255
Net Present Value
291,705
How to assess cash flows and
13-3
calculate NPV.
Step 2B NPV Analysis
Year Cash Flow Discount Factor Present Value
0
$(390,000)
1.000
$(390,000)
1-4
175,000
3.037
531,475
5
265,000
0.567
150,255
Net Present Value
$291,255
13-4
How to calculate IRR with
Uniform Cash flows.
Assume that a hospital has the opportunity to invest
$160,000 in a blood analyzer that will produce a net
cash flow of $57,184 in each of the next four years.
REQUIRED: Calculate the IRR for the blood analyzer.
Calculation:
df = Investment / Cash Flow
=$160,000 / $57,184 = 2.798
Since the life of the investment is four years, find the
four row of Exhibit 13B-2 and then move across this
row until df = 2.798 is found. The interest rate
corresponding to 2.798 is 16%, which is the IRR.
Multiple Period Settings
With Uneven Cash Flows
The simple truth is performing IRR is one of
the easiest tasks there is in Excel. It is a
matter of listing outflows in a column as
negative amounts and then in the same
column inflows as positive amounts.
Simply follow the directions in the Excel
drop down box and it will take less than a
couple of seconds to get a precise answer.
Define and Describe a Post
Audit
◙ It is the follow up when the capital
project is implemented.
◙ It compares the actual benefits with the
budgeted benefits.
◙ It compares actual operating costs with
the budgeted operating costs.
◙ It evaluates the overall outcome of the
investment and proposes corrective
action if needed.
What are the benefits of a
post audit?
1. It ensures that resources are used wisely.
2. It has an impact on managers behavior.
Because a post audit will be conducted, managers
are more likely to make decisions in the best
interest of the firm.
3. More objective results are obtained if the
post audit is done by an independent
party.
4. Post audits are costly to conduct.
Compare NPV to IRR
13-5
How to calculate NPV & IRR
for mutually exclusive
projects.
Consider two pollution prevention projects.
Design Papa and Oscar. Both have a
project life of 7 years. Design Papa
requires an outlay of $140,000 and has a
net after-tax inflow of $40,000 (revenues
of $180,000 minus costs of $140,000).
Design Oscar, with an initial outlay of
$300,000 has a net annual cash inflow of
$50,000 ($240,000 - $190,000). The after-tax
cash flows are summarized as follows:
13-5
How to calculate NPV & IRR
for mutually exclusive
projects.
Cash Flow Pattern
Year
Design Papa
Design Oscar
0
$(240,000)
$(300,000)
1
40,000
50,000
2
40,000
50,000
3
40,000
50,000
4
40,000
50,000
5
40,000
50,000
6
40,000
50,000
7
40,000
50,000
The cost of capital for the company is 12%.
REQUIRED: Calculate the NPV & the IRR for each.
13-5
How to calculate NPV & IRR
for mutually exclusive
projects.
Calculation:
Design Papa: NPV Analysis
Year Cash Flow Discount Factor Present Value
0
$(240,000)
1.000
$(240,000)
1-7
40,000
4,564
182,560
Net Present Value
$(57,440)
Design Papa: IRR Analysis
Discount factor = Initial Investment / Annual cash flow
= $240,000 / $40,000 = 6.000
From Exhibit 13B-2, df = 6.000 for 7 years implies that
IRR = 4.000%.
13-5
How to calculate NPV & IRR
for mutually exclusive
projects.
Design Oscar: NPV Analysis
Year Cash Flow Discount Factor Present Value
0
$(300,000)
1.000
$(300,000)
1-7
50,000
4,564
228,200
Net Present Value
$(71,800)
Design Oscar: IRR Analysis
Discount factor = Initial Investment / Annual cash flow
= $300,000 / $50,000 = 6.000
From Exhibit 13B-2, df = 6.000 for 7 years implies that
IRR = 4.000%.