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Capital Investment Decisions
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.
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 NPV is better than IRR for capital investment decisions involving mutually exclusive projects.
1. TYPES OF CAPITAL INVESTMENT DECISIONS
The opening scenario illustrates what capital budgeting is about and reveals the importance of both qualitative and quantitative factors. Begin by quickly reviewing the scenario and presenting a definition of capital budgeting.
Capital investment decisions involve planning, setting goals and priorities, arranging financing, and identifying criteria for making long-term investments.
There are two types of capital investment projects:
- independent projects that do not affect the cash flows of other projects
- mutually exclusive projects that, if accepted, preclude the acceptance of all other competing projects
2. NONDISCOUNTING MODELS
Managers must have some basic criteria for accepting or rejecting proposed investments when making capital budgeting decisions. Hansen and Mowen discuss four basic methods that can be used by managers to assist in making these decisions. These methods can be categorized as nondiscounting models and discounting models.
Nondiscounting models do not consider the time value of money. Two nondiscounting cash flow models are:
- payback period
- accounting rate of return (ARR)
Discounting models consider the time value of money. Two discounting cash flow models are:
- net present value (NPV)
- internal rate of return (IRR)
A. Payback Period
The payback period is the time required for a firm to recover its original investment. This method continues to be widely used, although it is rarely used by itself. The fact that it continues to be used, however, suggests that it must convey some useful information to management. When the cash flows of a project are assumed to be even, the following formula can be used:
Two weaknesses of the payback period method are as follows:
- Payback ignores the time value of money.
- Payback ignores the profitability of investments beyond the payback period.
Cornerstone 13-1: How to Calculate Payback
- See Mowen and Hansen text for in-class, demo problems.
B. Accounting Rate of Return
The accounting rate of return measures the return on a project in terms of income, as opposed to using the project’s cash flow. The accounting rate of return is computed by the following formula:
Average income can be found by adding the net income for each year and dividing this total by the number of years. Average net income for a project can be found by subtracting average depreciation from average cash flow. Investment can be defined as original investment or average investment, where the latter is found by adding the original investment to the salvage value and dividing this total by two.
The disadvantage of the accounting rate of return is that it does not consider the time value of money.
Cornerstone 13-2: How to Calculate the Accounting Rate of Return
- See Mowen and Hansen text for in-class, demo problems.
3. DISCOUNTING MODELS: THE NET PRESENT VALUE METHOD
- Discounting models consider the time value of money.
- Two discounting models are:
- net present value (NPV)
- internal rate of return (IRR)
- When using the net present value method:
- the cash flows for each year are identified
- all cash flows are stated in terms of their present value (discounted), and
- the present values are added together to find the net present value.
- The present values are determined using the required rate of return as the discount rate. The required rate of return is the minimum return that a project must earn in order to be acceptable.
- If net present value is positive, the project’s return is greater than the required rate of return or discount rate.
Cornerstone 13-3: How to Assess Cash Flows and Calculate NPV
- See Mowen and Hansen text for in-class, demo problems.
4. DISCOUNTING MODELS: THE INTERNAL RATE OF RETURN METHOD
- The internal rate of return is the interest rate (discount rate) that results in a net present value of zero.
- When net present value equals zero, the present value of the project’s cash inflows exactly equals the investment outlay. Therefore, the internal rate of return is the interest rate that equates the present value of the futur e cash flows to the investment.
Cornerstone 13-4: How to Calculate IRR with Uniform Cash Flows
- See Mowen and Hansen text for in-class, demo problems.
5. POSTAUDIT OF CAPITAL PROJECTS
Essentially, postaudits are designed to compare the actual performance of a capital investment with its expected performance. The outcome of a postaudit may result in corrective actions or even abandonment of the project (as the company described in the scenario did).
6. MUTUALLY EXCLUSIVE PROJECTS
A. NPV versus IRR
In choosing among competing projects, IRR may lead to the wrong choice, whereas NPV is consistent in providing the correct signal.
Two major differences between NPV and IRR are as follows:
1. The NPV method assumes that cash flows from the project are reinvested at the discount rate. The IRR method assumes that cash flows are reinvested at the internal rate of return of the project.
2. The NPV method measures the profitability of a project in absolute terms (in dollars), whereas the IRR method measures the profitability of a project in relative terms (as a percentage).
Because NPV consistently selects the wealth-maximizing alternative and IRR does not, NPV is generally preferred to IRR for choosing among competing projects. For mutually exclusive projects, the NPV method is recommended. The three steps in selecting the best project are as follows:
1. Determine the cash-flow pattern for each project.
2. Calculate the NPV of each project.
3. Identify the project with the greatest NPV.
Before presenting examples for the NPV method, the issues surrounding cash flows should be discussed. These issues have been broken down into two major categories: (1) forecasting cash flows, and (2) conversion of gross cash flows to after-tax cash flows. The next section focuses on these issues.
Cornerstone 13-5: How to Calculate NPV and IRR for Mutually Exclusive Projects
- See Mowen and Hansen text for in-class, demo problems.
B. Special Considerations for the Advanced Manufacturing Environment
- Capital budgeting in the advanced manufacturing environment differs from the traditional approach in the following ways:
- Investment. For standard manufacturing equipment, the direct costs of acquisition represent virtually the entire investment. For automated manufacturing, the direct costs can be as low as 50 percent to 60 percent of the total investment. In addition, software, engineering, training, and implementation costs must be considered as part of the total investment cost.
- Estimates of Operating Cash Flows. Typically, estimates of operating cash flows from investments in standard equipment were based on tangible benefits, such as direct savings from labor, power, and scrap. In the advanced manufacturing environment, it is important to consider intangible and indirect benefits, such as improved quality, greater reliability, improved customer satisfaction, and the ability to maintain or increase market share.
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