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Chapter 25

# Chapter 25 - 25 Capital Investment Analysis Student Version...

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1 25 Capital Investment Analysis Student Version

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1-2 25-2 2 1 1 Explain the nature and importance of capital investment analysis.
1-3 25-3 3 Capital investment analysis (or capital budgeting ) is the process by which management plans, evaluates, and controls investments in fixed assets. Capital Investment Analysis 1

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1-4 25-4 4 1. Management plans, evaluates , and controls investments in fixed assets. 2. Capital investments involve a long-term commitment of funds. 3. Investments must earn a reasonable rate of return . 4. Capital investment decisions are some of the most important decisions that management makes. Nature of Capital Investment Analysis 1
1-5 25-5 5 1 2 Evaluate capital investment proposals using the average rate of return and cash payment methods.

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1-6 25-6 6 Average Rate of Return Method The average rate of return , sometimes called the accounting rate of return , measures the average income as a percent of the average investment. The average rate of return is computed as follows: Average rate of return Estimated Average Annual Income Average Investment = (Initial Cost + Residual Value)/2 2
1-7 25-7 7 Machine cost \$500,000 Expected useful life 4 years Residual value none Expected total income \$200,000 Average rate of return Estimated Average Annual Income Average Investment = Average rate of return \$200,000/4 (\$500,000 + \$0)/2 = = 20% Purchase of Machine Example 2

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1-8 25-8 8 Cash Payback Method The expected period of time that will pass between the date of an investment and the complete recovery in cash (or equivalent) of the amount invested is the cash payback period . 2
1-9 25-9 9 When annual net cash flows are equal, the cash payback period is computed as follows: Cash payback period Initial Cost Annual Net Cash Flow = 2

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1-10 25-10 10 Cost of new machine \$200,000
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Chapter 25 - 25 Capital Investment Analysis Student Version...

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