Chapter 14--Revised - Chapter Fourteen Capital Investment...

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Chapter Fourteen Capital Investment Decisions
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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. 22
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Learning Objectives 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. 33
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Explain the meaning of capital investment decisions, and distinguish between independent and mutually exclusive capital investment decisions.
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Capital Investment Decisions Long range decisions involving opportunities to invest in new assets or projects Among the most important decisions made by managers Place large amounts of resources at risk for long periods of time Affect the future development of the firm Decision making process is called “Capital Budgeting” 55
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Capital Budgeting Managers must decide whether or not a capital investment will: Earn back its original outlay and provide a reasonable return Covering the opportunity cost of the funds invested To make a capital investment decision, managers must: Make estimates of the quantity and timing of after-tax cash flows Assess the risk of the investment Consider the impact of the project on the firm’s profits 66
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Capital Budgeting Two types: Independent projects (“Mutually exclusive projects”) If accepted or rejected, do not affect the cash flows of other projects Competing projects Acceptance of one alternative precludes the acceptance of another 77
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Making Capital Investment Decisions Managers must: Set goals Set priorities for capital investments Establish basic criteria for: Acceptance or rejection of proposed investments 88
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Making Capital Investment Decisions Two types of methods: Nondiscounting models Do not consider time value of money Two methods Payback period and Accounting rate of return Discounting models Use time value of money Two methods Net Present Value and Internal Rate of Return Most companies use both types of methods 99
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Compute the payback period and accounting rate of return for a proposed investment, and explain their roles in capital investment decisions.
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Payback Period Time required for a firm to recover its original investment If investment generates even cash flows Formula: If investment generates uneven cash flows Formula: Add cash flows until original investment is recovered 1111 Original investment / Annual cash flow Payback period =
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Analyzing Payback Periods Set a maximum payback period
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