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**Unformatted text preview: **1 Introduction to Accounting and Business 26 Capital Investment Analysis 2 1-2 26-2 1-2 After studying this chapter, you should be able to: Capital Investment Analysis 3 Evaluate capital investment proposals using the net present value and internal rate of return methods. 2 Evaluate capital investment proposals using the average rate of return and cash payback methods. 1 Explain the nature and importance of capital investment analysis. 26-2 3 1-3 26-3 26-3 Capital Investment Analysis (continued) 4 List and describe factors that complicate capital investment analysis. 5 Diagram the capital rationing process. 4 1-4 26-4 1 1 Explain the nature and importance of capital investment analysis. 26-4 5 1-5 26-5 Capital investment analysis (or capital budgeting ) is the process by which management plans, evaluates, and controls investments in fixed assets. Capital Investment Analysis 1 6 1-6 26-6 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 7 1-7 26-7 Methods of Evaluating Capital Investment Proposals 1. The average rate of return method 2. The cash payback method Methods that ignore present values: 1. The net present value method 2. The internal rate of return method Methods that use present values: 1 8 1-8 26-8 1 2 Evaluate capital investment proposals using the average rate of return and cash payment methods. 26-8 9 1-9 26-9 Average rate of return Cash payback method Net present value method Internal rate of return method 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 15% 53% 85% 76% Percentage of Respondents Reporting the Use of the Method as Always or Often Source: Patricia A. Ryan and Glenn P. Ryan. Capital Budgeting Practices of the Fortune 1,000. How Have Things Changed? Journal of Business and Management (Winter 2002). 2 10 1-10 26-10 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 11 1-11 26-11 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 12 1-12 26-12 1. Easy to compute....

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