CHAPTER 25 (FIN MAN); CHAPTER 10 (MAN)
CAPITAL INVESTMENT ANALYSIS
The principal objections to the use of the
average rate of return method are its failure
to consider the expected cash flows from
the proposals and the timing of these flows.
The principal limitations of the cash payback
method are its failure to consider cash flows
occurring after the payback period and its
failure to use present value concepts.
The average rate of return is not based on
cash flows, but on operating income. Thus,
for example, the average rate of return will
include the impact of depreciation, but the
internal rate of return will not. In addition, the
internal rate of return approach will use time
value of money concepts, while the average
rate of return does not.
The cash payback period ignores the cash
flows that occur after the cash payback pe-
riod, while the net present value method in-
cludes all cash flows in the analysis. The
cash payback period also ignores the time
value of money, which is also included in the
net present value method.
A one-year payback will not equal a 100%
average rate of return because the payback
period is based on cash flows, while the av-
erage rate of return is based on income. The
depreciation on the project will prevent the
two methods from reconciling.
The cash payback period ignores cash flows
occurring after the payback period, which
will often include large residual values.
The majority of the cash flows of a new mo-
tion picture are earned within two years of
release. Thus, the time value of money as-
pect of the cash flows is less significant for
motion pictures than for projects with time
extended cash flows. This would favor the
use of a cash payback period for evaluating
the cash flows of the project.
The $7,900 net present value indicates that
the proposal is desirable because the pro-
posal is expected to recover the investment
and provide more than the minimum rate of
The net present values indicate that both
projects are desirable, but not necessarily
equal in desirability. The present value index
can be used to compare the two projects.
For example, assume one project required
an investment of $10,000 and the other an
investment of $100,000. The present value
indexes would be calculated as 0.9 and
0.09, respectively, for the two projects. That
is, a $9,000 net present value on a $10,000
investment would be more desirable than
the same net present value on a $100,000
The computations for the net present value
method are more complex than those for the
methods that ignore present value. Also, the
method assumes that the cash received
from the proposal during its useful life will be
reinvested at the rate of return used to com-
pute the present value of the proposal. This
assumption may not always be reasonable.