Capital
Investment
Decisions and
the Time Value
of Money
20
W
HAT
Y
OU
P
ROBABLY
A
LREADY
K
NOW
People purchase lottery tickets in the hopes of winning the grand jackpot. On
November 15, 2005, seven employees of a medical center won the Mega Millions
grand prize of $315 million. Winners can choose to receive the money in 26 equal
payments over the upcoming 25 years or in a lump sum. The seven winners decided
to take a lumpsum payment. You probably already know that opting for the lump
sum payment means that something less than $315,000,000 is received because of
the time value of money. Receiving a dollar now is worth more than receiving it in
a year, 5 years, or 25 years in the future. The winnings are “discounted,” reduced
to the present value. The seven winners received $187 million. In this chapter, we
will study how to calculate the present value of future cash flows and how that
information is used to help management make decisions.
Learning Objectives/Success Keys
Describe the importance of capital investments and the capital budgeting
process.
The investment of
capital assets
, longterm assets, is vitally important to a business.
New equipment and technologies are necessary to stay competitive. Because resources
are limited it is crucial to use a process to make decisions among competing invest
ments; this process is called capital budgeting analysis.
This preview has intentionally blurred sections. Sign up to view the full version.
View Full Document688
Chapter 20  Capital Investment Decisions and the Time Value of Money
Use the payback and accounting rate of return methods to make capital invest
ment decisions.
The focus of capital budgeting is on the net cash inflows that are projected in the future.
One tool that is used to assess capital investments is the payback period. The
payback
period
is the amount of time it takes to recover the initial investment. You will calculate
the payback period for two different products in Demo Doc 1.
Review Exhibits 202 through 204 (pp. 1045–1047) for an illustration of the payback
period concept.
You can use the
accounting rate of return
to determine the rate of return from an asset
over its useful life. You will calculate the accounting rate of return for two different prod
ucts in Demo Doc 1. The average annual operating income can be computed as the net
cash inflow from the asset less depreciation expense. The average amount invested in
the asset is the average of the cost amount and the residual value.
Review the “Accounting Rate of Return” section of the text (pp. 1048–1050) for an
accounting rate of return calculation.
Use the time value of money to compute the present and future values of single
lump sums and annuities.
The concepts of present and future values are necessary to make longterm business
decisions. To properly compute the present or future value of money the following terms
should be understood:
•
Annuity
is a stream of equal installments made at equal time intervals.
•
Principal (
This is the end of the preview.
Sign up
to
access the rest of the document.
 Spring '11
 mentor
 Net Present Value

Click to edit the document details