Study_Guide_ch20 - 48257_07_ch20_p687-710 11/5/08 9:29 AM...

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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 lump-sum 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 , long-term 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.
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688 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 20-2 through 20-4 (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 long-term 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 (
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Study_Guide_ch20 - 48257_07_ch20_p687-710 11/5/08 9:29 AM...

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