CHAPTER 26
CAPITAL INVESTMENT ANALYSIS
DISCUSSION QUESTIONS
1. 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.
2. 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.
3. 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.
4. A one-year payback will not equal a 100% average rate of return because the payback period
is based on cash flows, while the average rate of return is based on income. The depreciation
on the project will prevent the two methods from reconciling.
5. The cash payback period ignores cash flows occurring after the payback period, which will
often include large residual values.
6. The majority of the cash flows of a new motion picture are earned within two years of
release. Thus, the time value of money aspect 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.
7. The $7,900 net present value indicates that the proposal is desirable because the proposal is
expected to recover the investment and provide more than the minimum rate of return.
8. 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 investment.
9. 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 compute the
present value of the proposal. This assumption may not always be reasonable.
10. The computations for the internal rate of return 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 internal rate of return. This assumption
may not always be reasonable.
11. The major advantages of leasing are that it avoids the need to use funds to purchase assets
and reduces some of the risk of loss if the asset becomes obsolete. There may also be some
income tax advantages to leasing.
12. Quicker delivery of products, higher production quality, and greater manufacturing flexibility
are examples of qualitative factors that should be considered.
26-1
© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
, CHAPTER Capital Investment
PRACTICE EXERCISES
PE 26–1A
Estimate average annual income $29,700 ($148,500 ÷ 5 years)
Average investment $165,000 [($300,000 + $30,000) ÷ 2]
Average rate of return 18% ($29,700 ÷ $165,000)
PE 26–1B
Estimate average annual income $12,000 ($36,000 ÷ 3 years)
Average investment $40,000 [($70,000 + $10,000) ÷ 2]
Average rate of return 30% ($12,000 ÷ $40,000)
PE 26–2A
5.8 years ($787,640 ÷ $135,800)
PE 26–2B
4.5 years ($41,850 ÷ $9,300)
PE 26–3A
a. $4,181 [($12,200 × 3.605) – $39,800]
b. 1.11 ($43,981 ÷ $39,800)
PE 26–3B
a. ($10,546) [($96,200 × 3.170) – $315,500]
b. 0.97 ($304,954 ÷ $315,500)
PE 26–4A
10% [($74,035 ÷ $17,000) = 4.355, the present value of an annuity factor for six
periods at 10%, from Exhibit 2]
PE 26–4B
15% [($362,672 ÷ $76,000) = 4.772, the present value of an annuity factor for nine
periods at 15%, from Exhibit 2]
26-2
, CHAPTER Capital Investment
PE 26–5A
a. Present value of $5,000 per year at 12% for 6 years*…………………………… $20,555
Present value of $12,000 at 12% at the end of 6 years**……………………… 6,084
Total present value of Project A…………………………………………………… $26,639
Less total cost of Project A………………………………………………………… 22,500
Net present value of Project A……………………………………………………… $ 4,139
* [$5,000 × 4.111 (Exhibit 2, 12%, 6 years)]
** [$12,000 × 0.507 (Exhibit 1, 12%, 6 years)]
b. Project A. Project A’s net present value of $4,139 is more than the net present
value of Project B, $3,500.
PE 26–5B
a. Present value of $15,000 per year at 20% for 4 years*...........................................$38,835
Present value of $38,000 at 20% at the end of 4 years**....................................... 18,316
Total present value of Project 1................................................................................$57,151
Less total cost of Project 1....................................................................................... 55,000
Net present value of Project 1.................................................................................. $ 2,151
* [$15,000 × 2.589 (Exhibit 2, 20%, 4 years)]
** [$38,000 × 0.482 (Exhibit 1, 20%, 4 years)]
b. Project 2. Project 1’s net present value of $2,151 is less than the net present
value of Project 2, $5,000.
26-3
, CHAPTER Capital Investment
EXERCISES
Ex. 26–1
Testing
Equipment Vehicle
Estimated average annual income:
$18,720 ÷ 6……………………………………………………………… $3,120
$15,360 ÷ 8……………………………………………………………… $1,920
Average investment:
($104,000 + $0) ÷ 2……………………………………………………… $52,000
($32,000 + $0) ÷ 2……………………………………………………… $16,000
Average rate of return:
$3,120 ÷ $52,000………………………………………………………… 6%
$1,920 ÷ $16,000……………………………………………………… 12%
Ex. 26–2
Average Rate
= Average Annual Income
of Return
Average Investment
= Average Savings* – Annual Depreciation – Additional Operating Costs
(Beginning Cost + Residual Value) ÷ 2
$34,000 – [($132,000 – $16,000) ÷ 10 years] – $5,380
=
($132,000 + $16,000) ÷ 2
$17,020
= $74,000
= 23%
* The effect of the savings in wages expense is an increase in income.
26-4
CAPITAL INVESTMENT ANALYSIS
DISCUSSION QUESTIONS
1. 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.
2. 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.
3. 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.
4. A one-year payback will not equal a 100% average rate of return because the payback period
is based on cash flows, while the average rate of return is based on income. The depreciation
on the project will prevent the two methods from reconciling.
5. The cash payback period ignores cash flows occurring after the payback period, which will
often include large residual values.
6. The majority of the cash flows of a new motion picture are earned within two years of
release. Thus, the time value of money aspect 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.
7. The $7,900 net present value indicates that the proposal is desirable because the proposal is
expected to recover the investment and provide more than the minimum rate of return.
8. 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 investment.
9. 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 compute the
present value of the proposal. This assumption may not always be reasonable.
10. The computations for the internal rate of return 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 internal rate of return. This assumption
may not always be reasonable.
11. The major advantages of leasing are that it avoids the need to use funds to purchase assets
and reduces some of the risk of loss if the asset becomes obsolete. There may also be some
income tax advantages to leasing.
12. Quicker delivery of products, higher production quality, and greater manufacturing flexibility
are examples of qualitative factors that should be considered.
26-1
© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
, CHAPTER Capital Investment
PRACTICE EXERCISES
PE 26–1A
Estimate average annual income $29,700 ($148,500 ÷ 5 years)
Average investment $165,000 [($300,000 + $30,000) ÷ 2]
Average rate of return 18% ($29,700 ÷ $165,000)
PE 26–1B
Estimate average annual income $12,000 ($36,000 ÷ 3 years)
Average investment $40,000 [($70,000 + $10,000) ÷ 2]
Average rate of return 30% ($12,000 ÷ $40,000)
PE 26–2A
5.8 years ($787,640 ÷ $135,800)
PE 26–2B
4.5 years ($41,850 ÷ $9,300)
PE 26–3A
a. $4,181 [($12,200 × 3.605) – $39,800]
b. 1.11 ($43,981 ÷ $39,800)
PE 26–3B
a. ($10,546) [($96,200 × 3.170) – $315,500]
b. 0.97 ($304,954 ÷ $315,500)
PE 26–4A
10% [($74,035 ÷ $17,000) = 4.355, the present value of an annuity factor for six
periods at 10%, from Exhibit 2]
PE 26–4B
15% [($362,672 ÷ $76,000) = 4.772, the present value of an annuity factor for nine
periods at 15%, from Exhibit 2]
26-2
, CHAPTER Capital Investment
PE 26–5A
a. Present value of $5,000 per year at 12% for 6 years*…………………………… $20,555
Present value of $12,000 at 12% at the end of 6 years**……………………… 6,084
Total present value of Project A…………………………………………………… $26,639
Less total cost of Project A………………………………………………………… 22,500
Net present value of Project A……………………………………………………… $ 4,139
* [$5,000 × 4.111 (Exhibit 2, 12%, 6 years)]
** [$12,000 × 0.507 (Exhibit 1, 12%, 6 years)]
b. Project A. Project A’s net present value of $4,139 is more than the net present
value of Project B, $3,500.
PE 26–5B
a. Present value of $15,000 per year at 20% for 4 years*...........................................$38,835
Present value of $38,000 at 20% at the end of 4 years**....................................... 18,316
Total present value of Project 1................................................................................$57,151
Less total cost of Project 1....................................................................................... 55,000
Net present value of Project 1.................................................................................. $ 2,151
* [$15,000 × 2.589 (Exhibit 2, 20%, 4 years)]
** [$38,000 × 0.482 (Exhibit 1, 20%, 4 years)]
b. Project 2. Project 1’s net present value of $2,151 is less than the net present
value of Project 2, $5,000.
26-3
, CHAPTER Capital Investment
EXERCISES
Ex. 26–1
Testing
Equipment Vehicle
Estimated average annual income:
$18,720 ÷ 6……………………………………………………………… $3,120
$15,360 ÷ 8……………………………………………………………… $1,920
Average investment:
($104,000 + $0) ÷ 2……………………………………………………… $52,000
($32,000 + $0) ÷ 2……………………………………………………… $16,000
Average rate of return:
$3,120 ÷ $52,000………………………………………………………… 6%
$1,920 ÷ $16,000……………………………………………………… 12%
Ex. 26–2
Average Rate
= Average Annual Income
of Return
Average Investment
= Average Savings* – Annual Depreciation – Additional Operating Costs
(Beginning Cost + Residual Value) ÷ 2
$34,000 – [($132,000 – $16,000) ÷ 10 years] – $5,380
=
($132,000 + $16,000) ÷ 2
$17,020
= $74,000
= 23%
* The effect of the savings in wages expense is an increase in income.
26-4
