FM2 Ch 12 summary. Capital investment analysis
Nature of capital investment analysis.
Companies use capital investment analysis to evaluate long-term investments. Capital investment
analysis is the process by which management plans, evaluates, and controls investments in fixed
assets. They use funds and affect operations, and must earn reasonable rate of return. Some of the
most important decisions. They can be grouped into two categories:
1. Methods that do NOT use present values.
- Average rate of return method
- Cash payback method
2. Methods that use present values. (consider the time value of money. A dollar today is worth
more than a dollar tomorrow interest)
- Net present value method
- Internal rate of return method
Methods NOT using present values.
Often used in evaluating capital investment proposals that have relatively short useful lives. Timing of
cash flows is less important. Easy to use and often used to screen proposals. If a proposal meets the
minimum standards, it may be subject to further analysis using the present value methods.
Average rate of return.
Measures the average income as percent of the average investment.
Average rate of return = estimated average annual income (after deducting depreciation, divide by
years) / average
Investment (book value)
Average investment = (Initial cost + residual value) / 2
First calculate the investment, if needed, in order to be able to calculate the average rate of return.
The average rate of return should be compared to the minimum rate of return required by
management. If it equals or exceeds the minimum rate, the machine should be purchased or
considered for further analysis. The higher the average rate of return, the more desirable.
Three advantages:
1. Easy to compute
2. Includes the entire amount of income earned over the life of the proposal
3. Emphasizes accounting income, which is often used by investors in evaluating performance
Two disadvantages:
1. Does not directly consider the expected cash flows from the proposal
2. Does not directly consider the timing of the expected cash flows
Cash payback method.
Capital investment uses cash and must return cash in the future. The expected period of time between
investment and recovery of cash of the amount invested is the cash payback period. When annual net
cashflows are equal, the cash payback period is computed as follows:
Cash payback period = initial cost / annual net cash flows.
Nature of capital investment analysis.
Companies use capital investment analysis to evaluate long-term investments. Capital investment
analysis is the process by which management plans, evaluates, and controls investments in fixed
assets. They use funds and affect operations, and must earn reasonable rate of return. Some of the
most important decisions. They can be grouped into two categories:
1. Methods that do NOT use present values.
- Average rate of return method
- Cash payback method
2. Methods that use present values. (consider the time value of money. A dollar today is worth
more than a dollar tomorrow interest)
- Net present value method
- Internal rate of return method
Methods NOT using present values.
Often used in evaluating capital investment proposals that have relatively short useful lives. Timing of
cash flows is less important. Easy to use and often used to screen proposals. If a proposal meets the
minimum standards, it may be subject to further analysis using the present value methods.
Average rate of return.
Measures the average income as percent of the average investment.
Average rate of return = estimated average annual income (after deducting depreciation, divide by
years) / average
Investment (book value)
Average investment = (Initial cost + residual value) / 2
First calculate the investment, if needed, in order to be able to calculate the average rate of return.
The average rate of return should be compared to the minimum rate of return required by
management. If it equals or exceeds the minimum rate, the machine should be purchased or
considered for further analysis. The higher the average rate of return, the more desirable.
Three advantages:
1. Easy to compute
2. Includes the entire amount of income earned over the life of the proposal
3. Emphasizes accounting income, which is often used by investors in evaluating performance
Two disadvantages:
1. Does not directly consider the expected cash flows from the proposal
2. Does not directly consider the timing of the expected cash flows
Cash payback method.
Capital investment uses cash and must return cash in the future. The expected period of time between
investment and recovery of cash of the amount invested is the cash payback period. When annual net
cashflows are equal, the cash payback period is computed as follows:
Cash payback period = initial cost / annual net cash flows.
