MAC 2

Capital Investment Decisions

Long range decisions involving

opportunities to invest in new assets or
projects
Among the most important decisions
made by managers
Place large amounts of resources at risk
for long periods of time
Affect the future development of the
firm
Decision making process is called
Capital Budgeting
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Capital Budgeting

Two types:

Independent projects (Mutually

exclusive projects)

If accepted or rejected, do not affect the

cash flows of other projects

Competing projects

Acceptance of one alternative precludes

the acceptance of another

Capital Budgeting
Managers must decide whether or not a
capital investment will:

Earn back its original outlay

Provide a reasonable return

Covering the opportunity cost of the

funds invested

To make a capital investment decision,

managers must:

Make estimates of the quantity and timing

of after-tax cash flows

Assess the risk of the investment

Consider the impact of the project on
the firms profits

Making Capital Investment Decisions

Managers must:

Set goals and priorities set for capital investments

Establish basic criteria for acceptance or rejection of
proposed investments

Two types of methods:

1.

Nondiscounting models

Do not consider time value of money

Two methods

2.

Discounting models

Use time value of money

Two methods

Payback period
Accounting rate of return (ARR)

Net present value (NPV)

Internal rate of return (IRR)

Most companies use both types of methods

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Definition
Payback
period = Original investment / Annual cash flow

Accounting Rate of Return

Measures the return on a project in terms
of income as opposed to using cash flow

Formula:

Accounting
Rate of = Average income / Initial investment
Return

Average income is not the same as cash flows

Formula:
Add net income for each year of the project and
divide by the number of years

Definition
Accounting
Rate of = Average Net Income / Initial Investment
Return

Net Present Value (NPV)

Difference between the present value of
the cash inflows and outflows associated
with a project
Measures the net cash flows of the project
Size of the positive NPV measures the
increase in value of the firm resulting
from an investment
To use NPV method, a required rate of
return must be defined

Minimum acceptable rate of return

Evaluating Net Present Value (NPV)

If NPV is positive:

Rate of return on the investment is greater than

the required rate of return
Investment, the minimum rate of return, and a
return in excess of profit are all recovered
Investment is acceptable

If NPV is zero:

Rate of return on the investment is exactly the

required rate of return
Investment and the minimum rate of return are
recovered
Decision maker will be ambivalent regarding
acceptance or rejection
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Evaluating Net Present Value (NPV)

If NPV is negative:

Rate of return on the investment is less than the

required rate of return
Investment cost may or may not be recovered, and
the minimum rate or return is not recovered
Initial investment should be rejected

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Internal Rate of Return (IRR)

Interest rate that sets the projects NPV to

zero

Formula: I = CFt / (1 + i)t

Can be found using trial and error, or
Using PV tables
Compared to required rate of return

If IRR > Required rate of return

Project is deemed acceptable
If IRR < Required rate of return
Project is rejected

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Definition
Internal Rate of Return
Discount factor = Investment / Annual Cash Flow

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Post Audit of Capital Projects

Follow-up analysis of project once it is
implemented
Should be completed by independent
party

Compares:

Often internal audit staff

Actual benefits to estimated benefits
Actual operating costs to estimated costs

Evaluates the overall outcome of the

investment
Proposes corrective action if needed
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Benefits of a Postaudit
By evaluating profitability and cash flows,
firms ensure that assets are used wisely
Managers held accountable for results of
capital investment decisions

More likely to make decisions in the best

interest of the firm
Feedback is gained and used in future decision
making

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Drawbacks of a Postaudit
Costly
Limitations:

Assumption driving original analysis may often

be invalidated by changes in the actual
operating environment

Accountability must be qualified:

By the impossibility of foreseeing every

possible eventuality

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Mutually Exclusive Projects

Net Present Value (NPV) and Internal Rate
of Return (IRR) can produce different
results
NPV

IRR

Assumes that each cash flow received is

reinvested at the required rate of return
Measures cash flow profitability in absolute
terms
Assumes that each cash flow is reinvested at
the computed IRR
Measures cash flow profitability in relative
terms

NPV consistently selects the project which17

Steps in Selecting Best Project

1.
2.
3.

Assess the flow pattern for each project

Compute the net present value (NPV) for
each project
Identify the project with the greatest NPV

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