Capital investments involve a long-term commitment of funds. Investments must earn a reasonable rate of return. The process should include a plan for encouraging and rewarding employees for submitting proposals.

1. Developed by Dr IKRAM UL HAQ CPA, Ph.D.
L 18
Capital Investment
Analysis
05/06/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY CPA, Ph.D.

2. 1. Explain the nature and importance of capital investment
analysis.
2. Evaluate capital investment proposals, using the
following methods: average rate of return, cash
payback, net present value, and internal rate of return.
3. List and describe factors that complicate capital
investment analysis.
L 18 Capital Investment Analysis
Objectives
05/06/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY CPA, Ph.D.

3. Nature of Capital Investment AnalysisNature of Capital Investment AnalysisNature of Capital Investment AnalysisNature of Capital Investment Analysis
1.Management plans, evaluates, and controls investments
in fixed assets.
2.Capital investments involve a long-term commitment of
funds.
3.Investments must earn a reasonable rate of return.
4.The process should include a plan for encouraging and
rewarding employees for submitting proposals.
Capital budgeting is the process by which
management plans, evaluates, and controls long-
term investments in fixed assets.
Capital budgeting is the process by which
management plans, evaluates, and controls long-
term investments in fixed assets.
05/06/18 Developed by Dr IKRAM UL HAQ CHOUDHARY CPA, Ph.D.

4. Methods of EvaluatingMethods of Evaluating
Capital Investment ProposalsCapital Investment Proposals
Methods of EvaluatingMethods of Evaluating
Capital Investment ProposalsCapital Investment Proposals
Here’s a survey of business practices in
a variety of industries. It reports the
capital investment analysis methods
used by large U.S. companies.
Here’s a survey of business practices in
a variety of industries. It reports the
capital investment analysis methods
used by large U.S. companies.
05/06/18
Developed by Dr IKRAM UL HAQ CHOUDHARY CPA, Ph.D.

5. Average rate
of return
Cash payback
method
Net present
value method
Internal rate
of return
method
0% 10% 20% 30% 40% 50% 60% 70% 80%
90%
15%
53%
85%
76%
Journal of Business and Management (Winter 2002)
05/06/18 Developed by Dr IKRAM UL HAQ CHOUDHARY CPA, Ph.D.

6.  Easy to calculate
 Considers accounting income (often used to
evaluate managers)
Average Rate of Return Method
Advantages:
 Ignores cash flows
 Ignores the time value of money
Disadvantages:
Methods that Ignore Present ValueMethods that Ignore Present ValueMethods that Ignore Present ValueMethods that Ignore Present Value
05/06/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY CPA, Ph.D.

7. Machine cost $500,000
Expected useful life 4 years
Residual value none
Expected total income $200,000
Assumptions:
Average Rate
of Return
Estimated Average
Annual Income
Average Investment
=
Average Rate of Return MethodAverage Rate of Return MethodAverage Rate of Return MethodAverage Rate of Return Method
Average Rate
of Return =
$200,000 ÷ 4 years
=
($500,000 + $0) / 2
20%
05/06/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY CPA, Ph.D.

8. Average annual income $ 30,000 $ 36,000
Average investment $120,000 $180,000
Assumptions: Proposal A Proposal B
$30,000
$120,000
= 25%
Average Rate of Return MethodAverage Rate of Return MethodAverage Rate of Return MethodAverage Rate of Return Method
05/06/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY CPA, Ph.D.

9. Average annual income $ 30,000 $ 36,000
Average investment $120,000 $180,000
Assumptions: Proposal A Proposal B
$36,000
$180,000
= 20%
Average Rate of Return MethodAverage Rate of Return MethodAverage Rate of Return MethodAverage Rate of Return Method
05/06/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY CPA, Ph.D.

10.  Considers cash flows
 Shows when funds are available
for reinvestment
 Ignores profitability (accounting income)
 Ignores cash flows after the payback
period
Cash Payback Method
Methods that Ignore Present ValueMethods that Ignore Present ValueMethods that Ignore Present ValueMethods that Ignore Present Value
Advantages:
Disadvantages:
05/06/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY CPA, Ph.D.

11. Cash Payback MethodCash Payback MethodCash Payback MethodCash Payback Method
Investment cost $200,000
Expected useful life 8 years
Expected annual net
cash flows (equal) $40,000
Assumptions:
Cash
Payback
Period
Total Investment
Annual Net
Cash Inflows
=
Cash
Payback
Period
$200,000
=
$40,000
= 5 years
05/06/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY CPA, Ph.D.

12. Year 1 $ 60,000 $ 60,000
Year 2 80,000 140,000
Year 3 105,000 245,000
Year 4 155,000 400,000
Year 5 100,000 500,000
Year 6 90,000 590,000
Net Cash Cumulative
Flow Net Cash Flow
Cash Payback MethodCash Payback MethodCash Payback MethodCash Payback Method
If the proposed investment is
$400,000, the payback period is at
the end of Year 4.
If the proposed investment is
$400,000, the payback period is at
the end of Year 4.
05/06/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY CPA, Ph.D.

13. The time value of money concept is used in many
business decisions. This concept is an important
consideration in capital investment analysis.
Present
Value
$ ????
What is the present value of
$1,000 to be received one year
from today at 8% per year?
What is the present value of
$1,000 to be received one year
from today at 8% per year?
Present Value MethodsPresent Value MethodsPresent Value MethodsPresent Value Methods
$ 925.93 = $1,000 ÷ 1.08
05/06/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY CPA, Ph.D.

14. How much would have to be invested on
February 1, 2006 in order to receive
$1,000 on February 1, 2009 if the interest
rate compounded annually is 12%?
How much would have to be invested on
February 1, 2006 in order to receive
$1,000 on February 1, 2009 if the interest
rate compounded annually is 12%?
Present Value MethodsPresent Value MethodsPresent Value MethodsPresent Value Methods
05/06/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY CPA, Ph.D.

15. Refer to the partial present
value table in Slide 18 to
answer the question.
Refer to the partial present
value table in Slide 18 to
answer the question.
Present Value MethodsPresent Value MethodsPresent Value MethodsPresent Value Methods
$1,000, 3
years, 12%
compounded
annually
05/06/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY CPA, Ph.D.

16. Calculating Present ValuesCalculating Present ValuesCalculating Present ValuesCalculating Present Values
Present values can be determined using present value
tables, mathematical formulas, a calculator or a computer.
Present Value of $1 with Compound InterestPresent Value of $1 with Compound Interest
1 0.943 0.909 0.893 0.870 0.833
2 0.890 0.826 0.797 0.756 0.694
3 0.840 0.751 0.712 0.658 0.579
4 0.792 0.683 0.636 0.572 0.482
5 0.747 0.621 0.567 0.497 0.402
6 0.705 0.564 0.507 0.432 0.335
Year 6% 10% 12% 15% 20%
$1,000 x .712 = $712$1,000 x .712 = $712
0.7120.712
05/06/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY CPA, Ph.D.

17. Present Value of an AmountPresent Value of an AmountPresent Value of an AmountPresent Value of an Amount
If $712 is invested on February 1, 2006
at an annual rate of 12 percent, $1,000
will accumulate by February 1, 2009.
If $712 is invested on February 1, 2006
at an annual rate of 12 percent, $1,000
will accumulate by February 1, 2009.
$1,000 x .712 = $712$1,000 x .712 = $712
05/06/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY CPA, Ph.D.

18. Present Value of an AmountPresent Value of an AmountPresent Value of an AmountPresent Value of an Amount
Feb. 1
2006 Feb. 1
2007 Feb. 1
2008 Feb. 1
2009
$712 x 1.12 $797 x 1.12 $893 x 1.12 $1,000
05/06/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY CPA, Ph.D.

19. Present Value of an AnnuityPresent Value of an AnnuityPresent Value of an AnnuityPresent Value of an Annuity
An annuity is a series of equal net
cash flows at fixed time intervals.
The present value of an annuity is the
sum of the present values of each
cash flows.
An annuity is a series of equal net
cash flows at fixed time intervals.
The present value of an annuity is the
sum of the present values of each
cash flows.
What would be the present value of a
$100 annuity for five periods at 12?
What would be the present value of a
$100 annuity for five periods at 12?
05/06/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY CPA, Ph.D.

20. Present Value of an Annuity of $1Present Value of an Annuity of $1
1 0.943 0.909 0.893 0.870 0.833
2 1.833 1.736 1.690 1.626 1.528
3 2.673 2.487 2.402 2.283 2.106
4 3.465 3.170 3.037 2.855 2.589
5 4.212 3.791 3.605 3.353 2.991
6 4.917 4.355 4.111 3.785 3.326
Year 6% 10% 12% 15% 20%
Calculating Present Values of AnnuitiesCalculating Present Values of AnnuitiesCalculating Present Values of AnnuitiesCalculating Present Values of Annuities
3.605 x $100 = $360.50
3.6053.605
05/06/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY CPA, Ph.D.

21. Net PresentNet Present
ValueValue
MethodMethod
Net PresentNet Present
ValueValue
MethodMethod
The net present value
method analyzes capital
investment proposals by
comparing the initial
cash investment with the
present value of the net
cash flows.
The net present value
method analyzes capital
investment proposals by
comparing the initial
cash investment with the
present value of the net
cash flows.
05/06/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY CPA, Ph.D.

22.  Considers cash flows and the time value
of money
Net Present Value MethodNet Present Value MethodNet Present Value MethodNet Present Value Method
Advantage:
 Assumes that cash received can be
reinvested at the rate of return
Disadvantage:
05/06/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY CPA, Ph.D.

23. Cash Flow Present Value
At the beginning of 2006, equipment with
an expected life of five years can be
purchased for $200,000. At the end of
five years it is anticipated that the
equipment will have no residual value.
At the beginning of 2006, equipment with
an expected life of five years can be
purchased for $200,000. At the end of
five years it is anticipated that the
equipment will have no residual value.
Net Present Value MethodNet Present Value MethodNet Present Value MethodNet Present Value Method
A net cash flow of $70,000 is expected at the end of
2006. This net cash flow is expected to decline
$10,000 each year (except 2010) until the machine is
retired. The firm expects a minimum rate of return
of 10%. Should the equipment be purchased?
A net cash flow of $70,000 is expected at the end of
2006. This net cash flow is expected to decline
$10,000 each year (except 2010) until the machine is
retired. The firm expects a minimum rate of return
of 10%. Should the equipment be purchased?05/06/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY CPA, Ph.D.

24. First, we must determine which
table to use… the present value of
$1 or the present value of an
annuity of $1.
First, we must determine which
table to use… the present value of
$1 or the present value of an
annuity of $1.
Net Present Value MethodNet Present Value MethodNet Present Value MethodNet Present Value Method
05/06/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY CPA, Ph.D.

25. Because there are multiple years
of net cash flows, shouldn’t we
use the present value of an
annuity of $1?
Because there are multiple years
of net cash flows, shouldn’t we
use the present value of an
annuity of $1?
Net Present Value MethodNet Present Value MethodNet Present Value MethodNet Present Value Method
05/06/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY CPA, Ph.D.

26. That would be true if the net cash flows
remained constant from 2006 through
2010. Note that the net cash flows are
$70,000, $60,000, $50,000, $40,000,
and $40,000, respectively.
That would be true if the net cash flows
remained constant from 2006 through
2010. Note that the net cash flows are
$70,000, $60,000, $50,000, $40,000,
and $40,000, respectively.
Net Present Value MethodNet Present Value MethodNet Present Value MethodNet Present Value Method
So, we have to use the
present value of $1 for each
of the five years.
So, we have to use the
present value of $1 for each
of the five years.05/06/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY CPA, Ph.D.

27. $ 63,630 $70,000 x 0.909 (n = 1; i = 10%)
$ 49,560 $60,000 x 0.826 (n = 2; i = 10%)
$ 37,550 $50,000 x 0.751 (n = 3; i = 10%)
$ 27,320 $40,000 x 0.683 (n = 4; i = 10%)
$ 24,840 $40,000 x 0.621 (n = 5; i = 10%)
Jan. 1
2006 Dec. 31
2006 Dec. 31
2007 Dec. 31
2008 Dec. 31
2009 Dec. 31
2010
$<200,000> $70,000 $60,000 $50,000 $40,000 $40,000
Net Present Value MethodNet Present Value MethodNet Present Value MethodNet Present Value Method
05/06/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY CPA, Ph.D.

28. $ 63,630
$ 49,560
$ 37,550
$ 27,320
$ 24,840
$ 2,900
Net Present Value MethodNet Present Value MethodNet Present Value MethodNet Present Value Method
Jan. 1
2006 Dec. 31
2006 Dec. 31
2007 Dec. 31
2008 Dec. 31
2009 Dec. 31
2010
$<200,000> $70,000 $60,000 $50,000 $40,000 $40,000
The equipment should
be purchased because
the net present value is
positive.
The equipment should
be purchased because
the net present value is
positive.
05/06/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY CPA, Ph.D.

29. When capital investment funds are
limited and the alternative proposals
involve different amounts of investment,
it is useful to prepare a ranking of the
proposals using a present value index.
(a.k.a. profitability index)
When capital investment funds are
limited and the alternative proposals
involve different amounts of investment,
it is useful to prepare a ranking of the
proposals using a present value index.
(a.k.a. profitability index)
Net Present Value MethodNet Present Value MethodNet Present Value MethodNet Present Value Method
05/06/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY CPA, Ph.D.

30. Total present value $107,000 $86,400 $93,600
Total investment 100,000 80,000 90,000
Net present value $ 7,000 $ 6,400 $ 3,600
Present value index 1.07 1.08 1.04
Assumptions:Assumptions:
Proposals
A B C
$107,000 ÷$107,000 ÷
$100,000$100,000
$107,000 ÷$107,000 ÷
$100,000$100,000
$86,400 ÷$86,400 ÷
$80,000$80,000
$86,400 ÷$86,400 ÷
$80,000$80,000
$93,600 ÷$93,600 ÷
$90,000$90,000
$93,600 ÷$93,600 ÷
$90,000$90,000
TheThe
bestbest
TheThe
bestbest
Net Present Value MethodNet Present Value MethodNet Present Value MethodNet Present Value Method
05/06/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY CPA, Ph.D.

31.  Considers cash flows and the time value of money
 Ability to compare projects of unequal size
Advantages:
Disadvantages:
 Requires complex calculations
 Assumes that cash can be reinvested
at the internal rate of return
Internal Rate of Return MethodInternal Rate of Return MethodInternal Rate of Return MethodInternal Rate of Return Method
05/06/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY CPA, Ph.D.

32. Internal Rate of Return MethodInternal Rate of Return MethodInternal Rate of Return MethodInternal Rate of Return Method
Assume a rate of return and calculate the present
value. Modify the rate of return and calculate a
new present value. Continue until the present
value approximates the investment cost.
The internal rate of return method uses the net cash
flows to determine the rate of return expected from the
proposal. The following approaches may be used:
Trial and ErrorTrial and Error
Computer FunctionComputer Function
Use a computer function to calculate exactly the
expected rate of return.
05/06/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY CPA, Ph.D.

33. $97,360
$20,000
= 4.868
Determine the table value using
the present value for an annuity
of $1 table.
Internal Rate of Return MethodInternal Rate of Return MethodInternal Rate of Return MethodInternal Rate of Return Method
Amount to be invested
Equal annual cash flow
Management is evaluating a proposal to acquire
equipment costing $97,360. The equipment is
expected to provide annual net cash flows of
$20,000 per year for seven years.
Management is evaluating a proposal to acquire
equipment costing $97,360. The equipment is
expected to provide annual net cash flows of
$20,000 per year for seven years.
05/06/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY CPA, Ph.D.

34. Present Value of an Annuity of $1Present Value of an Annuity of $1Present Value of an Annuity of $1Present Value of an Annuity of $1
1 0.943 0.909 0.893 0.870
2 1.833 1.736 1.690 1.626
3 2.673 2.487 2.402 2.283
4 3.465 3.170 3.037 2.855
5 4.212 3.791 3.605 3.353
6 4.917 4.355 4.111 3.785
7 5.582 4.868 4.564 4.160
Year 6% 10% 12% 15%
4.8684.868
Internal Rate of Return MethodInternal Rate of Return MethodInternal Rate of Return MethodInternal Rate of Return Method
Find the seven year line on the table. Then, go across the 7-
year line until the closest amount to 4.868 is located.
Move vertically to the top of the table to determine the interest rate
10%
05/06/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY CPA, Ph.D.

35. Factors That Complicate CapitalFactors That Complicate Capital
Investment AnalysisInvestment Analysis
Factors That Complicate CapitalFactors That Complicate Capital
Investment AnalysisInvestment Analysis
 Income tax
 Unequal proposal lives
 Lease versus capital investment
 Uncertainty
 Changes in price levels
 Qualitative considerations
05/06/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY CPA, Ph.D.

36. Qualitative ConsiderationsQualitative ConsiderationsQualitative ConsiderationsQualitative Considerations
1. Improve product quality
2. Reduce defects and manufacturing cycle time
3. Increase manufacturing flexibility
4. Reduce inventories and need for inspection
5. Eliminate non-value-added activities
Improvements that increase competitiveness and
quality are difficult to quantify. The following
qualitative factors are important considerations.
05/06/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY CPA, Ph.D.

37. Capital RationingCapital RationingCapital RationingCapital Rationing
1. Identify potential projects.
2. Eliminate projects that do not meet minimum
cash payback or average rate of return
expectations.
3. Evaluate the remaining projects, using present
value methods.
4. Consider the qualitative benefits of all projects.
5. Rank the projects and allocate available funds.
05/06/18
Developed by Dr IKRAM UL HAQ
CHOUDHARY CPA, Ph.D.