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2
LEARNING
LEARNING OBJECTIVES
OBJECTIVES
1. Explain what a capital investment decision
is; distinguish between independent &
mutually exclusive decisions.
2. Compute payback period, accounting rate of
return for proposed investment; explain their
roles.
3. Use net present value analysis for capital
investment decision of independent projects.
Continued
3
LEARNING
LEARNING OBJECTIVES
OBJECTIVES
4. Use internal rate of return to assess
acceptability of independent projects.
5. Discuss the role and value of postaudits.
6. Explain why NPV is better than IRR for
capital investment decisions of mutually
exclusive projects.
Continued
4
LEARNING
LEARNING OBJECTIVES
OBJECTIVES
7. Convert gross cash flows to after-tax flows.
8. Describe capital investment in advanced
manufacturing environment.
6
QUESTIONS TO THINK ABOUT:
Honley Medical
7
QUESTIONS TO THINK ABOUT:
Honley Medical
8
QUESTIONS TO THINK ABOUT:
Honley Medical
9
LEARNING
LEARNING OBJECTIVE
OBJECTIVE
1
investment decision is;
distinguish between
independent & mutually
exclusive decisions.
10
LO 1
CAPITAL
CAPITAL INVESTMENT
INVESTMENT
DECISIONS:
DECISIONS: Definition
Definition
11
LO 1
What is a reasonable
return on a capital
investment?
13
LO 1
CAPITAL INVESTMENT
METHODS
Methods used to guide managers
investment decisions are:
Nondiscounting
Payback period
Accounting rate of return
Discounting
Net present value (NPV)
Internal rate of return (IRR)
14
LEARNING
LEARNING OBJECTIVE
OBJECTIVE
Compute payback
2
period, accounting rate
of return for proposed
investment; explain
their roles.
15
LO 2
PAYBACK
PAYBACK PERIOD:
PERIOD: Definition
Definition
16
LO 2
HONLEY
HONLEY MEDICAL:
MEDICAL: Background
Background
Honley
HonleyMedical
Medicalinvests
invests$1,000,000
$1,000,000in inaa
new
newRVRVgenerator.
generator.The
Theinvestment
investmentisis
expected
expectedtotogenerate
generatenet
netcash
cashflows
flowsof of
$500,000
$500,000perperyear.
year.How
Howlong
longwill
willitittake
take
for
forthe
theproject
projectto
tobreak
breakeven?
even?
17
LO 2
Payback period
= Original investment Annual cash flows
= $1,000,000 / $500,000
= 2 years
18
LO 2
19
LO 2
20
LO 2
HONLEY
HONLEY MEDICAL:
MEDICAL: Background
Background
Honley
HonleyMedical
Medicalisischoosing
choosingbetween
between22
different
differenttypes
typesofofcomputer-aided
computer-aideddesign
design
systems
systems(CAD).
(CAD).EachEachsystem
systemrequires
requiresaa
$150,000
$150,000initial
initialoutlay
outlayand
andhas
hasaa5-year
5-year
life.
life.Will
Willusing
usingpayback
paybackperiod
periodhelp
help
make
makethe
theright
rightchoice?
choice?
21
LO 2
CAD DECISION
Payback period
Investment Year 1 Year 2 Year 3 Year 4 Year 5
CAD A $ 90,000 $ 60,000 $ 50,000 $ 50,000 $ 50,000
CAD - B 40,000
} 110,000 25,000 25,000 25,000
22
LO 2
PAYBACK
PAYBACK PERIOD:
PERIOD: Summary
Summary
Payback period provides information that can
be used to help
Control risks of uncertain future cash flows
Minimize impact of investment on liquidity
problems
Control risk of obsolescence
Control effects of investment on performance
measures
23
LO 2
HONLEY
HONLEY MEDICAL:
MEDICAL: Background
Background
Honley
HonleyMedicals
MedicalsIV IVDivision
Divisionisisconsidering
considering
investing
investingininaaspecial
specialtooling
toolingwith
withaa55
year
yearlife
lifethat
thatrequires
requiresan
aninitial
initialoutlay
outlayof
of
$100,000.
$100,000. Average
Averagecash
cashflow
flowisis$36,000
$36,000
&&depreciation
depreciationisis$20,000.
$20,000.Will
Willthe
the
investment
investmentearn
earnananacceptable
acceptable
accounting
accountingrate
rateof
ofreturn?
return?
24
LO 2
25
LO 2
26
LEARNING
LEARNING OBJECTIVE
OBJECTIVE
3
Use net present value
analysis for capital
investment decision of
independent projects.
27
LO 3
NET
NET PRESENT
PRESENT VALUE
VALUE (NPV):
(NPV):
Definition
Definition
28
LO 3
29
LO 3
ANALYZING NPV
When NPV is positive:
The initial investment has been recovered
The required rate of return has been
achieved
A return in excess of (1) & (2) has been
received
30
LO 3
HONLEY
HONLEY MEDICAL:
MEDICAL: Background
Background
Honley
HonleyMedical
Medicalisisconsidering
consideringproducing
producingaa
home
homeblood
bloodpressure
pressureinstrument.
instrument.Equipment
Equipment
costing
costing$320,000
$320,000plus
plus$40,000
$40,000increase
increasein in
working
workingcapital
capitalwould
wouldbe berequired
requiredfor
forthe
the
project.
project.Annual
Annualnetnetcash
cashflows
flowsofof$120,000
$120,000
are
areexpected
expectedand
andHonley
Honleyrequires
requiresaa12%
12%rate
rate
of
ofreturn.
return.Should
ShouldHonley
Honleyproduce
producethethenew
new
product?
product?
31
LO 3
EXHIBIT 13.2
32
LO 3
EXHIBIT 13.2
33
LEARNING
LEARNING OBJECTIVE
OBJECTIVE
4
Use internal rate of
return to assess
acceptability of
independent projects.
34
LO 4
INTERNAL
INTERNAL RATE
RATE OF OF RETURN
RETURN
(IRR):
(IRR): Definition
Definition
35
LO 4
HONLEY
HONLEY MEDICAL:
MEDICAL: Background
Background
Honley
HonleyMedical
Medicalisisconsidering
consideringinvesting
investing
$1,200,000
$1,200,000ininaanew
newultrasound
ultrasoundsystem
system
product.
product.Net
Netannual
annualcash
cashinflows
inflowsof
of
$499,500
$499,500will
willoccur
occurfor
for33years.
years.Should
Should
Honley
Honleyinvest
investin
inthe
thenew
newproduct?
product?
36
LO 4
FORMULA: IRR
IRR measures a projects rate of return against
a hurdle rate for accepting projects.
IRR
= Investment Annual cash flows
= $1,200,000 / $499,500
= 2.402 (12%)
37
LO 4
38
LEARNING
LEARNING OBJECTIVE
OBJECTIVE
39
LO 5
POSTAUDIT:
POSTAUDIT: Definition
Definition
40
LO 5
41
LO 5
POSTAUDIT RESULTS
In the case of Honley Medicals investment in
RF, the postaudit concluded that the
investment was a poor decision. Benefits:
Complaints decreased
Fewer rejections
Direct labor & materials costs decreased
Costs:
Investment & operating costs higher
Costs outweighed benefits
42
LO 5
43
LEARNING
LEARNING OBJECTIVE
OBJECTIVE
6
better than IRR for
capital investment
decisions of mutually
exclusive projects.
44
LO 6
45
LO 6
Selection process
Assess cash flow pattern for each project
Compute NPV for each project
Identify project with greatest NPV
46
LO 6
HONLEY
HONLEY MEDICAL:
MEDICAL: Background
Background
Honley
HonleyMedical
Medicalisischoosing
choosingbetween
between22
different
differentprocesses
processesto toprevent
preventproduction
production
of
ofcontaminants.
contaminants.Design
DesignAArequires
requires
initial
initialoutlay
outlayof
of$180,000
$180,000while
whileDesign
Design
BBrequires
requiresananinitial
initialoutlay
outlayof
of$210,000.
$210,000.
Honley
HonleyMedical
Medicalhas hasaa12%
12%cost
costof
of
capital.
capital.Which
Whichprocess
processshould
shouldbebe
selected?
selected?
47
LO 6
POLUTION CONTROL
Investment Design A Design B
Annual revenues $179,460 $239,280
Annual operating costs 119,460 169,280
Equipment (before Y1) 180,000 210,000
Project life 5 years 5 years
48
LO 6
EXHIBIT 13.3
49
LO 6
Design A
EXHIBIT 13.3
Design B
50
LO 6
Design A
NPV shows that
Design B is best.
EXHIBIT 13.3
Design B
51
LEARNING
LEARNING OBJECTIVE
OBJECTIVE
7
Convert gross cash
flows to after-tax
flows.
52
LO 7
53
LO 7
EXHIBIT 13-4
54
LO 7
8
Describe capital
investment in advanced
manufacturing
environment.
56
LO 8
57
CHAPTER 13
THE
THE END
END
58