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Capital Budgeting and Investment Analysis: Techniques and Methods, Lecture notes of Accounting

University of DerbyAccounting

An overview of capital budgeting and investment analysis, focusing on four techniques: non-present value methods (cash payback method and accounting rate of return) and present value methods (net present value and internal rate of return). Learn the advantages and disadvantages of each method, formulas, and calculations.

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ACCT 102 – Chapter 24
Capital Budgeting and Investment Analysis
Johnson
The major goal of this chapter is to be familiar with and be able to implement four capital
investment analysis techniques.
Capital budgeting is a bit more challenging than other types of management decisions, because
the impact involves longer term predictions and estimates that can impact the company for many
years to come.
Capital budgeting and investment analysis can take one of two directions:
1. Non-present value methods that do not consider the time value of money
2. Present value methods that do consider the time value of money
See last page for a summary of the advantages and disadvantages of these methods.
NON PRESENT VALUE METHODS –
These DO NOT consider the time value of money
Cash Payback Method
This represents the expected time period to recover the initial amount invested. The shorter the
recovery period, the better the investment is because you can now use your cash for other
purposes. You must compute the expected cash flows over the life of the product. Non-cash
expenses (like depreciation and accruals and deferrals) are not considered and therefore are
backed out.
Payback Period = Cost of Investment / Annual net cash flow
(assumes equal cash flows)
Note that the answer will be in a period of months or years.
If cash flows are uneven, you can accumulate the cash over the life until you reach the
investment amount similar to the table in your text.
Accounting Rate of Return
This method, also called the return on average investment, is the only method that uses GAAP
net income as opposed to cash.
Formula: After Tax Net income
_________________ == Accounting Rate of Return
Average Amount Invested *
* (Average Book Values summed up / the number of years of the asset) OR
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ACCT 102 – Chapter 24

Capital Budgeting and Investment Analysis

Johnson

The major goal of this chapter is to be familiar with and be able to implement four capital investment analysis techniques. Capital budgeting is a bit more challenging than other types of management decisions, because the impact involves longer term predictions and estimates that can impact the company for many years to come. Capital budgeting and investment analysis can take one of two directions:

  1. Non-present value methods that do not consider the time value of money
  2. Present value methods that do consider the time value of money See last page for a summary of the advantages and disadvantages of these methods.

NON PRESENT VALUE METHODS –

These DO NOT consider the time value of money

Cash Payback Method

This represents the expected time period to recover the initial amount invested. The shorter the recovery period, the better the investment is because you can now use your cash for other purposes. You must compute the expected cash flows over the life of the product. Non-cash expenses (like depreciation and accruals and deferrals) are not considered and therefore are backed out. Payback Period = Cost of Investment / Annual net cash flow (assumes equal cash flows) Note that the answer will be in a period of months or years. If cash flows are uneven, you can accumulate the cash over the life until you reach the investment amount similar to the table in your text.

Accounting Rate of Return

This method, also called the return on average investment, is the only method that uses GAAP net income as opposed to cash. Formula: After Tax Net income _________________ == Accounting Rate of Return Average Amount Invested *

  • (Average Book Values summed up / the number of years of the asset) OR

Alternatively for assets that use SL as method of depreciation (Beg BV + End BV)/ OR If an asset has salvage value then (Beg BV + SV)/ 2

PRESENT VALUE METHODS THAT

DO CONSIDER THE TIME VALUE OF MONEY

Net Present Value – This method applies the time value of money to future cash inflows and

outflows so that management can determine whether it is earning above it’s minimum desired rate of return, also called its “cost of capital” or sometimes “hurdle rate.” We know that a dollar received today is worth more than the same dollar to be received a year from now. The present value is what the future inflows on the assets would be worth in TODAY’s dollars. We will run through a basic PV calculation in class, and then discuss how tables can help us shortcut our calculations. The net present value method schedules out cash flows and present values the amounts back using the present value tables located in your book. If the present values of the cash flows are greater than the cost, then the investment is earning above what management desires. If not, and the resulting net present value is negative, then the investment is earning less than what management desires and should be rejected. If assets have salvage value, then a separate cash flow at the end of the life should be utilized and added on to the schedule of cash flows. If assets have differing costs, then you need calculate a profitability index in order to rank the investments, because they will not be automatically comparable. Profitability Index = NPV of cash flows/Amount of investment.

Computing the Internal Rate of Return – IRR

This method actually backs into the return, given the assets cash flows and life. It will yield the rate that yields an NPV of zero for a given investment. Step 1 – Compute the “Factor” for the investment Factor = Amount Invested/Net annual cash flows Step 2 – Look up the factor that you calculated based on life of the assets. If it isn’t exact, then you can estimate as shown in text.