Chapter 24 - Capital budgeting & investment analysis. The goals of this chapter are: Describe the selection of a hurdle rate for an investment, analyze a capital investment project using break-even time, compute payback period and describe its use, compute accounting rate of return and explain its use, compute net present value and describe its use, compute internal rate of return and explain its use. | Financial and Managerial Accounting Wild, Shaw, and Chiappetta Fourth Edition McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 24 Capital Budgeting & Investment Analysis Conceptual Learning Objectives C1: Describe the selection of a hurdle rate for an investment. 24- A1: Analyze a capital investment project using break-even time. Analytical Learning Objectives 24- P1: Compute payback period and describe its use. P2: Compute accounting rate of return and explain its use. P3: Compute net present value and explain its use. P4: Compute internal rate of return and explain its use. Procedural Learning Objectives 24- Capital budgeting: Analyzing alternative long- term investments and deciding which assets to acquire or sell. Outcome is uncertain. Large amounts of money are usually involved. Investment involves a long-term commitment. Decision may be difficult or impossible to reverse. Capital Budgeting C 1 24- Payback period = Cost of Investment Annual Net Cash Flow Payback Period The payback period of an investment is the time expected to recover the initial investment amount. Managers prefer investing in projects with shorter payback periods. Exh. 25-2 P1 24- Ignores the time value of money. Ignores cash flows after the payback period. Unacceptable for projects with long lives where time value of money effects are major. Using the Payback Period P1 24- The accounting rate of return focuses on annual income instead of cash flows. Accounting Rate of Return Accounting Annual after-tax net income rate of return Annual average investment = Beginning book value + Ending book value 2 Exh. 25-5,6 P2 24- Discount the future net cash flows from the investment at the required rate of return. Subtract the initial amount invested from sum of the discounted cash flows. . More work! – However. large dollar investments usually justify the extra time up front to insure that the investment choice is a wise one. Net Present Value P3 24- General decision rule . . . Using Net Present Value P3 24- Internal Rate of Return (IRR) The interest rate that makes . . . Present value of cash inflows Present value of cash outflows = The net present value equal zero. P4 24- 1. Determine the present value factor. $12,000 ÷ $5,000 per year = 2. Using present value of annuity table . . . IRR is the interest rate of the column in which the present value factor is found. IRR is approximately 12%. Exh. 26-9 P4 Internal Rate of Return (IRR) 24- Internal Rate of Return Compare the internal rate of return on a project to a predetermined hurdle rate (cost of capital). To be acceptable, a project’s rate of return cannot be less than the cost of capital. Using Internal Rate of Return P4 24- Comparing Methods C1 24- On this screen, we see a summary comparing the strengths and limitations of each of the four capital budgeting methods that we have studied. Recall that the major limitation of the payback method and the accounting rate of return method is that they neglect the time value of money. This limitation is overcome by using either the net present value or internal rate of return methods. End of Chapter 24 24-
