Managerial Accounting

Module 9: Capital Investment Analysis

Module Learning Outcomes

Capital Investment Analysis

9.1: Describe the capital budgeting process

9.2: Identify the essential elements of a capital budgeting decision
9.3: Use basic capital budgeting tools to analyze investment options
9.4: Use time value of money to analyze investment options
Capital Budgets
Learning Outcomes: Describe the capital budgeting process

9.1: Describe the capital budgeting process

9.1.1: Describe the capital budgeting process
9.1.2: Understand operating and implementation costs in a capital budgeting
analysis
9.1.3: Understand the focus on cash flows for capital investment decision
making
 Describe the Capital Budgeting Process

Capital budgeting is the process of considering alternative

capital projects and selecting those alternatives that
provide the most profitable return on available funds
within the framework of company goals and objectives.

A capital project is any available alternative to purchase,

build, lease, or renovate buildings, equipment, or other
long-range major items of property.

The alternative selected usually involves large sums of

money and brings about a large increase in fixed costs for
a number of years in the future.
Describe the Capital Budgeting Process

The capital budgeting process can be logically broken down into three
phases:

1. Screening - narrow down the options.

2. Analysis - estimate cost and cash flow.
3. Implementation - select the project and move forward.
 Understand Operating and Implementation Costs in a
Capital Budgeting Analysis
Phase 2--Step 4: Estimate operating and
implementation costs.

Implementation costs are the total initial

investment, which is the total cost of the asset
being acquired, or the total investment necessary
to fund the project.

Operating costs are the ongoing expenses needed

to fund day-to-day operations.
What is Capital Budgeting?

• [Link]
Understand the Focus on Cash Flows for Capital
Investment Decision Making
Cash flows give us a solid basis for a simpler
but yet accurate measure of the results of our
capital investment so we can compare options.

Net Annual Cash Flows =

Cash Inflows - Cash Outflows
Essential Elements of Capital Analysis
 Learning Outcomes: Identify the essential elements of a
capital budgeting decision
9.2: Identify the essential elements of a capital budgeting decision
9.2.1: Understand the time horizon related to capital investments
9.2.2: Understand the time value of money
9.2.3: Understand discount rates and how they are used in capital budgeting
9.2.4: Understand how long-term assets are depreciated and how that affects
taxes
 Understand the Time Horizon Related to Capital
Investments
In order to successfully analyze these long-term
investments, they need to be broken into discrete
projects with definite beginning and ending dates.

Whether you are using a payback period, net present

value (NPV) analysis, internal rate of return (IRR),
or accounting rate of return (ARR), you need to
establish a definite number of time periods.
 Understand the Time Value of Money

The time value of money recognizes that a dollar

received or spent in the future is less valuable than a
dollar received or spent in the present.

Calculations such as the internal rate of return, net

present value, and excess present value include
adjustments for the time value of money.

Essentially, money is said to have time value

because if invested—over time—it can earn interest.
Understand the Time Value of Money

FV = Future value of money

PV = Present value of money
i = interest rate
n = number of compounding periods per year
t = number of years

Based on these variables, the formula for TVM is:

FV = PV x [ 1 + (i / n) ] (n x t)
Time value of money

• [Link]
Understand Discount Rates and How They Are Used in
Capital Budgeting
Determining a 'hurdle rate,' or the
minimum acceptable return on a capital
investment based on project risk is a
critical step in the capital budgeting
process.

There are several methods used:

• WACC
• Opportunity cost model
• Present value table
• Annuity table
 Understand How Long-Term Assets Are Depreciated and
How That Affects Taxes

Depreciation of long-term assets

serves as a “tax shield.

Depreciation is subtracted from

revenue to lower taxable income.
Practice Question 1

Roberto invested $10,000 in an account that pays 2% per quarter. After 4 years, how much is
the account worth? (Use the mathematical formula and round to the nearest penny.)

A. $10,201.51
B. $10,824.32
C. $10,830.71
D. $13,727.86
Basic Capital Budgeting Tools
 Learning Outcomes: Use basic capital budgeting tools to
analyze investment options
9.3: Use basic capital budgeting tools to analyze investment options
9.3.1: Calculate the payback period on a steady flow of cash
9.3.2: Calculate the payback period using discounted cash flows
9.3.3: Calculate the accounting rate of return
 Calculate the Payback Period on a Steady Flow of Cash

The formula for payback period on a steady flow of cash is:

cost/annual cash flows

If cash flows are not steady, the payback period must be calculated manually.

The payback method is quick and easy to apply, but it has several drawbacks. First,
it doesn’t take the overall investment into account. In addition, this analysis does
not take into account the time value of money.
 Calculate the Payback Period Using Discounted Cash
Flows
The discounted cash flow approach to the
payback period uses the time value of
money to give a more accurate analysis.

This is an improvement over the simple

payback method, but still does not take
into account the overall rate of return and it
does not address cash flows that occur
after the payback period.
 Calculate the Accounting Rate of Return

The Accounting Rate of Return (ARR) formula is as follows:

ARR = average annual profit / average investment

Calculating ARR is actually a 5 step process:

1. Calculate total net cash inflows for the project.

2. Calculate total depreciation expense.
3. Subtract the depreciation expense from total net cash
inflows to get net profit (accounting income).
4. Divide accounting income by the project lifespan to get the
average annual net profit.
5. Divide average annual net profit by average cost of the
investment (net investment / 2).
Advanced Capital Budgeting Tools
 Learning Outcomes: Use time value of money to analyze
investment options
9.4: Use time value of money to analyze investment options
9.4.1: Calculate the net present value of a capital project
9.4.2: Calculate the internal rate of return
9.4.3: Calculate the profitability index
 Calculate the Net Present Value of a Capital Project

To calculate the net present value of a capital project, start with the nominal cash flows. NPV
discounts future cash flows to their present value at the expected rate of return.

You can calculate NPV using Excel, a financial calculator, or a PV table.

 Calculate the Internal Rate of Return

The Internal Rate of Return (IRR)

shows the profitability or growth
potential of an investment at the point
where NPV equals zero.

It determines the actual rate of return a

project earns.
Calculate the Profitability Index

The profitability index (PI) is a measure of a

project's or investments attractiveness. Compared
to most calculations, the profitability index is a
simple calculation:

The present value of future expected cash flows

Divided by

The initial investment amount in the project

Practice Question 2

Using Excel, Karyn calculates her IRR at 41% on her investment in her business. If she uses
this rate in her NPV analysis, she will see that:

A. NPV is equal to or close to zero

B. NPV is significantly less than zero
C. NPV is significantly greater than zero
Quick Review

• What is the capital budgeting process?

• What are operating and implementation costs in a capital budgeting analysis?
• Why is there a focus on cash flows for capital investment decision-making?
• What is the time horizon related to capital investments?
• What is the time value of money?
• What are discount rates and how are they used in capital budgeting?
• How are long-term assets depreciated and how does that affect taxes?
Quick Review (Continued)

• How do you calculate the payback period on a steady flow of cash?

• How do you calculate the payback period using discounted cash flows?
• How do you calculate the accounting rate of return?
• How do you calculate the net present value of a capital project?
• How do you calculate the internal rate of return?
• How do you calculate the profitability index?