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Capital investment analysis.

Capital investments often involve very large amounts of money and affect the firm for many years. Therefore, decisions about major investments must be made very carefully. In times of economic uncertainty, failure to plan such investments can have a devastating impact on the ability of a business to survive.

A careful analysis of investment opportunities will include many evaluation methods. Most careful managers use a combination of methods to provide the broadest possible picture of the results of such a purchase. Quantitative methods of analysis can be categorized into two groups: those that consider the time value of money and those that don't.

ARR and Cash Payback

Money on hand today is worth more than money to be received in the future, since dollars on hand today may be invested today and begin earning interest while future dollars cannot. Methods that ignore the time value of money are easy to use. They also offer the advantage of early screening of proposals, especially projects with a short life, where the ability of dollars to earn interest is less critical. The two methods are the accounting (or average) rate of return and the cash payback method.

The accounting rate of return (ARR) measures profitability of a capital project. Typically a firm will set a "cut off" point for profitability, below which the project is rejected. The ARR is calculated by dividing the estimated average annual income by the average investment cost. The average investment cost is the sum of the original cost of the project plus salvage, divided by two.

Assume, for example, that NespaCo has a policy requiring that all capital projects earn a minimum ARR of 20%. Estimates indicate a new machine costing $320,000 will earn an average of $40,000 net income each year for five years. If the salvage value of the machine is $32,000, the average investment cost is ($320,000 + $32,000)/2, or $176,000. The ARR would be $40,000/$176,000, or 23.25%. Thus, this project would meet NespaCo's demand for a minimum ARR of at least 20%.

Some firms set a time limit within which the cost of an investment must be recovered. Payment for the investment may be dependent on cash flows generated by the investment. The faster cash is generated, the more favorably management and creditors would look on such a project. If NespaCo expected the annual net cash flow from this new machine to be $80,000, the cost could be recovered in $32,000/$80,000=4 years. This may be a sufficiently fast cash payback period to warrant further consideration of the project.

Considering the Time Value of Money

More complex to use are the two evaluation methods that consider the time value of money. The increased difficulty in calculation is offset by the improved realism of considering the changing value of money over time.

The net present value method (NPV) computes the present value of anticipated future cash flows from a proposal and compares that value to the cost of the proposal. If the NPV is positive, the project can be undertaken. The interest rate chosen by management considers the desired rate of return, the cost of capital in the marketplace, the nature of the business, the condition of the economy and other factors.

If cash flows are expected to be steady over the years, they can be evaluated as an annuity. Frequently, however, the cash flow will change from year to year. In that case, each year must be discounted individually to arrive at the total discounted cash flows.

Continuing with our example of NespaCo, we know that the machine under scrutiny is expected to provide $80,000 of increased cash flow for each of the next five years. Assume further that NespaCo has decided that the appropriate interest rate is 10%. Using the table of present values of an annuity of $1, we find the multiplier for 5 periods at 10% to be 3.791. Therefore, the discounted cash flow is $80,000 x 3.791 or $303,280. Since the cost of the machine is $320,000, the NPV is ($16,720), suggesting that NespaCo should decline the project.

The internal rate of return (IRR) differs from the NPV method in that it seeks to figure out not the discounted cash flow but the interest rate required to provide an NPV of zero; that is, a discounted cash flow equal to the cost of the investment. If that interest rate is at least as great as management's desired rate of return, then the project may be explored further.

To find the IRR, the cost of the project is divided by the average annual net cash flow. The resulting number is a present value multiplier found on the annuity table. The multiplier is located on the row representing the number of years the cash flows will last. The column in which the multiplier is found is headed by the internal rate of return.

For NespaCo, the multiplier is $320,000 / $80,000 = 4.000. Looking at the present value of a $1 annuity table in the row representing five years, that multiplier is found between the columns representing 7% and 8%. NespaCo must decide if an IRR of approximately 7.5% is acceptable.

Other Qualitative Considerations

While these quantitative methods provide useful information, there are qualitative factors that should be a part of the decision-making process as well. Each of the quantitative methods we have reviewed require estimates and we need to recognize the uncertainty inherent in estimates. The condition of the economy should be gauged to determine if a recovery can be depended on or if a return to recession is likely. Tax law changes in deductible depreciation or investment tax credit may have an effect on the taxable income generated by an investment. The effect of the investment on product quality, work force morale, customer loyalty and environmental issues should also be researched.

As always, the more information on hand, the better the decisions will be. Practicing accountants must provide their clients with enough information to carefully weigh the pros and cons of investment proposals.

To test your skills at such evaluation, try the following quiz above. The answer will be found in next month's Accounting Scene.
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Title Annotation:Accounting Scene
Author:Winicur, Barbara
Publication:The National Public Accountant
Date:Aug 1, 1993
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