Two methods of evaluating capital investments are frequently used for investment purchases which have fairly short useful lives. In these instances, the time value of money is less significant, and the evaluation can be based more heavily on the income to be earned solely from the investment. The first of these methods, the average rate of return, is generally used to determine the profitability of an investment in a fixed asset. Average Rate of Return = Estimated Average Annual Income/Average Investment
The estimated average annual income is the total income which this asset will provide divided by the number of years that the asset will be used. The amount of the investment may simply be the original cost, or depreciation may be considered and the average investment cost may be used. The latter assumption takes into consideration the fact that the asset's usefulness will decline with age. Average investment cost is the midpoint of the depreciable portion of the asset cost. This amount is calculated by adding the asset's original cost to any residual value and dividing by two. This method is useful when comparing two assets as shown in the following example.
Example: Asset A costs $120,000 and will generate an average estimated income of $15,000. Asset B costs $180,000 and will generate an average estimated income of $18,000. Assuming straight-line depreciation and no residual value, the respective average investment costs are $60,000 and $90,000. Asset A will yield a 25% rate of return (15,000/60,000) and Asset B will yield a 20% rate of return (18,000/90,000). Using only the rate of return to make a decision, Asset A would be preferred since it gives a greater rate of return.
The main advantage of the average rate of return method is its ease of computation and its emphasis on income earned over the entire life of the proposal rather than only a portion of that life. However, the rate of return method has one drawback. It ignores any cash flows that may arise and which in turn may be used to generate other income producing investments.
The second method of evaluating investment decisions, the cash payback method, looks at cash flows and the amount of time necessary to recover the initial cost of the asset. The cash payback period is defined as the period of time required to recover the amount invested. When using this method, to simplify things, the expected revenue and the associated expenses are assumed to be all cash. The annual net cash flow is the excess of revenue generated by the asset over the expenses required to create that revenue for the year. The amount of time required for the net cash flow to equal the initial investment is the payback period. The net cash flow may be the same annually or may vary from year to year. In the first case, the payback period is determined by dividing the annual cash flow into the amount of original investment.
Figure 1 Year Net Cash Flow Cumulative Cash Flow 1 $ 30,000 $ 30,000 2 50,000 80,000 3 80,000 160,000 4 90,000 250,000
Example: Equipment with a useful life of 10 years is purchased at a cost of $250,000. If the equipment has an anticipated annual net cash flow of $50,000, the payback period is five years (250,000/50,000).
When the annual cash flow varies, the payback period is the amount of time for the cumulative cash flows to equal the original investment. Figure 1 shows the payback schedule for the same asset with a cost of $250,000. The payback period in this case is four years. The cumulative cash flow at the end of that time is equal to the amount invested.
Obviously, the shorter the payback period, the better the investment. The sooner the cash is recovered, the sooner it is available for future growth and the less chance there is for economic failure due to future conditions.
The major disadvantage of the cash payback method is its failure to consider the total profitability of an investment. An investment with a short payback period may be less profitable in the long run than an investment with a longer payback period but more profitability. Another disadvantage is that any cash flow after the payback period is ignored. A 10-year program with a five-year payback period and five years of good cash flow is better than an equivalent 10-year project with the same five-year payback period and minimal cash flow in the remaining five years. Neither of these methods of analyzing capital investments considers the time value of money. It is important to recognize that cash on hand is more valuable than cash to be received in the future, particularly when looking at a long-term project. The present and future value of money will be discussed in next month's column.
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|Title Annotation:||methods for evaluating capital investments; includes quiz on method discussed;|
|Author:||Schwartz, Marlyn A.|
|Publication:||The National Public Accountant|
|Date:||May 1, 1991|
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