11.1 Describe Capital Investment Decisions and How They Are Applied
- Capital investment decisions select a project for future business development. These projects typically require a large outlay of cash, provide an uncertain return, and tie up resources for an extended period of time.
- Having a large number of alternatives requires a careful budgeting and analysis process. This process includes determining capital needs, exploring resource limitations, establishing baseline criteria for alternatives, evaluating alternatives using screening and preference decisions, and making the decision.
- Screening decisions help eliminate undesirable alternatives that may waste time and money. Preference decisions rank alternatives emerging from the screening process to help make the final decision. Both decision avenues use capital budgeting methods to select between alternatives.
11.2 Evaluate the Payback and Accounting Rate of Return in Capital Investment Decisions
- The payback method determines how long it will take a company to recoup their investment. Annual cash flows are compared to the initial investment but the time value of money is not considered and cashflows beyond the payback period are ignored.
- The accounting rate of return considers incremental net income as it compares to the initial investment. Time value of money is not considered with this method.
- Incremental net income determines the net income expected if the company accepts the investment opportunity, as opposed to not investing. Incremental net income is the difference between incremental revenues and incremental expenses.
11.3 Explain the Time Value of Money and Calculate Present and Future Values of Lump Sums and Annuities
- A dollar is worth more today than it will be in the future. This is due to many reasons including the power of investment in today’s economy, market inflation, and the ability to use the money in the present to make more money in the future, with interest.
- Present value expresses the future value of a dollar in today’s (present) value. Present value tables, showing the present value factor intersection of periods and interest rate, are used to multiply by the final payout amount to compute today’s value.
- The future value shows what the value of an investment will be after a certain period of time. Future value tables, showing the future value factor intersection of periods and interest rate, are used to multiply by the initial investment amount to compute future value.
- A lump sum is a one-time payment after a certain period of time, whereas an ordinary annuity involves equal installments in a series of payments over time. A business can use lump sum or ordinary annuity calculations for present value and future value calculations.
11.4 Use Discounted Cash Flow Models to Make Capital Investment Decisions
- The discounted cash flow model assigns values to a project’s alternatives using time value of money and discounts future rates back to present value. Two measurement tools are used in discounted cash flows: net present value and internal rate of return.
- Net present value considers an expected rate of return, converts future cash flows into present value, and compares that to the initial investment cost. If the outcome is positive, the company would look to invest in the project.
- Internal rate of return shows the profitability of an investment, where NPV equals zero. If the corresponding interest rate exceeds the expected rate of return, the company would invest in the project.
11.5 Compare and Contrast Non-Time Value-Based Methods and Time Value-Based Methods in Capital Investment Decisions
- The payback method uses a simple calculation, removes unviable alternatives quickly, and considers investment risk. However, it disregards the time value of money, ignores profitability, and does not consider cash flows after recouping the investment.
- The accounting rate of return uses a simple calculation, considers profitability, and removes unviable options quickly. However, it disregards the time value of money, values return rates more than risk, and ignores external influential factors.
- Net present value considers the time value of money, ranks higher risk investments, and compares future earnings in today’s value. However, it cannot easily compare dissimilar investment opportunities, it uses a more difficult calculation, and it has limitations with the estimation of an expected rate of return.
- Internal rate of return considers the time value of money, removes the dollar bias, and leads a company to a decision, unlike non-time value methods. However, it has a bias toward return rates instead of higher risk investment consideration, it is a more difficult calculation, and it does not consider the time it will take to recoup an investment.