The process for capital decision-making involves five steps: 1. Determine capital needs. 2. Explore resource limitations. 3. Establish baseline criteria for alternatives. 4. Evaluate alternatives using screening and preference decisions. 5. Make the decision.
The company then needs to establish alternatives, which are options available for investment, and evaluate the options using common measurement methods, including the payback method, accounting rate of return, net present value, and internal rate of return.
From the standpoint of the decision to replace the asset, the book value of an existing asset is irrelevant. Book value is just the historical cost (or value) of the asset less the total depreciation calculated to date. A gain or loss situation often happens when the asset is sold for more or less than its book value, respectively. It is only at that point that the company truly realizes whether they have extra value or not enough value in the assets. This difference can provide either a gain or a loss to the company that will impact the taxes at year-end. Therefore, gains or losses affecting tax payments, plus cash flows, are important, since cash-flow effects are relevant in capital investment decisions.
It is used to determine the length of time needed for a long-term project to recapture or pay back the initial investment in the project.
Advantage: The ARR compares income to the initial investment rather than to cash flows; thus, incremental revenues, cost savings, and incremental expenses associated with the investment are reviewed and provide a more complete picture than payback, which uses cash flows. Disadvantage: ARR is limited in that it does not consider the value of a dollar over time.
Accounting Rate of Return = (Incremental revenues – Incremental expenses) ÷ Initial Investment
They need to know what the future value is of their investment compared to today’s present value, and what potential earnings they could see because of delayed payment.
The Present Value of $1 table.
For NPV computations, a minimum required rate of return or discount rate is used as a screening tool to determine whether or not a capital investment decision meets a predetermined set of criteria. If the net present value of an investment is positive, then the capital investment generates an actual return greater than the discount rate and the project will be deemed acceptable. The discount rate, however, is not the actual rate of return earned by the project.
The internal rate of return determines the actual rate of return that a project earns.
The internal rate of return (IRR) shows the profitability or growth potential of an investment. All external factors are removed from calculation, such as inflation concerns, and the project with the highest return rate percentage is considered for investment. A company may have several viable alternatives that need a differentiating factor. IRR gives a solid differentiation, presented as a percentage rather than a dollar figure, as seen in NPV. This removes bias from projects with dissimilar NPVs and is a way to compare more than one option.
Answers will vary but should include something like the following: the NPV weighs the early receipt of cash more heavily because when the receipts come in earlier, the discount is closer to 100%; however, the interest rate also impact the NPV.
Strengths: It considers the time value of money, removes the dollar bias, and allows for a company to make a decision, unlike non-time value methods. Weaknesses: It has a bias toward return rates instead of higher risk investment consideration, uses a more difficult calculation, and does not consider the time it will take to recoup an investment.