10/1/2019

Capital Investment
Decisions
Natalia Semenova
Lecture 5
October 2, 2019

Learning Outcomes
• Understand the need for control over capital investment
decision-making.
• Understand and be able to apply two simple methods of
capital investment appraisal: payback and accounting rate of
return.
• Understand the time value of money.
• Understand and be able to apply more complex methods of
capital investment appraisal: net present value and internal
rate of return.
• Understand some of the limitations of capital investment
appraisal techniques.

What is Capital Investment?

• As well as expenditure on fixed and variable
costs, managers must make decisions about
spending on capital items.
• Capital expenditure is expenditure on items such
as fixed assets and investments in other
businesses.
• It involves appraisal of profits and cash flow
generated over more than one accounting period.

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Capital Budgeting
• Capital expenditure must fit into the framework of the
business’s strategy and objectives.

• Many businesses in practice subject capital expenditure,

even on small items, to scrutiny.

Typical Investment Decisions

Plant expansion

Equipment selection Equipment replacement

Lease or buy Cost reduction

Typical Investment Decisions

Investment decisions tend to fall into two
broad categories . . .

Screening decisions. Does a proposed

project meet some present standard of
acceptance?

Preference decisions. Selecting from

among several competing projects.

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Capital Investment Appraisal in

Practice

Four principal methods will be examined:

• Accounting rate of return (ARR)

• Payback
• Net present value (NPV)
• Internal rate of return (IRR).

11-8

Accounting Rate of Return

Method
it focuses on accounting net operating income.

The following formula is used to calculate the

simple rate of return:

-
Simple rate Annual incremental net operating income
of return =
Initial investment*
*Should be reduced by any salvage from the sale of the old equipment

11-9

Simple Rate of Return Method

Management of the Daily Grind wants to install an

espresso bar in its restaurant that:
1. Cost $140,000 and has a 10-year life.
2. Will generate incremental revenues of
$100,000 and incremental expenses of
$65,000 including depreciation.

What is the simple rate of return on the investment

project?

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11-10

Simple Rate of Return Method

Simple rate $35,000

= = 25%
of return $140,000

11-11

Criticism of the Simple Rate of Return

Ignores the
time value
of money.

Short-comings
of the simple
The same project
rate of return.
may appear
desirable in some
years and
undesirable
in other years.

Capital Investment Appraisal (1)

Example: Proctor Hedges Limited

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Capital Investment Appraisal (2)

Maximum capacity:
Machine A – 40 000 units per year
Machine B – 60 000 units per year
Demand:

Accounting Rate of Return

Calculating Average Expected

Return (1)

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Calculating Average Expected

Return (2)

Calculating Average Capital

Employed

Accounting Rate of Return

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11-19

The Payback Method

The payback method
focuses on the
payback period,
which is the length of
time that it takes for
a project to recoup
its initial cost out of
the cash receipts
that it generates.

11-20

The Payback Method

When the annual net cash inflow is the same

each year, this formula can be used to compute
the payback period:

Investment required
Payback period =
Annual net cash inflow

11-21

The Payback Method

Management at the Daily Grind wants to install an

espresso bar in its restaurant that
1. Costs $140,000 and has a 10-year life.
2. Will generate annual net cash inflows of
$35,000.

Management requires a payback period of 5 years

or less on all investments.

What is the payback period for the espresso bar?

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11-22

The Payback Method

Investment required
Payback period =
Annual net cash inflow

$140,000
Payback period = $35,000

Payback period = 4.0 years

According to the company’s criterion,

management would invest in the espresso bar
because its payback period is less than 5 years.

11-23

Quick Check 
Consider the following two investments:
Project X Project Y
Initial investment $100,000 $100,000
Year 1 cash inflow $60,000 $60,000
Year 2 cash inflow $40,000 $35,000
Year 14-10 cash inflows $0 $25,000
Which project has the shortest payback period?
a. Project X
b. Project Y
c. Cannot be determined

11-24

Quick Check 
Consider the following two investments:
Project X Project Y
Initial investment $100,000 $100,000
Year 1 cash inflow $60,000 $60,000
Year 2 cash inflow $40,000 $35,000
Year 14-10 cash inflows $0 $25,000
Which project has the shortest payback period?
a. Project X
b. Project Y
1.c.Project
CannotXbe
hasdetermined
a payback period of 2 years.
2. Project Y has a payback period of slightly more than
two years.
3. Which project do you think is better?

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11-25

Evaluation of the Payback Method

Ignores the
time value
Short-comings of money.
of the payback
method.

Shorter payback
period does not
Ignores cash always mean a
flows after more desirable
the payback investment.
period.

11-26

Evaluation of the Payback Method

Serves as
screening
tool.
Identifies
Strengths investments that
of the payback will recoup cash
period. investments
quickly.
Identifies
products that
recoup initial
investment
quickly.

11-27

Payback and Uneven Cash Flows

When the cash flows associated with an
investment project change from year to year,
the payback formula introduced earlier cannot
be used.
Instead, the unrecovered investment must be
tracked year by year.
$1,000 $0 $2,000 $1,000 $500

1 2 3 4 5

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11-28

Payback and Uneven Cash Flows

For example, if a project requires an initial
investment of $4,000 and provides uneven net
cash inflows in years 1-5 as shown, the
investment would be fully recovered in year 4.

$1,000 $0 $2,000 $1,000 $500

1 2 3 4 5

Payback (1)
Machine A

Payback (2)
Machine A

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Payback (3)
Machine B

Payback (4)
Machine B

The Time Value of Money (1)

Discounting

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The Time Value of Money (2)

Discounting

• What is the discount factor for £1 at the end of year 3,

which has been invested since Time 0 at a constant rate
of 4%?

The Time Value of Money (3)

• So, £0.88 is the present value of £1 at the end of year 3 using
a discount rate of 4%.

Calculating Present Values

An investment can be viewed in two
ways—its future value or its present
value.

Present Future
Value Value
Let’s look at the situation where the
future value is known and the present
value is the unknown.

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Present Value – An Example

If an investment will pay $100 in two years,
what is the present value of the $100 if an
investor can earn a return of 12% on
investments?

Cn
Present Value = PV =
(1 + r)n
C = the cash flow at the end of the period n.
P = the amount invested now.
r = the discount rate.
n = the number of periods.

Present Value – An Example

$100
PV =
(1 + 0.12)2
PV = $79.72
This process is called discounting. We have
discounted the $100 to its present value of
$79.72. The interest rate used to find the
present value is called the discount rate.

Calculating Present Values

If an investment will pay $100 in two

years, what is the present value of the
$100 if an investor can earn a return of
12% on investments?

We can determine the present value

factor using the formula or using
present value tables.

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Present Value

Present value = PV

PV = discount factor  C1

Present Value
Discount factor = DF = PV of $1
DF  1
(1 r ) t

Discount factors can be used to compute the

present value of any cash flow
PV  DF2  C2
PV  1
(1.07) 2
114.49  100
PV  DF2  C2  0.8734 114.49  100

Present Value
Cn
PV =
(1 + r)n
Rate
Periods 10% 12% 14%
1 0.909 0.893 0.877
2 0.826 0.797 0.769
3 0.751 0.712 0.675
4 0.683 0.636 0.592
5 0.621 0.567 0.519

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Present Value – An Example

$100 × 0.797 = $79.72 present value

Rate
Periods 10% 12% 14%
1 0.909 0.893 0.877
2 0.826 0.797 0.769
3 0.751 0.712 0.675
4 0.683 0.636 0.592
5 0.621 0.567 0.519

Present value factor of $1 for 2 periods at 12%.

Quick Check 

How much would you have to put in the bank

today to have $100 at the end of five years if
the interest rate is 10%?
a. $62.10
b. $56.70
c. $90.90
d. $51.90

Quick Check 

How much would you have to put in the bank

today to have $100 at the end of five years if
the interest rate is 10%?
a. $62.10
$100  0.621 = $62.10
b. $56.70
c. $90.90
d. $51.90

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Present Value of a Series of Identical

Cash Flows
An investment that involves a series of
identical cash flows at the end of each year is
called an annuity.

$100 $100 $100 $100 $100 $100

1 2 3 4 5 6

Present Value of a Series of Identical

Cash Flows – An Example

Lacey Inc. purchased a tract of land on which

a $60,000 payment will be due each year for
the next five years. What is the present value
of this stream of cash payments when the
discount rate is 12%?

Present Value of a Series of Identical

Cash Flows – An Example

We could solve the problem like this . . .

Present Value of an Annuity of $1
Periods 10% 12% 14%
1 0.909 0.893 0.877
2 1.736 1.690 1.647
3 2.487 2.402 2.322
4 3.170 3.037 2.914
5 3.791 3.605 3.433

$60,000 × 3.605 = $216,300

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Quick Check 

If the interest rate is 14%, how much would

you have to put in the bank today so as to be
able to withdraw $100 at the end of each of
the next five years?
a. $34.33
b. $500.00
c. $343.30
d. $360.50

Quick Check 

If the interest rate is 14%, how much would

you have to put in the bank today so as to be
able to withdraw $100 at the end of each of
the next five years?
a. $34.33
b. $500.00
c. $343.30 $100  3.433 = $343.30
d. $360.50

Net Present Value (1)

Machine A

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Net Present Value (2)

Machine B

The Net Present Value Method

If the Net Present
Value is . . . Then the Project is . . .
Acceptable because it promises
Positive . . . a return greater than the
required rate of return.

Acceptable because it promises

Zero . . . a return equal to the required
rate of return.

Not acceptable because it

Negative . . . promises a return less than the
required rate of return.

Internal Rate of Return (1)

Machine A: calculate NPV at various rates

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Internal Rate of Return (2)

Machine A

• The internal rate of return lies somewhere between 18% and

20%.

Internal Rate of Return (3)

Internal Rate of Return (4)

Machine A: linear interpolation

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Internal Rate of Return (5)

Machine A: linear interpolation

Internal Rate of Return (6)

Machine A: linear interpolation

IRR is 18% + 1.54% = 19.54%

NB: IRR for Machine B is 17.68%

Internal Rate of Return (1 of 10)

6-60

Internal Rate of Return (IRR)

Discount rate at which NPV = 0
Internal Rate of Return Rule
Invest in any project offering a rate of return
that is higher than the opportunity cost of
capital
payoff
Rate of return = 1
investment

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without
Copyright © 2017 McGraw-Hill Education. All rights reserved. the prior
No reproduction written without
or distribution consent of written
the prior McGraw-Hill Education.
consent of McGraw-Hill Education.

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Internal Rate of Return (2 of 10)

6-61

Example
You can purchase a turbo powered machine
tool gadget for $4,000. The investment will
generate $2,000 and $4,000 in cash flows
for two years, respectively. What is the IRR
on this investment?

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution

without
Copyright © 2017 McGraw-Hill Education. All rights reserved. the prior
No reproduction written without
or distribution consent of written
the prior McGraw-Hill Education.
consent of McGraw-Hill Education.

Internal Rate of Return (3 of 10)

6-62

Example
You can purchase a turbo powered machine tool
gadget for $4,000. The investment will generate
$2,000 and $4,000 in cash flows for two years,
respectively. What is the IRR on this investment?

2,000 4,000
NPV  4,000   0
(1  IRR)1 (1  IRR)2
IRR  28.08%

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution

without
Copyright © 2017 McGraw-Hill Education. All rights reserved. the prior
No reproduction written without
or distribution consent of written
the prior McGraw-Hill Education.
consent of McGraw-Hill Education.

Choosing Between Projects

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Strengths and Weaknesses of the Common

Investment Appraisal Techniques ARR
Strengths:
• Calculation very straightforward
• Widely used measurement
• Non-financial managers can understand it.
Weaknesses:
• Takes no account of the time value of money
• Calculated on accounting profits, rather than cash flow
• Fails to take into account the relative size of competing
projects.

Strengths and Weaknesses of the Common

Investment Appraisal Techniques – Payback
Strengths:
• Calculation very straightforward
• Useful where rapid recovery of funds is a priority
• Non-financial managers can easily understand it.
Weaknesses:
• Takes no account of the time value of money
• Provides little useful information
• All cash flows beyond the payback point are simply ignored.

Strengths and Weaknesses of the Common

Investment Appraisal Techniques NPV
Strengths:
• Builds the time value of money into calculations
• Takes all the future cash flows of projects into account
• Very useful for ranking projects as it deal in absolute values,
not percentages.
Weaknesses:
• Can be difficult to explain to non-financial managers
• There are significant practical difficulties in determining an
appropriate discount rate.

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Strengths and Weaknesses of the Common

Investment Appraisal Techniques IRR
Strengths:
• Builds the time value of money into calculations.
Weaknesses:
• Can be difficult to explain to non-financial managers
• Significant practical difficulties in determining appropriate discount
rate
• IRR is expressed in percentage terms so it ignores absolute values
• It is not always possible to calculate IRR.

CFO Decision Tools

5-68

Survey Data on CFO Use of Investment

Evaluation Techniques

SOURCE: Graham and Harvey, “The Theory and Practice of Finance:

Evidence from the Field,” Journal of Financial Economics 61 (2001),
pp. 187-243.
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution
without the prior written consent of McGraw-Hill Education.

Summary
• Focus of this lecture – longer-term decision-making.
• Four techniques explained.
• Important to appreciate the limitations of the techniques.

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