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The controller at Ranyah Corporation analyzed a proposed equipment purchase for the firm and decided that the investment met all the firm’s criteria regarding payback, net present value, and internal rate of return. Notwithstanding the positive results, top management decided to reject purchase of the machine. Elaborate on why a firm might reject a project even though it satisfies all the capital budgeting analyses.

Embed course material concepts, principles, and theories (requires supporting citations) along with at least one scholarly, peer-reviewed reference in supporting your answer. Keep in mind that these scholarly references can be found in the Saudi Electronic Library by conducting an advanced search specific to scholarly references.

You are required to reply to at least two peer discussion question post answers to this weekly discussion question and/or your instructor’s response to your posting. These post replies need to be substantial and constructive in nature. They should add to the content of the post and evaluate/analyze that post answer. Normal course dialogue doesn’t fulfill these two peer replies but is expected throughout the course. Answering all course questions is also required.

 Required:

Capital Investment Analysis

MODULE 11 Chapter 12

Nature of Capital Investment Analysis
(slide 1 of 3)

Companies use capital investment analysis to evaluate long-term investments.

Capital investment analysis (or capital budgeting) is the process by which management plans, evaluates, and controls investments in fixed assets.

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Nature of Capital Investment Analysis
(slide 2 of 3)

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Nature of Capital Investment Analysis
(slide 3 of 3)

The two methods that use present values consider the time value of money.

The time value of money concept recognizes that a dollar today is worth more than a dollar tomorrow because today’s dollar can earn interest.

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Methods Using Present Values
(slide 1 of 2)

An investment in fixed assets may be viewed as purchasing a series of net cash flows over a period of time.

The timing of when the net cash flows will be received is important in determining the value of a proposed investment.

Present value methods use the amount and timing of the net cash flows in evaluating an investment.

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Methods Using Present Values
(slide 2 of 2)

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An investment in fixed assets may be viewed as purchasing a series of net cash flows over a period of time.

The timing of when the net cash flows will be received is important in determining the value of a proposed investment.

Present value methods use the amount and timing of the net cash flows in evaluating an investment.

Methods Using Present Values

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Both the net present value and the internal rate of return methods use the following two present value concepts:

Present value of an amount

Present value of an annuity

Present Value Concepts

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Assume that you have $1 to invest as follows:

Present Value of an Amount
(slide 1 of 3)

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After one year, the $1 earns interest of $0.12 ($1 × 12%) and, thus, will grow to $1.12 ($1 × 1.12).

In the second year, the $1.12 earns 12% interest of $0.134 ($1.12 × 12%) and, thus, will grow to $1.254 ($1.12 × $1.12) by the end of the second year.

By the end of the third year, your $1 investment will grow to $1.404.

This process of interest earning interest is called compounding.

Present Value of an Amount
(slide 2 of 3)

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Compound Amount of $1
for Three Periods at 12%

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On January 1, 2016, what is the present value of $1.404 to be received on December 31, 2018?

The partial present value of $1 table on the next slide indicates that the present value of $1 to be received in three years with earnings compounded at the rate of 12% per year is 0.712.

Present Value of an Amount
(slide 3 of 3)

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Partial Present Value of $1 Table

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Present Value of an Amount of $1.404

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An annuity is a series of equal net cash flows at fixed time intervals.

Cash payments for monthly rent, salaries, and bond interest are all examples of annuities.

The present value of an annuity is the amount of cash needed today to yield a series of equal net cash flows at fixed time intervals in the future.

Present Value of an Annuity
(slide 1 of 4)

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The present value of a $100 annuity for five periods at 12% could be determined by using the present value factors in the partial present value of $1 table (see slide 28). Each $100 net cash flow could be multiplied by the present value of $1 at a 12% factor for the appropriate period and summed to determine a present value of $360.50.

Present Value of an Annuity
(slide 2 of 4)

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Present Value of a $100 Amount
for Five Consecutive Periods

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Using a present value of an annuity table, such as the one on the next slide, is a simpler approach.

Present Value of an Annuity
(slide 3 of 4)

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Partial Present Value of an Annuity Table

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The present value factors in the table are the sum of the present value of $1 factors (see slide 28) for the number of annuity periods. Thus, 3.605 in the annuity table is the sum of the five present value of $1 factors at 12% (see slide 28), computed as follows:

Present Value of an Annuity
(slide 4 of 4)

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The net present value method and present value index are often used in combination.

Net Present Value Method and Index

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The net present value method compares the amount to be invested with the present value of the net cash inflows.

It is sometimes called the discounted cash flow method.

Net Present Value Method
(slide 1 of 6)

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The interest rate (return) used in net present value analysis is the company’s minimum desired rate of return.

This rate, sometimes termed the hurdle rate, is based on such factors as the purpose of the investment and the cost of obtaining funds for the investment.

If the present value of the cash inflows equals or exceeds the amount to be invested, the proposal is desirable.

Net Present Value Method
(slide 2 of 6)

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Assume the following data for a proposed investment in new equipment:

Net Present Value Method
(slide 3 of 6)

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The present value of the net cash flow for each year is computed by multiplying the net cash flow for the year by the present value factor of $1 for that year (see slide 28), as follows:

Net Present Value Method
(slide 4 of 6)

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Present Value of Equipment Cash Flows

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The net present value of $2,900 indicates that the purchase of the new equipment is expected to recover the investment and provide more than the minimum rate of return of 10%. Thus, the purchase of the new equipment is desirable.

Net Present Value Method
(slide 5 of 6)

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© 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

The net present value method has the following three advantages:

It considers the cash flows of the investment.

It considers the time value of money.

It can rank projects with equal lives, using the present value index.

The net present value method has the following two disadvantages:

It has more complex computations than methods that don’t use present value.

It assumes the cash flows can be reinvested at the minimum desired rate of return, which may not be valid.

Net Present Value Method
(slide 6 of 6)

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When capital investment funds are limited and the proposals involve different investments, a ranking of the proposals can be prepared using a present value index.

The present value index is computed as follows:

Present Value Index
(slide 1 of 4)

Present Value Index =

Total Present Value of Net Cash Flow

Amount to Be Invested

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The present value index for the investment in the preceding slides is 1.0145, computed as follows:

Present Value Index
(slide 2 of 4)

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A project will have a present value index greater than 1 when the net present value is positive.

When the net present value is negative, the present value index will be less than 1.

Present Value Index
(slide 3 of 4)

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Assume that a company is considering three proposals. The net present value and the present value index for each proposal are as follows:

Proposal B is the most desirable.

Proposal B returns $1.08 present value per dollar invested, whereas Proposal A returns only $1.07.

Proposal B requires an investment of $80,000, compared to an investment of $100,000 for Proposal A.

Present Value Index
(slide 4 of 4)

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A project has estimated annual net cash flows of $50,000 for seven years and is estimated to cost $240,000. Assume a minimum acceptable rate of return of 12%. Using Exhibit 5, determine (a) the net present value of the project and (b) the present value index, rounded to two decimal places.

Net Present Value

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The internal rate of return (IRR) method uses present value concepts to compute the rate of return from a capital investment proposal based on its expected net cash flows.

This method, sometimes called the time-adjusted rate of return method, starts with the proposal’s net cash flows and works backward to estimate the proposal’s expected rate of return.

Internal Rate of Return Method
(slide 1 of 6)

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Assume that management is evaluating the following proposal to purchase new equipment:

Internal Rate of Return Method
(slide 2 of 6)

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Net Present Value Analysis at 12%

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The $36,050 present value of the cash inflows, based on a 12% rate of return, is greater than the $33,530 to be invested. Thus, the internal rate of return must be greater than 12%.

Through trial and error, the rate of return equating the $33,530 cost of the investment with the present value of the net cash flows can be determined to be 15%.

Internal Rate of Return Method
(slide 3 of 6)

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Present Value of an Annuity
at the Internal Rate of Return Rate

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When equal annual net cash flows are expected from a proposal, the internal rate of return can be determined as follows:

Step 1. Determine a present value factor for an annuity of $1 as follows:

Step 2. Locate the present value factor determined in Step 1 in the present value of an annuity of $1 table (see slide XX) as follows:

Locate the number of years of expected useful life of the investment in the Year column.

Proceed horizontally across the table until you find the present value factor computed in Step 1.

Identify the internal rate of return by the heading of the column in which the present value factor in Step 2 is located.

Internal Rate of Return Method
(slide 4 of 6)

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Assume that management is evaluating the following proposal to purchase new equipment:

Internal Rate of Return Method
(slide 5 of 6)

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Steps to Determine the Internal Rate of Return

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The internal rate of return method has the following three advantages:

It considers the cash flows of the investment.

It considers the time value of money.

It ranks proposals based upon the cash flows over their complete useful life, even if the project lives are not the same.

The internal rate of return method has the following two disadvantages:

It has complex computations, requiring a computer if the periodic cash flows are not equal.

It assumes the cash received from a proposal can be reinvested at the internal rate of return, which may not be valid.

Internal Rate of Return Method
(slide 6 of 6)

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A project is estimated to cost $208,175 and provide annual net cash flows of $55,000 for six years. Determine the internal rate of return for this project, using Exhibit 5.

Internal Rate of Return

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Questions?

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