P1: Compute payback period and describe its use.
P2: Compute accounting rate of return and explain its use.
P3: Compute net present value and explain its use.
P4: Compute internal rate of return and explain its use.
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Financial and Managerial AccountingWild, Shaw, and Chiappetta Fourth Edition McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.Chapter 24Capital Budgeting & Investment AnalysisConceptual Learning ObjectivesC1: Describe the selection of a hurdle rate for an investment.24-*A1: Analyze a capital investment project using break-even time.Analytical Learning Objectives24-*P1: Compute payback period and describe its use.P2: Compute accounting rate of return and explain its use.P3: Compute net present value and explain its use.P4: Compute internal rate of return and explain its use.Procedural Learning Objectives24-*Capital budgeting:Analyzing alternative long-term investments and deciding which assets to acquire or sell. Outcomeis uncertain. Large amounts ofmoney are usuallyinvolved. Investment involves along-term commitment. Decision may bedifficult or impossibleto reverse.Capital BudgetingC 124-*Paybackperiod= Cost of Investment Annual Net Cash FlowPayback PeriodThe payback period of an investmentis the time expected to recoverthe initial investment amount.Managers prefer investing in projects with shorter payback periods.Exh. 25-2P124-*Ignores the time valueof money.Ignores cashflows after the paybackperiod.Unacceptable forprojects with longlives where timevalue ofmoney effectsare major. Using the Payback PeriodP124-* The accounting rate of return focuses onannual income instead of cash flows.Accounting Rate of Return Accounting Annual after-tax net incomerate of return Annual average investment=Beginning book value + Ending book value2Exh. 25-5,6P224-* Discount the future net cash flows from the investment at the required rate of return. Subtract the initial amount invested from sum of the discounted cash flows.. More work! – However. large dollar investments usually justify the extra time up front to insure that the investment choice is a wise one.Net Present ValueP324-*General decision rule . . .Using Net Present ValueP324-*Internal Rate of Return (IRR)The interest rate that makes . . .Presentvalue ofcash inflowsPresentvalue ofcash outflows= The net present value equal zero.P424-* 1. Determine the present value factor. $12,000 ÷ $5,000 per year = 2.4000 2. Using present value of annuity table . . . IRR is theinterest rateof the columnin which thepresent valuefactor is found. IRR isapproximately12%.Exh. 26-9P4Internal Rate of Return (IRR)24-*Internal Rate of ReturnCompare the internal rateof return on a project to a predetermined hurdle rate (cost of capital).To be acceptable, a project’s rate of return cannot be less than thecost of capital.Using Internal Rate of ReturnP424-*Comparing MethodsC124-*End of Chapter 2424-*