Analyze capital investment same way, and the projects with the highest net present value—the amount that

LO 4 Analyze capital investment same way, and the projects with the highest net present value—the amount that

exceeds the initial investment—are selected for implementation. proposals using the net present

value method.

Advantages of the Net Present Value Method

A significant advantage of the net present value method is that it incorporates

the time value of money into the analysis of proposed capital investments. Future Because it is based on cash flow,

Study Note

cash inflows and outflows are discounted by the company’s minimum rate of the net present value method is

return to determine their present values. The minimum rate of return should at widely used not only in business

least equal the company’s average cost of capital.

but also by individuals. When dealing with the time value of money, use discounting to find the present value of an amount to be received in the future. To determine the present values of future amounts of money, use Tables 1 and 2 in the appendix on present value tables. Remember:

씰 Table 1 deals with a single payment or amount. 씰 Table 2 is used for a series of equal periodic amounts.

Tables 1 and 2 are used to discount each future cash inflow and cash out- flow over the life of the asset to the present. If the net present value is positive (the total of the discounted net cash inflows exceeds the cash investment at the beginning) , the rate of return on the investment will exceed the company’s mini- mum rate of return, or hurdle rate, and the project can be accepted. Conversely,

if the net present value is negative (the cash investment at the beginning exceeds If the net present value is zero,

Study Note

the discounted net cash inflows), the return on the investment is less than the the investment will earn the

minimum rate of return and the project should be rejected. If the net present minimum rate of return.

value is zero (if discounted cash inflows equal discounted cash outflows), the

The Net Present Value Method

The company’s minimum rate of return is 16 percent. Management must decide

Study Note

between two models.

When using the net present 씰 Model M costs $17,500 and will have an estimated residual value of $2,000 value method, remember to

after five years. It is projected to produce cash inflows of $6,000, $5,500, consider the present value of

$5,000, $4,500, and $4,000 during its five-year life.

the residual or disposal value. 씰 Model N costs $21,000 and will have an estimated residual value of $2,000.

It is projected to produce cash inflows of $6,000 per year for five years. Because Model M is expected to produce unequal cash inflows, Table 1

in the appendix on present value tables is used to determine the present value of each cash inflow from each year of the machine’s life. The net present value of Model M is determined as follows:

Model M

Net Cash

Present Value

5 4,000 0.476 1,904.00 Residual value

Total present value of cash inflows

Less purchase price of Model M

Net present value

$ 303.50 All the factors for this analysis can be found in the column for 16 percent

in Table 1. The factors are used to discount the individual cash flows, including the expected residual value, to the present. The amount of the investment in Model M is deducted from the total present value of the cash inflows to arrive at the net present value of $303.50. Since the entire investment of $17,500 in Model M is a cash outflow at the beginning—that is, at time zero—no discount- ing of the $17,500 purchase price is necessary.

씰 Because the net present value is positive, the proposed investment in Model M

will achieve at least the minimum rate of return. Because Model N is expected to produce equal cash receipts in each year of

its useful life, Table 2 in the appendix on present value tables is used to deter- mine the combined present value of those future cash inflows. However, Table 1 is used to determine the present value of the machine’s residual value because it represents a single payment, not an annuity. The net present value of Model N is calculated as follows:

Model N

Net Cash

Present Value

CHAPTER 25 Capital Investment Analysis