Accounting: The Language of Business - Vol. 1 (Part 155)

Today the strategies of many companies in the real estate industry are premised on low interest rates, an assumption that has resulted in the rapid expansion of the real estate securitization [Securitization is the process in which certain types of assets are pooled so that they can be repackaged into interest-bearing securities. The interest and principal payments from the assets are passed through to the purchasers of the securities.(imf.org)] business. This trend could be regarded as a risk factor, as it exposes the real estate sector to at least three potential problems: first, interest rate hikes; second, revisions to securitization business accounting standards; and third, overheating [During the COVID-19 pandemic, the American housing market started to heat up as buyers were competing more than ever before for inventory, and real estate entrepreneurs and sellers were able to make more money than they ever imagined from selling property. (California Business Journal)] in the real estate market.

Akira Mori

 Capital Investment Analysis (Part A)

by

Charles Lamson

Why do students pay tuition, study their textbooks, and spend time and money on a higher education? Most people believe that the money and time spent now will return them more income in the future. In other words, a higher education is an investment in future earning ability. How would you know if this investment is worth it? One method would be to compare the cost of a higher education against the estimated future increased earning power. The more your future increased earnings exceed the investment, the more attractive the investment. As you will see in the next several posts, the same is true for business investments in fixed assets. Business organizations analyze potential capital investments by using various methods that compare investment costs to future earnings and cash flows.

In the next several posts, we will describe analyses useful to making investment decisions, which may involve thousands, millions, or even billions of dollars. We will emphasize the similarities and differences among the most commonly used methods of evaluating investment proposals, as well as the uses of each method. We will also discuss qualitative considerations affecting investment analysis. Finally, we will discuss considerations complicating investment analysis and the process of allocating available investment funds among competing proposals.

Nature of Capital Investment Analysis

Companies use capital investment analysis to help evaluate long-term investments. Capital investment analysis (or capital budgeting) is the process by which management plans, evaluates, and controls investments in fixed assets. Capital investments involve the long-term commitment of funds and affect operations for many years. Thus, these investments must earn a reasonable rate of return, so that the business can meet its obligations to creditors and provide dividends to stockholders. Because capital investment decisions are some of the most important decisions their management makes, capital investment analysis must be carefully developed and implemented.

A capital investment program should encourage employees to submit proposals for capital investments. It should communicate to employees the long-range goals of the business, so that useful proposals are submitted. All reasonable proposals should be considered and evaluated with respect to economic costs and benefits. The program may reward employees whose proposals are accepted.

Methods of Evaluating Capital Investment Proposals

Capital investment evaluation methods can be grouped into the following two categories:

1. Methods that do not use present values

2. Methods that use present values

Two methods that do not use present values are (1) the average rate of return method and (2) the cash payback method. Two methods that use present values are (1) The net present value method and (2) the internal rate of return method. These methods consider the time value of money. The time value of money concept recognizes that an amount of cash invested today will earn income and therefore has value over time.

Management often uses a combination of methods in evaluating capital investment proposals. Each method has advantages and disadvantages. In addition, some of the computations are complex. Computers, however, can perform the computations quickly and easily. Computers can also be used to analyze the impact of changes in key estimates and evaluating capital investment proposals. 

Methods That Ignore Present Value

The average rate of return and the cash payback methods are easy to use. These methods are often initially used to screen proposals. Management normally sets minimum standards for accepting proposals, and those not meeting these standards are dropped from further consideration. If a proposal meets the minimum standards, it is often subject to further analysis.

The methods that ignore present value are often useful in evaluating capital investment proposals that have relatively short useful lives. In such cases, the timing of the cash flows is less important.

Average Rate of Return Method

The average rate of return, sometimes called the accounting rate of return, is a measure of the average income as a percent of the average investment in fixed assets. The average rate of return is determined by using the following equation:

Average rate of return = Estimated average annual income / Average investment

The numerator is the average of the annual income expected to be earned from the investment over the investment life, after deducting depreciation. The denominator is the average book value over the investment life. Thus, if straight-line depreciation and no residual value are assumed, the average investment over the useful life is equal to one half of the original cost.

To illustrate, assume that management is considering the purchase of a machine at a cost of $500,000. The machine is expected to have a useful life of 4 years, with no residual value, and to yield total income of $200,000. The estimated average annual income is therefore $50,000 ($200,000 / 4). And the average investment is $250,000 [($500,000 + $0 residual value) / 2] . Thus, the average rate of return on the average investment is 20%, computed as follows:

Average rate of return = Estimated average annual income / average investment

Average rate of return = $200,000 / 4 / ($500,000 + $0) / 2 = 20% 

The average rate of return of 20% should be compared with the minimum rate for such investments. If the average rate of return equals or exceeds the minimum rate, the machine should be purchased. When several capital investment proposals are considered, the proposals can be ranked by their average rates of return. The higher the average rate of return, the more desirable the proposal. For example, assume that management is considering two capital investment proposals and has computed the following average rate of return:

If only the average rate of return is considered, Proposal A, with an average rate of return of 25%, would be preferred over Proposal B.

In addition to being easy to compute, the average rate of return method has several advantages. One advantage is that it includes the amount of income earned over the entire life of the proposal. In addition, it emphasizes accounting income, which is often used by investors and creditors in evaluating management performance. Its main disadvantage is that it does not directly consider the expected cash flows from the proposal and the timing of these cash flows.

Cash Payback Method

Cash flows are important because cash can be reinvested. Very simply, the capital investment uses cash and must therefore return cash in the future in order to be successful.

The expected period of time that will pass between the date of an investment and the complete recovery in cash (or equivalent) of the amount invested is the cash payback period. To simplify the analysis, the revenues and expenses other than depreciation related to operating fixed assets are assumed to be all in the form of cash. The excess of the cash flowing in from revenue over the cash flowing out for expenses is termed net cash flow. The time required for the net cash flow to equal the initial outlay for the fixed asset is the payback period.

To illustrate, assume that the proposed investment in a fixed asset with an 8-year life is $200,000. The annual cash revenues from the investment are $550,000, and the annual cash expenses are $10,000. Thus, the annual net cash flow is expected to be $40,000 ($50,000 - $10,000). The estimated cash payback period for the investment is five years, computed as follows:

$200,000 / $40,000 = 5 year cash payback period

In this illustration, the annual net cash flows are equal ($40,000 per year). If these annual net cash flows are not equal, the cash payback period is determined by adding the annual net cash flows until the cumulative sum equals the amount of the proposed investment. To illustrate, assume that for a proposed investment of $400,000, the annual net cash flows and the cumulative net cash flows over the proposal's 6-year life are as follows:

The cumulative net cash flow at the end of the fourth year equals the amount of the end investment, $400,000. Thus, the payback period is 4 years. If the amount of the proposed investment had been $450,000, the cash payback period would occur during the fifth year. If the net cash flows are uniform during the period, the cash payback period would be 4.5 years.

The cash payback method is widely used in evaluating proposals for investments and new projects. A short payback period is desirable, because the sooner the cash is recovered, the sooner it becomes available for reinvestment in other projects. in addition, there is less possibility of losses from economic conditions, out-of-date assets, and other unavoidable risks when the payback period is short. The cash payback period Is also important to bankers and other creditors who may be depending upon the net cash flow for repaying debt related to the capital investment. The sooner the cash is recovered, the sooner the debt or other liabilities can be paid. Thus, the cash payback method is especially useful to managers whose primary concern is liquidity.

One of the disadvantages of the cash payback method is that it ignores cash flows occurring after the payback period. In addition, the cash payback method does not use present value concepts in valuing cash flows occurring in different periods. In the next section, we will review present value concepts and introduce capital investment methods that use present volume. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 1035-1038*

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