Capital Investment Analysis & Standard Costing Techniques
Learning Objectives:
After studying this topic you should be able to:
  Define and explain capital investment analysis.   Evaluate capital investment proposals using average rate of return method, cash payback method, net present value method, and internal rate of return method.   Explain the advantages and disadvantages of various methods of evaluating capital investment proposals.   Explain the concept of the time value of money (present value and future value).


Contents:
Capital investment analysis is a process of planning, evaluating, and controlling investments in plant assets. It is also known as capital budgeting. Management should carefully develop and implement capital investment analysis because it involves long term investment in assets that effects operations for many years. Capital investment decisions are very important because they involve long term commitment of funds. An enterprise has to meet obligations to creditors and provide dividends to stockholder so these investments must earn a sufficient rate of return.Employees at all levels should be encouraged to submit their proposals for capital investments. Serious considerations should be given to all reasonable proposals. Management should carefully identify the effects of economic implications that are expected from these proposals. Employees whose proposals are accepted for implementation should be rewarded by the the enterprise. Methods for the Evaluation of Capital Investment Proposals:

Following four methods are usually used for the evaluation of capital investment proposals: 1. The average rate of return method. 2. The payback period method (also known as cash payback period method). 3. The net present value method. 4. The internal rate of return method.Method 1 and 2 are the methods that do not use the present values. Method 3 and 4 use the present values. So these methods for the evaluation of capital investment can be grouped into tow categories: Methods that Do Not Use Present Value Methods that Use Present Value ↓ ↓ ↓ ↓
Average rate of return method. Payback period method net present value method internal rate of return method

Methods That Use Present Value:Methods that use present values (net present value method and internal rate of return method) in the capital investment analysis take into account the time value of money. The concept is that the money has value over time because it can be invested to earn interest income. A dollar in hand today is more valuable than a dollar to be received a year from today. For example, if we invest $5,000 today to earn a 10% interest per year, we will have $5,500 after one year. Thus $5,000 is the present value of $5,500 to be received a year from today if the rate of interest is 10%.This concept is further clarified by the following calculation: Today, in hand $5,000 Rate of interest 10% p.a.
After 1 year $5,000 + ($5,000 × 10/100) = $5,500

Methods That Ignore Present Value:Methods that do not use the present value (average rate of return method and payback method) are easy to use. Management uses these methods initially to screen proposals. If a proposal meets the minimum standards set by management, it is subject to further analysis otherwise it is dropped from further consideration.Methods that ignore present values are normally used for the evaluation of capital investment proposals that have relatively short useful lives. In such cases, management focuses on the expected income to be earned from the investment and the total net cash to be received rather than the timing of the cash flows.Usually a combination of methods is used to evaluate capital investment proposals. According to a survey of different industries the use of capital investment analysis is as follows: Method Use of net present value Percentage of use Average...
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