Chapter 25 - Summary
Explain the nature of capital investment decisions.
Capital investment decisions generally refer to projects or proposals that
require the purchase of plant assets. These decisions are crucial to the long-run
financial health of a business enterprise. Not only do they require that resources
be committed for long periods of time, they are also difficult or impossible
to reverse once funds have been invested and a project has begun.
Identify nonfinancial factors in capital investment decisions.
Nonfinancial factors may dictate the appropriate course of action. Such factors
may include, for example, compliance with laws, corporate image, employee morale,
and various aspects of social responsibility. Management must remain alert to
Evaluate capital investment proposals using (a) payback period, (b) return
on investment, and (c) discounted cash flows.
The payback period is the length of time needed to recover the cost of an investment
from the resulting net cash flows. However, this type of investment analysis
fails to consider the total life and overall profitability of the investment.
Return on average investment expresses the average estimated net income from
the investment as a percentage of the average investment. This percentage represents
the rate of return earned on the investment. A shortcoming is that average estimated
net income ignores the timing of future cash flows. Therefore, no consideration
is given to the time value of money.
Discounting future cash flows determines the net present value of an investment
proposal. Proposals with a positive net present value usually are considered
acceptable, while proposals with a negative net present value are considered
unacceptable. This technique considers both the life of the investment and the
timing of future cash flows.
Discuss the relationship between net present value and an investor's required
rate of return.
The discount rate used in determining an investment's net present value may
be viewed as the investor's minimum required return for that investment. Thus,
when an investment's net present value is positive, its expected rate of return
exceeds the minimum return required by the investor. Conversely, a negative
net present value suggests that an investment's return potential is less than
the minimum return required by the investor.
Explain the behavioral issues involved in capital budgeting and identify how
companies try to control the capital budgeting process.
Employees may be optimistic or pessimistic in their capital budgeting cash
flow estimates because their futures are affected by the selected capital budgeting
proposals. Firms audit capital budgeting projects to attempt to control for
overly optimistic or pessimistic estimates.