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Following four methods are usually
used for the evaluation of capital investment proposals:
-
The average rate of return
method.
-
The payback period method (also
known as cash payback period method).
-
The net present value method.
-
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 rate
of return |
No |
46% |
| Payback
period |
No |
71% |
| Net present
value |
Yes |
64% |
| Internal rate
of return |
Yes |
69% |
|
Each method has its own
advantages and disadvantages. Some may be more
complex than others under various conditions.
The problem of complexity can, however, be
overcome with the help of modern computers.
Sophisticated computer software can be used to
develop models that indicate the effect of
changes in key estimates on the evaluation of
capital investment proposals.
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