Contabilidad II | © John Petroff Source: PEOI |

Investment analysis

© 1989 John Petroff

RELEVANT INFORMATION

The information needed for many business decisions requiring to
choose between several alternatives, goes beyond the data
provided in the financial statements and involves expected or
future revenues and costs. In this analysis of expected numbers,
only what changes is relevant: what does not change is
irrelevant. Thus, the name given to this analysis as differential
or incremental. Note that, while variable cost do naturally vary,
some fixed cost can also change in some of these decisions. Note
also that past costs are irrelevant: they called sunk costs.

LEASING OR SELLING EQUIPMENT

When comparing the choice between leasing or selling currently
unused equipment, the additional, incremental or differential
elements of either are studied for

1- revenue,

2- costs, and

3- net gain.

Book value and accumulated depreciation are omitted as irrelevant,
but net tax effects are not.

MAKE OR BUY

When a manufacturer has excess productive capacity in space,
equipment and labor, producing components may be better than
purchasing them. Producing is chosen if the incremental cost is
lower than the purchase price. The incremental cost combines
additional direct materials, direct labor, fixed factory overhead
and variable factory overhead. Non economic factors, such as
relations with suppliers, also often come into consideration.

REPLACING PLANT ASSETS

The differential analysis for plant asset replacement
takes the following into consideration: annual variable costs
of both new and old equipment, the expected life of new
equipment, the cost of new equipment, the proceeds from the sale
of
old equipment, and any annual differential in cost.

OPPORTUNITY COST

When a benefit or profit that could have been obtained, was not,
this foregone benefit is referred to as an opportunity cost.
While accounting is concerned with out-of-pocket costs, for most
business decisions, opportunity costs are just as real and, in
some cases, more significant.

DISCONTINUING UNPROFITABLE SEGMENTS

Products, branches, segments, departments, and territories that
are unprofitable should be considered for elimination. If
eliminating the unprofitable segments has no effect on fixed
costs, the overall net income from operations will improve from
the reduction in variable costs. This depends, however, on
whether the remaining products or segments are competing or
complementary. In the later case, revenue may decrease creating
an opportunity cost in excess of the out-of-pocket cost
reduction. Fixed costs can also play a role if alternative uses
for the plant capacity exist. Lastly, layoffs can affect morale.

SELLING OR PROCESSING GOODS FURTHER

Manufacturing companies often sell their products at an
intermediary stage of production. When differential analysis is
used to determine whether goods should be sold now or processed
further, only costs and revenues from further processing need
to be considered. When more net income can be earned by
processing goods further, they should be produced providing
the production capacity exists.

ACCEPTING SPECIAL ORDERS

A company may accept additional business at a special price.
Incremental or differential analysis is used to determine the
differential revenue and costs. Companies not operating at full
capacity usually can benefit from additional business, if fixed
costs remain the same and the fixed cost per unit produced
decreases. However, a company operating at full capacity is
likely to see both fixed costs and variable costs rise.

CAPITAL BUDGETING

Capital investment analysis or capital budgeting is used by
management to plan, evaluate, and control long-term investment
decisions. Capital investment decisions commonly affect operations
for a number of years and require a long-term commitment of funds.
Capital investment decisions are usually based on either

1- payback period,

2- average rate of return,

3- net present value, or

4- internal rate of return.

AVERAGE RATE OF RETURN METHOD

The average rate of return is calculated by dividing average
annual net income by average investment. When comparing projects,
the highest average rate of return is selected, but consideration
for risk is given. The method is commonly used to determine
investment proposals with a short life span, and therefore, it
is
not essential to use present values. The advantage of the method
is its simplicity, but ignoring time value of money is a drawback.

PAYBACK PERIOD

The payback period or cash payback method measures the number
of years it will take to recover a capital investment. It is
determined by dividing the original investment by annual net cash
flows, or, if the cash flows are uneven, by adding up cash flows
until the original investment is recovered. Generally, the
shorter the payback period the better. A disadvantage of this
method is that it does not take into account cash flows beyond
the payback period since proposals with longer payback periods
may prove to be more profitable in the long-run. The method is
used by firms with liquidity problems or high risk.

DISCOUNTED CASH FLOW METHODS

Net present value and internal rate of return are both discounted
cash flow methods and give recognition to the time value of money
by discounting, that is, taking the present value of all future
cash flows. Both methods require a discount rate or opportunity
cost of capital. This rate is influenced by a number of factors
such as presence of risk, availability of borrowing, relative
profitability, minimum desired rate of return, nature of the
business and purpose of capital investments. The calculation of
discounted cash flows can involve the use of factor tables, exact
formulas, financial calculators or computers.

NET PRESENT VALUE

The net present value is the sum of the discounted future net
cash flows minus the initial investment. All proposals with
positive net present value are acceptable. When competing
alternative proposals are compare, the one with the largest net
present value is chosen. An index determined by dividing the
total present value of net cash flows by the initial investment
is
sometimes used instead when comparing project with different size
of initial investment.

INTERNAL RATE OF RETURN

The internal rate of return, also called the discount rate, is
the rate for which the net present value is zero. That is, the
sum of future net cash flows discounted for time value of money
is just equal to the initial investment for that particular rate.
This internal rate of return is compared to the cost of capital
or cutoff rate, and if higher, the project is accepted. When
competing proposal are compared the project with the highest
internal rate of return is chosen. Calculating the internal rate
of return requires either a trial and error method by looking
up
in present value tables a present value factor given by dividing
the initial investment by the annual cash flow, or with the use
of a financial calculator or computer.

CAPITAL INVESTMENT ANALYSIS - PROBLEMS

A number of factors complicate capital investment analysis.
They are inflation, income taxes, incorrect estimates and
the possibility of leasing instead of buying.

CAPITAL RATIONING

Capital rationing means that there is only enough capital for
the
projects with the greatest profit potential. The proposals are
initially evaluated to see if they meet minimum cash payback
period or required average rate of return. If they do, they are
then further evaluated by present value techniques. Proposals
that have met all financial criteria are then subjected to
nonfinancial analysis.

CAPITAL EXPENDITURES BUDGET

Once capital expenditure proposals have been approved, a capital
expenditure budget is prepared. Procedures for controlling
expenditures should also be established. Capital expenditures
budgets compare actual results with projections.

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