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# Methods for the Evaluation of Capital Investment Proposals:

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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 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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## More study material from this topic:

 Methods for the evaluation of capital investment analysis Average rate of return or accounting rate of return method Cash payback method Net present value method Internal rate of return method Simple interest Future value of a single sum Future value of an annuity Present value of a single sum Present value of an annuity Qualitative consideration in capital investment analysis Capital investment analysis and unequal proposal lives Capital rationing decision process Difference between simple interest and compound interest Difference between nominal and effective interest rate Future value of \$1 table Present value of \$1 table Present value of ordinary annuity table Future value of ordinary annuity table

A D V E R T I S E M E N T

 Financial Accounting Topics Introduction to Accounting ---------------------------------------------------------------------------- Transactions and Accounting Equation ---------------------------------------------------------------------------- Analysis of Business Transactions ---------------------------------------------------------------------------- Journal, Ledger and Trial Balance ---------------------------------------------------------------------------- Accounting for Bills of Exchange ---------------------------------------------------------------------------- Special Journals ---------------------------------------------------------------------------- Cash Book ---------------------------------------------------------------------------- Bank Reconciliation Statement ---------------------------------------------------------------------------- Final Accounts ---------------------------------------------------------------------------- Work Sheet ---------------------------------------------------------------------------- Capital and Revenue Items ---------------------------------------------------------------------------- Valuation of Inventories ---------------------------------------------------------------------------- Accounts of Non-profit Making Organizations ---------------------------------------------------------------------------- Statement of Cash Flows ---------------------------------------------------------------------------- Accounting Ratios Analysis ---------------------------------------------------------------------------- Depreciation, Provisions and Reserves ---------------------------------------------------------------------------- Accounting Dictionary ---------------------------------------------------------------------------- Financial Calculators

 Managerial Accounting Topics Financial Statements ---------------------------------------------------------------------------- Cost Volume Profit Relationship ---------------------------------------------------------------------------- Variable Costing System ---------------------------------------------------------------------------- Materials and Inventory Cost Control ---------------------------------------------------------------------------- Activity Based Costing System ---------------------------------------------------------------------------- Standard Costing and Variance Analysis ---------------------------------------------------------------------------- Balanced Scorecard ---------------------------------------------------------------------------- Capital Investment Analysis/Capital Budgeting