# Chapter 25 Key Terms

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Capital Investment Analysis

### Annuity:

a series of equal cash flows at fixed intervals. Cash payments for monthly rents, salaries, and bond interest are all examples of annuities.

### Average rate of return:

a method of evaluating Capital Investment proposals that focuses on the expected profitability of the investment.

### Capital Investment analysis:

the process by which a management plans, evaluates, and controls long-term Capital Investments involving property, plant, and equipment.

### Capital rationing:

the process by which management plans, evaluates, and controls long-term Capital Investments involving fixed assets.

Alternative proposals are initially screened by establishing minimum standards and using the cash pay back and the average rate of return methods. The proposals that survive this screening are further analyzed, and using the net present value and internal rate of return method.

### Cash pay back period:

the expected period of time that will eat lacks between the date of a capital expenditure and the complete recovery in cash (or equivalent) of the amount invested.

### Currency exchange rate:

the rate at which currency in another country can be exchanged for local currency.

### Inflation:

a periodic in which prices in general are rising and the purchasing power of money is declining.

### Internal rate of return method:

a method of analysis of proposed Capital Investments that uses present value concepts to compute the rate of return from the net cash flows expected from the investment. This method, sometimes called the time adjusted rate of return method, starts with the proposal's net cash flows and works backward to estimate the proposal's expected rate of return.

### Net present value method:

a method of analysis of proposed Capital Investments that focuses on the present value of the cash flows expected from the investments. The net present value method that compares the amount to be invested with the present value of the net cash inflows. It is sometimes called the discounted cash flow method.

The interest rate used in the net present value analysis, is the company's minimum desired rate of return. This rate, sometimes termed the hurdle rate, is based on such factors as the purpose of the investment and the cost of obtaining funds for the investment. If the present value of the cash inflows equals or exceeds the amount to be invested, the proposal is desirable.

### Present value concepts:

cash to be received (or paid) in the future is not the equivalent of the same an amount of money received at an earlier date. Both the net present value and the internal rate of return methods used the following two present value concepts: present value of an amount; present value of an annuity.

### Present value index:

an index computed by dividing the total present value of the net cash flow to be received from a proposed Capital Investment by the amount to be invested.

### Present value of an annuity:

the sum of the present values of a series of equal cash flows to be received at fixed intervals.

### Time value of money concept:

the concept that an amount of money invested today will earn income.

Example: