Some of the common criteria used to evaluate proposals for capital expenditures and compare alternatives involving capital assets are (1) present values, (2) rate of return, and (3) payoff period. It is recommended that the present value criterion be employed in evaluating alternative capital investments.
Present value Criterion:
Present value methods for comparing alternatives take the sum of present values of all future out of pocket expenditures and credits over the economic life of the asset. This figure is compared for each alternative. If differences in revenue also are involved, their present values must also be accounted for.
Suppose we are considering machine that costs $15,000 installed. We estimate that the economic life of the machine is eight years, at which time its salvage value is expected to be about $3000. For simplicity’s sake, we take the average operating and maintenance costs to be $5000 per year. At 10 percent interest, the present value of the expenditures and credits is
Initial investment = $15,000 x PVsp = 15,000 x 1.000 = 15,000
Annual operating and
Maintenance costs =
5000 x PVa = 5000 x 5.353 = 26,675
= 41, 675
Less credit of:
Value of salvage to be received in eight years = 300 x PVsp =
300 x 0.467 = 1,401
Net total $ 40, 274
The net total of $40, 274 is the present value of the expenditures and credits over the eight year expected life of the machine. The initial investment is already at present value; that is, PV sp = 1. the annual costs of operations and maintenance are an eight year annuity, so the entire stream of annual costs can be adjusted to present value by the multiplication of PV a from Appendix Table. Finally, the present value of the salvage is deducted. This total could be compared with similar figures for other alternatives over the same eight year period.
Suppose that another machine is estimated to have a different economic life (perhaps four years).Then, to make the present value totals comparable, we compare two cycles of the four year machine with one cycle of the eight year machine. If the operating and maintenance costs increase as the machine ages, the presence value of the expenditure in each year would be determined separately by PV sp .
Rate of Return Criterion:
One common method of evaluating new projects or comparing courses of action is to calculate rate of return, which is then judged for adequacy. Usually, no attempts are made to consider interest costs, so the resulting figure is referred to as the unadjusted rate of return (i.e. unadjusted for interest values). It is computed as follows:
Unadjusted rate of return = 100 (Net monetary operating advantage – Amortization) /Average investment.
The net operating advantage reflects the algebraic sum of the incremental costs of operation and maintenance and possible differences in revenue. If the rate computed is a before tax rate, then the amortization- incremental investment / economic life is subtracted, and the result is divided by the average investment and multiplied by 100 to obtain a percentage return. If an “after tax” rate is sought, the net increase in income taxes due to the project is subtracted from the net monetary advantage, and the balance of the calculation is as before. Obviously, the adequacy of a given arte of return changes drastically if it is being judged as an after tax return. The rate of return is that rate for which the present value of net monetary operating advantage equals the cost of the initial investment.