Learning Objectives

After reading and studying Chapter 15, you should be able to answer the following questions:

1. Why do most capital budgeting methods focus on cash flows?

2. How is payback period computed and what does it measure?

3. What are the net present value and profitability index of a project and how are they measured?

4. How is the internal rate of return on a project computed and what does it measure?

5. How do taxation and depreciation affect cash flows?

6. What are the underlying assumptions and limitations of each capital project evaluation method?

7. How do managers rank investment projects?

8. How is risk considered in capital budgeting analysis?

9. How and why should management conduct a post-investment audit of a capital project?

10. (Appendix 1 ) How are present values calculated?

11. (Appendix 2) What are the advantages and disadvantages of the accounting rate of return method?

Terminology

Accounting rate of return (ARR): the rate of earnings obtained on the average capital investment over the life of a capital project; computed as average annual profits divided by average investment; not based on cash flow

Annuity: a series of equal cash flows (either positive or negative) per period

Annuity due: a series of equal cash flows received or paid at the beginning of a period

Capital asset: an asset used to generate revenues or cost savings by providing production, distribution, or service capabilities for more than one year

Capital budgeting: the evaluation of future long-range projects or courses of activity in order to allocate limited resources effectively and efficiently

Cash flow: the receipt or disbursement of cash; in capital budgeting, it refers to cash flows that arise from the purchase, operation, and disposition of a capital asset

Compound interest: a method of determining interest in which interest that was earned in prior periods is added to the original investment so that, in each successive period, interest is earned on both principal and interest

Compounding period: the time between each interest computation

Cost of capital (COC): the weighted average cost of the various sources of funds (debt and equity) that compose a firmЎЇs financial structure

Discounting: the process of reducing future cash flows to present value amounts by removing the portion of the future values representing interest

Discount rate: the rate of return used to discount future cash flows to their present value amounts; it should equal or exceed an organizationЎЇs weighted average cost of capital

Financing decision: a judgment regarding the method of raising capital to fund an investment

Future value (FV): the amount to which one or more sums of money invested at a specified interest rate will grow over a specified number of time periods

Hurdle rate: the rate of return specified as the lowest acceptable return on investment; it should generally be at least equal to the cost of capital; the hurdle rate is commonly the discount rate used in computing net present value amounts

Independent project: an investment project that has no specific bearing on any other investment project

Internal rate of return (IRR): the discount rate that causes the present value of the net cash inflows to equal the present value of the net cash outflows

Investment decision: a judgment about which assets will be acquired by an entity to achieve its stated objectives

Judgmental method (of risk adjustment): method in which decision makers use logic and reasoning to decide whether a project provides an acceptable rate of return in relation to its risk

Mutually exclusive projects: projects that fulfill the same function; one project will be chosen from such a group, excluding all others from further consideration because they would provide unneeded or redundant capability

Mutually inclusive projects: a set of proposed capital projects that are all related; if the primary project is chosen, all related projects are also selected

Net present value (NPV): the difference between the present values of all cash inflows and outflows for an investment project

Net present value method: a process that uses the discounted cash flows of a project to determine whether the rate of return on that project is equal to, higher than, or lower than the desired rate of return

Ordinary annuity: a series of equal cash flows received or paid at the end of a period

Payback period: measures the time required for a projectЎЇs cash inflows to equal the original investment

Postinvestment audit: the process of gathering information on the actual results of a capital project and comparing them to the expected results

Preference decision: a decision where projects are ranked according to their impact on the achievement of company objectives

Present value (PV): the amount that one or more future cash flows is worth currently, given a specified rate of interest

Profitability index (PI): a ratio that compares the present value of net cash flows to the present value of the net investment

Reinvestment assumption: an assumption made about the rates of return that will be earned by intermediate cash flows from a capital project; NPV and PI assume reinvestment at the discount rate; IRR assumes reinvestment at the IRR

Return of capital: the recovery of the original investment (or principal) by a project

Return on capital: income equal to the rate of return multiplied by the amount of the investment

Risk: uncertainty reflecting the possibility of differences between the expected and actual future returns from an investment

Risk-adjusted discount rate method: a formal method of adjusting for risk in which the decision maker increases the rate used for discounting the future cash inflows and decreases the rate used for discounting future cash outflows to compensate for increased risk

Screening decision: determines whether a capital project is desirable based on some previously established minimum criterion or criteria

Sensitivity analysis: a process of determining the amount of change that must occur in a variable before a different decision would be made

Simple interest: a method of determining interest in which interest is earned on only the original investment (or principal) amount

Tax benefit (of depreciation): the amount of depreciation deductible for tax purposes multiplied by the tax rate; the reduction in taxes caused by the deductibility of depreciation

Tax shield (of depreciation): the amount of depreciation deductible for tax purposes; the amount of revenue shielded from taxes because of the depreciation deduction

Time line: a representation of the amounts and timing of all cash inflows and outflows used in analyzing cash flow from a capital project

Lecture Outline

LO.1: Why do most capital budgeting methods focus on cash flows?

A. Introduction

1. This chapter discusses techniques used to evaluate the potential financial costs and benefits of proposed capital projects.

a. Choosing the assets in which an organization will invest is one of the most important business decisions for managers.

2. Capital assets consist of assets that are used to generate future revenues or cost savings by providing production, distribution, or service capabilities for more than one year.

B. Capital Asset Acquisition

1. Capital budgeting involves the evaluation and ranking of alternative future long-range projects to allocate limited resources effectively and efficiently.

a. Managers and accountants apply various criteria to evaluate the feasibility of alternative projects.

b. Although financial criteria are used to assess virtually all projects, firms now also use nonfinancial criteria to critically assess activities that have benefits that are difficult to quantify monetarily.

2. P lanned annual expenditures for capital projects for the near term (less than 5 years) and summary information for the long term (6 to 10 years) are shown in the capital budget, which is a key instrument in implementing organizational strategies.

3. Text Exhibit 15ЁC1 provides quantitative and qualitative criteria used by the forest products industry to evaluate capital projects.

C. Use of Cash Flows in Capital Budgeting

1. Any investment made by an organization is expected to earn some type of return in the form of interest, cash dividends, or operating income.

2. Converting accrual-based income to cash flow information puts all investment returns on an equivalent basis.

3. Cash flows are the receipts or disbursements of cash; when related to capital budgeting, cash flows arise from the purchase, operation, and disposition of a capital asset.

4. Interest cost is a cash outflow caused by the financing method used for the project and is not a factor that should be considered in the project selection process.

5. Project funding is a financing, not an investment decision.

6. A financing decision is a judgment, regarding the method of raising capital to fund an investment.

7. An investment decision is a judgment about which assets to acquire to achieve an entityЎЇs stated objectives.

8. Cash flows from a capital project are received and paid at different times during a projectЎЇs life.

a. Some cash flows occur at the beginning of a period, other cash flows occur during the period, while others occur at the end.

b. Analysts assume that cash flows always occur at either the beginning or the end of the time period during which they actually occur in order to simplify capital budgeting analysis.

D. Cash Flows Illustrated

1. Text Exhibit 15-2 presents the expected costs and cost savings of a proposed capital project for the company discussed in the chapter.

2. Time lines

a. A time line is a device that visually illustrates the points in time when cash flows are expected to be received or paid, making it a helpful tool for analyzing the cash flows of a capital investment proposal.

b. As shown in the illustration provided in the chapter, cash inflows are shown as positive amounts on a time line and cash outflows are shown as negative amounts.

LO.2: How is payback period computed and what does it measure?

3. Payback period

a. The payback period is the time it takes an investor to recoup an original investment through cash flows from a project.

b. The longer it takes to recover the initial investment, the greater is the projectЎЇs risk because cash flows in the more distant future are more uncertain than relatively current cash flows.

c. The faster capital is returned from an investment, the more rapidly it can be invested in other projects.

d. Payback period for a project having unequal cash inflows is determined by accumulating cash flows until the original investment is recovered.

e. An annuity is a series of equal cash flows (either positive or negative) per period.

i. When the cash flows represent an annuity, the payback period is determined as follows:

Payback Period = Investment ЎВ Annuity

f. Company management typically sets a maximum acceptable payback period as one of the evaluation techniques for capital projects.

g. The payback period method ignores three important aspects: inflows occurring after the payback period has been reached; the companyЎЇs desired rate of return; and the time value of money.

E. Discounting Future Cash Flows

1. A time value is associated with money because interest is paid or received on money.

a. For example, $1 received today has more value than $1 received one year from today because money received today can be invested to generate a return that will cause it to accumulate to more than $1 over time; this effect is referred to as the time value of money

2. Discounting is the process of reducing future cash flows to present value amounts by removing the portion of the future values representing interest.

3. The Ў°imputedЎ± interest amount is based on two considerations: the time delay until the cash flow is received or paid and the rate of interest assumed.

4. Present value (PV) is the common base of current dollars of all future values associated with a project after discounting.

5. The capital budgeting discounting process requires the use of several estimates:

a. The project cost must be estimated and should include purchase price, installation, and additional investments in working capital items such as inventory; these items constitute the projectЎЇs cash outflows.

b. The amounts and timing of future cash inflows and outflows must be estimated.

c. Managers must estimate the rate of return on capital investments required by the company; this rate is called the discount rate.

6. The discount rate is the rate of return used to determine the imputed interest portion of future cash receipts and expenditures; it should equal or exceed an organizationЎЇs weighted average cost of capital.

7. Cost of capital (COC) is the weighted average cost of the various sources of funds (debt and stock) that comprise a firmЎЇs financial structure.

8. Managers must distinguish between cash flows that represent a return of capital and those that represent a return on capital.

a. A return of capital is the recovery of the original investment or the return of principal in a project.

b. A return on capital represents income and equals the discount rate multiplied by the investment amount.

LO.3: What are the net present value and profitability index of a project and how are they measured?

F. Discounted Cash Flow Methods

1. Net present value method

a. The net present value method is a process that uses the discounted cash flows of a project to determine whether the rate of return on that project is equal to, higher than, or lower than the desired rate of return.

b. A projectЎЇs net present value (NPV) is the difference between the present values of all cash outflows for an investment project.

c. Net present value data and calculations are provided in text Exhibit 15-3.

d. The net present value represents the net cash benefit (or, if negative, the net cash cost) of acquiring and using the proposed asset.

i. If the NPV is zero, the projectЎЇs actual rate of return is equal to the required rate of return.

ii. If the NPV is positive, the actual rate is more than the required rate of return. If the NPV is negative, the actual rate is less than the required rate of return.

e. Text Exhibit 15ЁC4 provides net present values at alternative discount rates and indicates that the NPV is not a single, unique amount, but is a function of several factors:

i. Changing the discount rate while holding the amounts and timing of cash flows constant affects the NPV. Increasing the discount rate causes NPV to decrease; decreasing the discount rate causes NPV to increase.

ii. Changes in estimated amounts and/or timing of cash inflows and outflows affect a projectЎЇs net present value.

iii. When amounts and timing of cash flows change in conjunction with one another, the effects of the changes can be determined only by calculation.

f. The net present value method provides information on how the actual rate compares to the desired rate, allowing managers to eliminate from consideration any projects on which the rates of return are less than the desired rate and, therefore, not acceptable.

i. This method can also be used to select the best project when choosing among investments that can perform the same task or achieve the same objective.

ii. This method should not be used to compare independent projects requiring different levels of initial investment as such a comparison favors projects having higher net present values over those with lower net present values without regard to the capital invested in the project.

2. Profitability Index

a. The profitability index (PI) is a ratio that compares the present value of net cash flows to the projectЎЇs net investment and is calculated as:

PI = Present Value of Net Cash Flows ЎВ Net Investment

a. The present value (PV) of net cash flows equals the PV of future cash inflows minus the PV of future cash outflows.

b. The PV of net cash inflows represents an output measure of the projectЎЇs worth, whereas the net investment represents an input measure of the projectЎЇs cost.

c. By relating these two measures, the profitability index gauges the efficiency of the firmЎЇs use of capital.

d. The higher the index, the more efficient is the capital investment.

e. The present value of the net cash inflows is equal to the cash benefit provided by the project or the present value of future cash inflows minus the present value of future cash outflows.

f. A firm that makes capital budgeting decisions on a profitability basis would judge a project acceptable if the projectЎЇs PI is equal to or greater than 1.00.

g. Like NPV, the PI does not indicate the projectЎЇs expected rate of return.

LO.4: How is the internal rate of return on a project computed and what does it measure?

3. The internal rate of return

a. The internal rate of return (IRR) is the discount rate that causes the present value of the net cash inflows to equal the present value of the net cash outflows and is the projectЎЇs expected rate of return; if the IRR is used to determine the NPV of a project, the NPV is zero. The following formula should be considered to determine NPV:

NPV = ЁCInvestment + PV of cash inflows ЁC PV of cash outflows other than the investment

NPV = ЁCInvestment + Cash inflows (PV factor) ЁC Cash outflows (PV factor)

b. The IRR is most easily calculated for projects having equal annual net cash flows. When an annuity exists, the IRR formula can be restated as follows:

NPV = ЁCNet investment + PV of annuity amount

NPV = ЁCNet investment + (Cash flow annuity amount ЎБ PV factor)

c. The investment and annual cash flow amounts are known from the expected data and NPV is known to be zero at the IRR; the IRR and its PV factor are unknown. To determine the IRR, substitute known amounts into the formula, rearrange terms, and solve for the unknown PV factor:

NPV = ЁCNet investment + (Annuity ЎБ PV factor)

0 = ЁCNet investment + (Annuity ЎБ PV factor)

Net investment = (Annuity ЎБ PV factor)

Net investment ЎВ Annuity = PV factor

d. The solution yields a PV factor for the number of annuity periods corresponding to the projectЎЇs life at an interest rate equal to the IRR.

e. Finding this factor in the PV of an annuity table and reading the interest rate at the top of the column in which the factor is found provides the IRR.

f. Refer to text Exhibit 15ЁC5 for a plot of the NPVs that result from discounting the example projectЎЇs cash flows at various rates of return.

g. A companyЎЇs hurdle rate is the rate of return specified as the lowest acceptable rate on investment; it should be at least equal to the cost of capital.

h. The higher the IRR, the more financially attractive is the investment proposal.

i. In choosing among alternative investments, however, managers cannot look solely at the internal rates of return on projects because the rates do not reflect the dollars involved as an investor would normally rather have a 20 percent return on $1,000 than a 100 percent return on $10!

i. Using the IRR has three drawbacks:

i. When uneven cash flows exist, the iterative process is inconvenient;

ii. Unless PV tables that provide factors for fractional interest rates are available, finding the precise IRR on a project is difficult; and

iii. Sometimes it is possible to find several rates of return that will make the NPV of the cash flows equal zero. (This phenomenon usually occurs when there are net cash inflows in some years and net cash outflows in other years of the investment projectЎЇs life other than at time 0).

LO.5: How do taxation and depreciation affect cash flows?

G. Effect of Depreciation on After-Tax Cash Flows

1. Depreciation provides a tax shield which is the amount of depreciation deductible for tax purposes.

2. This tax shield provides a tax benefit is the amount of depreciation deductible for tax purposes multiplied by the tax rate.

3. The depreciation for purposes of calculating income taxes rather than the amount used for financial accounting purposes is relevant in discounted cash flow analysis.

4. See text Exhibit 15ЁC6 for the different after-tax cash flows and net present values that result if the same project is subjected to either a 25 percent (situation B) or 40 percent (situation C) tax rate.

5. Based on the net present value criterion, a decrease in the tax rate makes the equipment a more acceptable investment; an increase has the opposite effect.

6. Managers are best able to make informed decisions concerning capital investments if they understand how depreciation and taxes affect the various capital budgeting techniques.

LO.6: What are the underlying assumptions and limitations of each capital project evaluation method?

H. Assumptions and Limitations of Methods

1. Text Exhibit 15-7 summarizes the assumptions and limitations of the various capital budgeting models.

2. Managers should understand the basic similarities and differences of the various methods and use several techniques to evaluate a project.

3. All of the methods have two similar limitations:

a. None of the methods provides a mechanism to include management preferences in regard to the timing of cash flows except to the extent that payback indicates the promptness of the investment recovery; and

b. All the methods use single, deterministic measures of cash flow amounts rather than probabilities.

4. The first limitation can be compensated for by subjectively favoring projects whose cash flow profiles better suit managementЎЇs preferences, assuming other project factors are equal; the second limitation can be overcome by using probability estimates of cash flows.

I. Investment Decision

1. Management must identify the best asset(s) for the firm to acquire to fulfill the companyЎЇs goals and objectives. Making such an identification requires answers to the following four questions.

2. Is the activity worthy of an investment?

a. A company acquires assets when they have value in relation to specific activities in which the company is engaged.

b. An activityЎЇs worth is measured by cost-benefit analysis, and for most capital budgeting decisions, costs and benefits can be measured in monetary terms.

c. Difficulty in quantification is no reason to exclude benefits from capital budgeting analyses since surrogate quantifiable measures can be obtained for hard-to-quantify benefits.

d. Monetary benefits of the capital project may be known in advance not to exceed the costs, but the project is essential for other reasons.

3. Which assets can be used for the activity?

a. The determination of available and suitable assets to conduct the intended activity is closely connected to the evaluation of the activityЎЇs worth.

b. Management must have an idea of how much the needed assets will cost to determine if the activity should be pursued and therefore should gather the following specific monetary and nonmonetary information for each asset to make this determination: initial cost, estimated life, salvage value, raw material and labor requirements, operating costs (both fixed and variable), output capability, service availability and cost, maintenance expectations, and revenues to be generated, if any (See text Exhibit 15-8 ).

c. Information used in a capital project analysis may employ surrogate, indirect measures, and management must have both quantitative and qualitative information on each asset to answer the next question.

4. Of the available assets for each activity, which is the best investment?

a. Management should select the best asset from the possible candidates and exclude all others from consideration, using all available information.

b. A company has a standing committee to discuss, evaluate, and approve capital projects. Such a committee should recognize that two types of capital decisions need to be madeЎЄscreening and preference decisions.

c. A screening decision is the first decision made in evaluating capital projects that determines whether a project is desirable based on some previously established minimum criterion or criteria.

d. A preference decision is the second decision made in capital project evaluation in which projects are ranked according to their impact on the achievement of company objectives.

5. In which of the best investments should the company invest?

a. Mutually exclusive projects are composed of a set of proposed capital projects that fulfill the same function; one project will be chosen from such a group, causing all others to be excluded from further consideration because they would provide unneeded or redundant capability.

b. Independent projects are investment projects that have no specific bearing on one another.

c. Mutually inclusive projects are composed of a set of capital projects that are all related and that must all be chosen if the primary project is chosen.

d. Text Exhibit 15ЁC9 illustrates a typical investment decision process in which a firm is determining the best way to provide transportation for its sales force.

LO.7: How do managers rank investment projects?

J. Ranking Multiple Capital Projects

1. All time-value-of-money evaluation techniques will typically indicate the same decision alternative.

2. Often managers must choose among multiple, mutually exclusive projects.

a. Multiple project evaluation decisions require that a ranking be made, generally using net present value, profitability index, and/or internal rate of return techniques.

b. Managers can use results from the evaluation techniques to rank projects in descending order of acceptability.

c. Although based on the same figures, the NPV and PI methods do not always provide the same rank order because the former is a dollar measure and the latter is a percentage.

d. When the IRR is used, rankings of multiple projects are based on expected rates of return. Rankings provided by the IRR method are not always in the same order as those given by the NPV or PI methods.

e. Conflicting results arise because of differing underlying reinvestment assumptions among the three methods.

i. The reinvestment assumption focuses on how the cash flows released during a projectЎЇs life are assumed to be reinvested until the end of that projectЎЇs life.

ii. The NPV and PI techniques assume that released cash flows are reinvested at the discount rate, which is typically the cost of capital rate.

iii. The IRR method assumes that released cash flows are reinvested at the expected internal rate of return, which is higher than the COC for projects with positive NPVs.

Ў¤ In such a case, the IRR method could provide a misleading indication of project success because additional projects that have such a high return might not be found.

LO.8: How is risk considered in capital budgeting analysis?

K. Compensating for Risk in Capital Project Evaluation

1. Risk is uncertainty; it reflects the possibility of differences between the expected and actual future returns from an investment.

a. Managers considering a capital investment should understand and compensate for the degree of risk involved in that investment.

b. A manager may use the following three approaches to compensate for risk: the judgmental method, the risk-adjusted discount rate method, or sensitivity analysis.

2. Judgmental method

a. The judgmental method of risk adjustment is an informal method of adjusting for risk that allows the decision makers to use logic and reasoning to decide whether a project provides an acceptable rate of return in relation to its risk.

3. Risk-adjusted discount rate method

a. The risk-adjusted discount rate method is a formal method of adjusting for risk in which the decision maker increases (decreases) the rate used for discounting the future cash inflows (outflows) to compensate for increased risk.

b. Text Exhibit 15ЁC10 provides estimates of the development cost and annual cash savings for the example capital project.

4. Sensitivity analysis

a. Sensitivity analysis is a process of determining the amount of change that must occur in a variable before a different decision would be made.

b. Sensitivity analysis considers the possibility of Ў°what ifЎ± a variable is different than originally expected.

5. Range of the discount rate

a. A capital project that provides a rate of return equal to or greater than the hurdle or discount rate is considered to be an acceptable investment.

b. Because the discount and hurdle rates should be set minimally at the organizationЎЇs cost of capital, an increase in the cost of capital should cause an increase in the discount rateЎЄand a corresponding decrease in the NPV of the projectЎЇs cash flows.

c. Sensitivity analysis allows a company to ascertain what increases may occur in the estimated cost of capital and still have an acceptable project; as long as the projectЎЇs IRR is equal to or greater than the cost of capital, the project will be acceptable.

6. Range of the cash flows

a. An investmentЎЇs projected cash flows are also sensitive to changes in estimation.

b. Company management wants to know how small the net cash inflows can be for the project to still remain desirable, and such a determination requires that the present value of the cash flows be greater than the cost of the investment.

7. Range of the life of the asset

a. Asset life is related to many factors, some are controllable while others are not.

b. An error in the assetЎЇs estimated life will change the number of periods from which cash flows are to be expected, and such changes could affect the accept/reject decision for a project.

8. Sensitivity analysis does not reduce the uncertainty surrounding the estimate of each variable, but it does provide management with a sense of tolerance for estimation errors by providing ranges with upper and lower limits for selected variables.

LO.9: How and why should management conduct a postinvestment audit of a capital project?

L. Postinvestment Audit

1. A postinvestment audit is the process of gathering information on the actual results of a capital project and comparing them to the expected results.

2. The postinvestment audit process provides a feedback or control feature both to the persons who submitted and those who approved the original project information.

3. A postinvestment audit becomes more crucial as the size of the capital expenditure increases.

4. The performance of a postinvestment audit is difficult since the actual information may not be in the same form as were the original estimates, and some project benefits may be difficult to quantify.

5. Postinvestment audits provide management with information that can help to make better capital investment decisions in the future.

LO.10: (Appendix 1 ) How are present values calculated?

M. Time Value of Money

1. Future value (FV) refers to the amount to which a sum of money invested at a specified interest rate will grow over a specified number of time periods.

2. Present value (PV) is the amount that future cash flows are worth currently, given a specified rate of interest.

3. Future and present values depend on three things: amount of the cash flow, rate of interest, and timing of the cash flow.

4. The discount rate is the rate of return used in present value calculations; a present value is a future value discounted back the same number of periods at the same rate of interest.

5. Simple interest is a method of determining interest in which interest is earned only on the original investment or principal amount.

6. Compound interest is a method of determining interest in which interest that was earned in prior periods is added to the original investment so that, in each successive period, interest is earned on both principal and interest.

7. The compounding period is the time between each interest computation.

N. Present Value of a Single Cash Flow

1. A present value is simply a future value discounted back the same number of periods at the same rate of interest as it would require to compound from the resulting present value to the same future value.

2. Present values are computed as follows:

PV = FV ЎВ (1 + i) n

where PV = present value of a future amount

FV = future value of a current investment

i = interest rate per compounding period

n = number of compounding periods

O. Present Value of an Annuity

1. An annuity is a cash flow (either positive or negative) that is repeated over consecutive periods.

a. An ordinary annuity is a series of equal cash flows, each being received or paid at the end of a period.

b. An annuity due is a series of equal cash flows, each being received or paid at the beginning of a period.

2. Situations often exist in which an annuity is Ў°nestedЎ± or surrounded by unequal flows.

3. The appendix illustrates how to compute the present value of an annuity.

LO.11: (Appendix 2) What are the advantages and disadvantages of the accounting rate of return method?

P. Accounting Rate of Return

1. The accounting rate of return (ARR) measures the rate of earnings obtained on the average capital investment over a projectЎЇs life; the formula to calculate the ARR is:

ARR = Average Annual Profits from Project ЎВ Average Investment in Project

a. Project investment includes original cost and project support costs, such as those needed for working capital items.

b. Investment cost, salvage value, and working capital released at the end of the projectЎЇs life are summed and divided by two to obtain the average investment.

c. A projectЎЇs calculated ARR is compared with a pre-established ARR hurdle rate set by management which may be higher than the discount rate since the method does not include the time value of money.