Capital Budgeting Decisions:
Learning Objectives:
- Evaluate the acceptability of an
investment project using the net present value method.
- Evaluate the acceptability of an
investment project using the internal rate of return method.
- Evaluate an investment project that has
uncertain cash flows.
- Rank investment projects in order of
preference.
- Determine the payback period for an
investment.
- Compute the simple rate of return for an
investment.
- Understand present value concepts and
the use of present value tables.
- Include income taxes in a capital
budgeting analysis.
Capital
Budgeting - Definition and Explanation:
The term capital budgeting
is used to describe how managers plan significant outlays on projects that
have long-term implications such as the purchase of new equipment and the
introduction of new products.
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Typical Capital Budgeting
Decisions:
Business decisions that
require capital budgeting analysis are decisions that involve in outlay now
in order to obtain some return in the future.
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Time Value of Money:
Investments commonly involve returns that
extend over fairly long period of time.
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Screening and
Preference Decisions:Capital budgeting decisions
fall into two broad categories - screening decisions and preference
decisions.
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Present Value and Future Value -
Explanation of the Concept:
A dollar received now is more valuable than a dollar received a year
from now for the simple reason that if you have a dollar today, you can
put it in the bank an have more than a dollar a year from now. Since
dollars today are worth more than dollars in the future, we need some
means of weighing cash flows that are received at different times so
that they can be compared.
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Net Present Value (NPV) Method in Capital
Budgeting Decisions:
Under the net present value method, the present
value of a project's cash inflows is compared to the present value of the
project's cash out flows. The difference between the present value of these
cash flows is called "the net present value". This net present value
determines whether or not the project is an acceptable investment.
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Internal Rate of Return (IRR) Method - Definition and Explanation:The internal rate of return is the rate of return promised by an investment
project over its useful life. It is some time referred to simply as yield on
project. The internal rate of return is computed by finding the discount rate
that equates the present value of a project's cash out flow with the present
value of its cash inflow In other words, the internal rate of return is that
discount rate that will cause the net present value of a project to be equal to
zero.
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Net Present Value (NPV) Method Vs Internal Rate of Return (IRR) Method:The net present value
method has several important advantages over the internal rate of return
method. First the net present value method is often simpler to use. As
mentioned earlier, the internal rate of return method may require
hunting for the discount rate that results in a net present value of
zero.
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Net Present Value (NPV) Method - Comparing the Competing Investment Projects:
The net present value method can be used to
compare competing investment projects in two ways. One is the total cost
approach, and the other is the incremental cost approach.
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Least Cost Decisions:
Revenues are not directly involved in some decisions. For example, a
company that does not charge for delivery service may need to replace an
old delivery truck, or a company may be trying to decide whether to
lease or to buy its fleet of executive cars. In situations such as
these, there no revenues are involved, the most desirable alternative
will be the one that promises the least total cost from the present
value perspective.
Capital Budgeting Decisions With
Uncertain Cash Flows:
The analysis in this chapter (capital
budgeting decisions) has assumed that all of the future cash flows are known
with certainty. However, future cash flows are often uncertain or difficult
to estimate. A number of techniques are available for handling this
complication. Some of these techniques are quite technical involving
computer simulations or advanced mathematical skills and are beyond the
scope of this book. However, we can provide some very useful information to
managers without getting too technical.
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Ranking Investment Projects:
All
investments are not treated equally. Investment projects are ranked
according to their importance. A lot of factors are taken into account to
determine which project is more important and which is not.
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Payback Period Method for Capital Budgeting Decisions:
The payback is another method to evaluate an investment project. The payback
method focuses on the payback period. The payback period is the length of
time that it takes for a project to recoup its initial cost out of the cash
receipts that it generates.
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Simple rate of Return Method:The
simple rate of return method is another capital budgeting technique that
does not involve discounted cash flows. The method is also known as the
accounting rate of return, the unadjusted rate of return, and the financial
statement method. Unlike the other capital budgeting methods that we have
discussed, the simple rate of return method does not focus on cash flows.
Rather, it focuses on accounting net operating income. The approach is to
estimate the revenue that will be generated by a proposed investment and
then to deduct from these revenues all of the projected expenses associated
with the project.
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Post Audit of Investment Projects:
After an investment project has been approved and implemented, a
post audit
should be conducted. A post audit involves checking whether or not expected
results are actually realized. This is a key part of the capital budgeting
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Inflation and Capital
Budgeting Analysis:
Doesn't
inflation have an impact in a capital budgeting analysis? The answer is
qualified yes in that inflation does have an impact on the numbers that are
used in capital budgeting analysis. But it does not have impact on the
results of the analysis if certain conditions are satisfied.
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Income Taxes in Capital Budgeting
Decisions:
In our discussion of capital budgeting
decisions in this chapter, we ignored income taxes for two
reasons. First, many organizations do not pay income taxes. Not-for-profit
organizations, such as hospitals and charitable foundations, and government
agencies are exempt from income taxes. Second, capital budgeting is complex
and is best absorbed in small doses.
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Review
Problem 1: Basic Present Value Computations
Review
Problem 2: Comparison of Capital Budgeting Methods
Future Value and Present
Value Tables |
