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Capital Budgeting Decisions:

Learning Objectives:

  1. Evaluate the acceptability of an investment project using the net present value method.
  2. Evaluate the acceptability of an investment project using the internal rate of return method.
  3. Evaluate an investment project that has uncertain cash flows.
  4. Rank investment projects in order of preference.
  5. Determine the payback period for an investment.
  6. Compute the simple rate of return for an investment.
  7. Understand present value concepts and the use of present value tables.
  8. 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. Click here to read full article.

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. Click here to read full article.

Time Value of Money:

Investments commonly involve returns that extend over fairly long period of time. Click here to read full article.

Screening and Preference Decisions:

Capital budgeting decisions fall into two broad categories - screening decisions and preference decisions. Click here to read full article.

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. Click here to read full article.

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. Click here to read full article.

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. Click here to read full article.

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. Click here to read full article.

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. Click here to read full article.

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. Click here to read full article.

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. Click here to read full article.

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. Click here to read full article.

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. Click here to read full article.

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 process. Click here to read full article.

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. Click here to read full article.

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. Click here to read full article.

Review Problem 1: Basic Present Value Computations

Review Problem 2: Comparison of Capital Budgeting Methods

Future Value and Present Value Tables


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