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Chapter 14

Capital budgeting involves committing funds now to receive a return in the future through investment projects. There are two decisions in capital budgeting: screening decisions to determine if a project is acceptable, and preference decisions to select among multiple acceptable options. Common criteria for evaluating capital budgeting decisions include net present value (NPV), internal rate of return (IRR), payback period, and accounting rate of return. These criteria emphasize cash flows rather than accounting profits since cash flows consider the timing of cash in and out of the organization. The internal rate of return is the interest yield promised by an investment over its lifetime and will cause the NPV of a project to equal zero.

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70 views

Chapter 14

Capital budgeting involves committing funds now to receive a return in the future through investment projects. There are two decisions in capital budgeting: screening decisions to determine if a project is acceptable, and preference decisions to select among multiple acceptable options. Common criteria for evaluating capital budgeting decisions include net present value (NPV), internal rate of return (IRR), payback period, and accounting rate of return. These criteria emphasize cash flows rather than accounting profits since cash flows consider the timing of cash in and out of the organization. The internal rate of return is the interest yield promised by an investment over its lifetime and will cause the NPV of a project to equal zero.

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jhouvan
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Chapter 14 (Garrison Text) Dr. M.S.

Bazaz

Capital Budgeting – involves investment – a company must commit funs now in order
to receive a return in the future.
 Two decisions:
 Screening decisions – whether a project is acceptable
 Preference decisions – selecting one among several acceptable choices.
 Criteria for Capital budgeting decisions:
 Net present value (NPV)
 Internal rate of return (IRR)
 Payback period
 Simple (accounting) rate of return
 Emphasis on Cash flow (NOT on accounting net income) for the first three criteria:
[The reason is that accounting net income is based on accrual concepts that ignore the
timing of cash flows into and out of an organization.]
 Cash outflows:
 Initial investment (net of salvage value of existing assets to be replaced)
 Working capital
 Repairs and maintenance
 Incremental operating costs
 Cash inflows:
 Incremental revenues
 Reduction in costs
 Salvage value
 Release of working capital
 Assumptions:
 All cash flows other than the initial investment occur at the end of a period
 All cash flows generated by an investment project are immediately reinvested.
 Discount rate or Cost of capital is the average rate of return the company must pay to
its long-term creditors and shareholders for the use of their funds.
 Internal rate of return -- interest yield promised by an investment project over its
useful life.
 IRR (yield) will cause the NPV of a project to be equal to zero.
 Factor of the IRR = investment required / net annual cash inflow
 IRR is compare with the company’s required rate of return
 Comparison of NPV and IRR
 NPV is often simpler to use.
 both methods assume that cash flows generated by a project during its useful life
are immediately reinvested elsewhere.
 The NPV method can be used to compare competing investment projects in two
ways:
 Total-cost approach
 Incremental –cost approach
 Whenever there are no revenues involved, the most desire alternative is the project,
which promises the least total cost from the present value perspective.
 For ranking projects, NPV is useful for equal size projects

 To compare two or more unequal size projects it is more appropriate to use the
profitability index.
 Profitability index = present value of cash inflow/investment required or
 Profitability index = present value of cash inflow/ present value of cash
outflows.
 Payback period – defined as the length of time that it takes for a project to recoup its
initial cost out of the cash receipts that it generates.
 When the net annual cash inflow is the same every year:
 Payback Period = Investment required / Net annual cash inflow
 When it is uneven – it is necessary to track the unrecovered investment year by
year.
 Payback period does not consider the time value of money.
 The Simple Rate of return (Accounting rate of return, ARR):
 It does not focus on cash flows.
 It focuses on accounting net income.
 It does not consider time value of money.
 ARR = (Incremental revenue – incremental expenses including depreciation
= incremental net income) / initial investment.
 If the cost reduction project is involved: ARR = (Cost savings – Depreciation on
new equipment) / initial investment.

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