Capital
Budgeting and Investment Decisions

Capital Budgeting is LongTerm Asset
Management
 longterm assets...
 are generally more expensive  they require capital
(i.e., company funds)
 create difficulties trying to estimate how far into the
future the asset will benefit the company
 serviceable life is affected by physical wear and as well
as obsolescence
 costs are recoverable through depreciation
 need to be evaluated before committing company funds
 the process of evaluating the investment opportunities is
called capital budgeting
 the final list of approved projects is called the
capital budget

Capital Budgeting Tools
 Average Rate of Return (ARR)
 compares average annual after tax net income resulting
from the investment

net annual saving
ARR = 
average investment
 where average investment =
(initial investment + residual value) / 2
 advantage:
 disadvantages:
 based on net income and not cash flow
 ignores the time value of money
 Payback Method
 evaluation based on annual cash flow savings

initial investment
Payback Period = 
net annual cash savings
 advantages:
 simple
 shows number of years to recoup asset initial investment
 disadvantages:
 depends on the depreciation method used
 ignores the time value of money
 Internal Rate of Return (IRR)
 is the rate of return that equates cash flows to the
initial investment outlay
 the required rate of return must be estimated by
management
 the IRR must be greater than the estimated rate of return
in order to accept the investment
 Net Present Value (NPV)
 discounts all future cash inflows and outflows to present
values
 consists of four steps...
 identify the amount and the period for investment
 determine cash inflows and cash outflows
 determine the present value of all cash flows
 here we assume the interest rate is the rate of
return (also called the hurdle rate)
which is the minimum return management wants to earn on their
investments
 evaluate the net present value of the investment
 advantages:
 takes into account the time value of money
 disadvantages:
 the process is more difficult and complex

Time Value of Money
 Future Value
 found by compounding interest over a given number of time
periods
 an annuity means we have a constant cash flow over time
 FV = PV ( 1 + i )^{
n}
where i = the interest rate and n = number of periods
compounded
 Present Value
 discounts future cash flows (both inflows and
outflows) to the present

FV
PV = 
( 1 + i )^{ n}
