Capital
Budgeting and Investment Decisions
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Capital Budgeting is Long-Term Asset
Management
- long-term 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
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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
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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
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