Managerial Accounting
Class Notes and Lecture Outline
Capital Budgeting and Investment Decisions
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
Capital Budgeting Tools
  1. 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:
      • simplicity
    • disadvantages:
      • based on net income and not cash flow
      • ignores the time value of money
  2. 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
  3. 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
  4. Net Present Value  (NPV)
    • discounts all future cash inflows and outflows to present values
    • consists of four steps...
      1. identify the amount and the period for investment
      2. determine cash inflows and cash outflows
      3. 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
      4. 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

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this page is maintained by Reed Fisher
last updated January 15, 2011