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Capital Budgeting
Budgeting for the acquisition of capital assets Capital budgeting techniques (a) Payback period (b) Accounting Rate of Return (c) Net Present Value (d) Internal Rate of Return
Capital Budgeting
Outcome is uncertain. Large amounts of money involved.
Analyzing alternative longterm investments and deciding which assets to acquire or sell.
Decision may be difficult or impossible to reverse.
Example
Casey Co. is considering an investment of $130,000 in new equipment. The new equipment is expected to last 10 years. It will have zero salvage value at the end of its useful life. The straight-line method of depreciation is used for accounting purposes. The expected annual revenues and costs of the new product that will be produced from the investment are: Sales Cost of goods sold Depreciation expense Selling & Admin expense Income before income tax Income tax expense Net Income $145,000 13,000 22,000 $200,000 180,000 $20,000 7,000 $13,000
Payback Period
Time period required to recover the cost of the investment from the annual cash inflow produced by the investment.
Amount invested Expected annual net cash inflow
$26,000
5 years
Payback = 3 years
Payback = 5 years
Consider two projects, each with a 5-year life and each costing $6,000.
Project One Net Cash Inflows $ 2,000 2,000 2,000 2,000 2,000 Project Two Net Cash Inflows $ 1,000 1,000 1,000 1,000 1,000,000
Year 1 2 3 4 5
Would you invest in Project One just because it has a shorter payback period?
Compare accounting rate of return to companys required minimum rate of return for investments of similar risk. The minimum return is based on the companys cost of capital.
(130,000) 26,000
NPV
$16,900
Cash Flow When? Type of cash PV factor flow (130,000) 36,000 32,000 29,000 27,000 26,000 24,000 23,000 22,000 21,000 20,000 NPV
Present value ($130,000) 32,148 25,504 20,648 17,172 14,742 12,168 10,396 8,888 7,581 6,440 $25,687
$130,000 /
$26,000
5.0
Comparing Methods
Basis of measurement Measure expressed as Payback period Cash flows Number of years Easy to Understand Accounting rate of return Accrual income Percent Easy to Understand Net present Internal rate value of return Cash flows Cash flows Profitability Profitability Dollar Percent Amount Considers time Considers time value of money value of money
Strengths
Limitations
Allows Allows Accommodates Allows comparison comparison different risk comparisons across projects across projects levels over of dissimilar a project's life projects Doesn't Doesn't Difficult to Doesn't reflect consider time consider time compare varying risk value of money value of money dissimilar levels over the projects project's life Doesn't consider cash flows after payback period Doesn't give annual rates over the life of a project