Business Environment and Concepts

t
ITAL BUDGETING
budgeting refers to any technique used to determine the financial wisdom of a long-
rm investment. Two capital budgeting techniques (net present value method and the
internal rate of return method) are considered theoretically superior because (1) they
take into ac-:0unt the time value of money and (2) they rely entirely on future cash
flows.
Net present value method computes the present value of the expected cash inflows
from an investment based on the buyer's desired (or required) rate of return.
Sometimes, the rate of return is the cost of the capital that will be expended. .,:*-
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a. The difference between the present value and the cost is the net present value. If
present value is above cost, investment has a positive net present value which
indicates that it is a good investment.
b. Present value is the most that would be paid for an investment. Any payment over
present value would create a negative net present value.
2. Internal rate of return method (sometimes called the time-adjusted rate of
return method is based on computing the exact rate of return that is being earned on
an investment at a certain price. _••-:•;-,; :,-,;; ... \;f. ,;-->• , ., , ..-
a. The cost is divided by the estimated cash flows (either a single amount or one
payment in an annuity) to determine the present value factor.
b. The present value factor is found on a chart which indicates the exact rate of
return being earned. If it is equal to or above the company's desired rate of return, the
investment is a good buy.
The net present value method is often considered superior to the internal rate of return
method because the internal rate of return method assumes that funds generated can
be reinvested at the internal rate of return of the project. Accordingly, in evaluating
mutually exclusive projects, the internal rate of return method may give a suboptimal
result.
>me companies use capital budgeting techniques although they are considered to be
inferior methods.
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The payback method determines the length of the time that will be required for
company to get its initial cash outlay back. A short payback period is considered to be
better than a long payback period. Some companies require all investments to have a
payback period that is within a certain time limit. However, it does not take the time
value of money into account. ---,,-,
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Cash flows can be approximated by eliminating (adding) depreciation expense from
net income.
The discounted payback method is similar to the payback method but the future
cash flows are discounted to their present values in computing the result- This is only
a slight advantage over the regular payback method as neither method considers the
overall prof- , , itability of the investment. .?''••••&'•/ ..-• ;.-; -=.. .-
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Accounting rate of return is computed by dividing the cost of the investment into
the expected annual net income. In some cases, the current year book value is used
rather than cost.
a. Net income can be approximated by subtracting depreciation from anticipated
annual cash flows.
Capital Budgeting - 37