Unit 8: Capital Budgeting
Now that we understand how businesses create budgets to manage the day-to-day operations of a business, let's focus on how they use capital budgeting to evaluate long-term investments. For example, should a company replace its machinery now or wait another three years to make this major investment, when revenue may be greater and the equipment may cost less? Business managers typically prepare their capital budget process when the create their master budget. They base their decision to choose or reject various projects on the "time value of money" and "discounted cash flows."
Completing this unit should take you approximately 5 hours.
Upon successful completion of this unit, you will be able to:
- apply the concept of the time value of money to management decisions;
- define capital budgeting and capital projects;
- evaluate investments using the net present value (NPV) approach;
- evaluate investments using the internal rate of return (IRR) approach;
- explain the impact of cash flows, qualitative factors, and ethical issues on long-term investment decisions;
- evaluate investments using the payback method; and
- explain the impact that income taxes, working capital, and investment cash outflows have on capital budgeting decisions.
8.1: Capital Budgeting and Decision Making
Jackson’s Quality Copies, a store that makes photocopies for its customers and that has several copy machines wants to evaluate the purchase of an expensive new copier, that could reduce expenses, increase productivity and increase profits. It costs $50,000. Julie Jackson the President has to make the decision if the new copier is actually a good or bad addition. Managerial accounting methods can give her several tools to evaluate this investment. You use two methods to evaluate long-term investments, both of which consider the time value of money. The first is called the net present value (NPV) method, and the second is called the internal rate of return method. Before you start to consider the two methods, let’s discuss the time value of money (present value) concept first.
8.2: Net Present Value and Time Value of Money
NPV combines the present value of all cash flows associated with an investment - both positive (for example from sales) and negative (from expenses) into one figure suitable for management decisions making. The term discounted cash flows is also used to describe the NPV method. One critical factor in determining the NPV is the discount rate: that is, what time value (forgone interest rate) does you associate with future receipts of money.
The concept “the time value of money” is vital to understanding Net Present Value. The time value of money basically is that a dollar received today is worth more than a dollar received in the future.
A hundred dollars given up today is not worth $100 upon its return in three years because there is an opportunity cost of forgoing the use of that money for those three years. If I invested $100 this year for three years at an annual rate of 4%, that $100 would be worth about $112.33 at the end of year three (given compounding). So if I was to forgo that $100 now and receive it in three years, I would want to receive at least $112.33 at term. Similarly, if someone said I will pay you $100 in three years I would not give them $100 now – it would be less!
For capital budgeting decisions, the issue is how to value future cash flows in today’s dollars. The term cash flow refers to the amount of cash received or paid at a specific point in time. The term present value describes the value of future cash flows (both in and out) in today’s dollars.This resource provides an introduction to the time value of money. It is important to understand the basics of time value of money.
8.3 The Internal Rate of Return
Using the internal rate of return (IRR) to evaluate investments is similar to using the net present value (NPV) in that both methods consider the time value of money. The IRR represents the time-adjusted rate of return for the investment being considered. The IRR decision rule states that if the IRR is greater than or equal to the company’s required rate of return (recall that this is often called the hurdle rate), the investment is accepted; otherwise, the investment is rejected. This method ensures that any capital investments the company makes are at least equal to the existing rate of return on capital or exceed it. The ‘hurdle rate’ will vary from company to company.
This resource is an excellent guide to the present value of money and its many applications.
8.4: Other Factors Affecting NPV and IRR Analysis
Julie Jackson’s life would be easier if all she had to do was find a number and use it to make a decision. “Yes! I will buy the new copier. The NPV, and IRR say yes.” Unfortunately life is seldom as easy as following a formula. Other factors affect what Julie Should do. In this section you consider some of those factors.
8.5: The Payback Method
You hear people talk about "payback period." "I live in Nevada where there are 280 days each year are bright and sunny. Yes, I am going solar! My payback period is seven years on a domestic hot water system powered by the sun.” The payback period, typically stated in years, is the time it takes to generate enough cash receipts from an investment to cover the cash outflows from the investment. The method uses a simple sum of future earnings/savings over an arbitrary time period to evaluate capital improvements. It is a quick way to look at an investment and sort potential investments, but the payback method is somewhat lacking in rigor.
8.6: Complexities of Estimating Cash Flows
When you have finished reading chapter 8.6, click the link at the top right to move on to 8.7 and read it. There are three additional items related to estimating cash flows that must be considered:
- Investment cash outflows
- Working capital
- Effect of income taxes
These two sections will discuss how these considerations impact long-term investment decisions.
Unit 8 Conclusion
This unit has provided a comprehensive review of capital budgeting and how it can be used for project selection. A capital budget is a normal and regular activity usually conducted along with Master Budget preparation. In the next unit you explore performance evaluation in decentralized organizations.