### 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 a major investment when revenue may be greater and the equipment may cost less? Business managers typically prepare their capital budget process when they 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, has several copy machines. The company wants to evaluate the purchase of an expensive new copier that could reduce expenses, increase productivity, and increase profits. It costs $50,000. The company president, Julie Jackson, has to decide if the new copier is actually a good 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 consider these two methods, we will discuss the time value of money (present value).

### 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 suitable figure for management decision-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: what time value (forgone interest rate) is associated with future receipts of money.

The time value of money is vital to understanding the net present value. The time value of money basically states 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 were 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 they would pay me $100 in three years, I would not give them $100 now – the amount they returned to me in three years would be worth 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.

### 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 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. It would be easy to agree to buy a new copier if 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, we will consider some of those factors.

### 8.5: The Payback Method

You hear people talk about the payback period, as in:

"I live in Nevada, where there are 280 bright and sunny days each year. 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

Read sections 8.6 and 8.7. 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 affect long-term investment decisions.

### Unit 8 Assessment

Take this assessment to see how well you understood this unit.

- This assessment
**does not count towards your grade**. It is just for practice! - You will see the correct answers when you submit your answers. Use this to help you study for the final exam!
- You can take this assessment as many times as you want, whenever you want.

- This assessment

### Unit 8 Conclusion

This unit has reviewed capital budgeting and how it can be used for project selection. A capital budget is a normal activity that is usually conducted as the master budget is prepared. In the next unit, we will explore performance evaluation in decentralized organizations.