## Unit 8 Study Guide: Capital Budgeting

### 8a: Apply the concept of the time value of money to management decisions.

Since capital budgeting pertains to making long-term investments, investors should value future cash flows in terms of today’s dollar amounts.

• Define capital budgeting.
• Define annual interest rate, period, and amount of cash flow.
• Why do many investors believe money is worth more today than it will be tomorrow?
• Calculate present value using the present value formula, when given the annual interest rate, the number of periods, and the amount of cash flows.

Review Capital Budgeting and Decision Making from Managerial Accounting.

### 8b: Define capital budgeting and capital projects.

• What is the main objective of capital budgeting?
• Define cash inflow and cash outflow.
• Describe the relationship among capital budgeting, cash inflows, and cash outflows.

Review Capital Budgeting and Decision Making from Managerial Accounting.

### 8c: Evaluate investments using the net present value (NPV) approach.

The net present value (NPV) of an investment equals the present value of cash inflows minus the present value of cash outflows.

The net present value method of evaluating investments follows three steps:

Step 1: Identify the amount of money and time cash flows require over the life of an investment.

Step 2: Identify an appropriate interest rate needed to evaluate an investment, or the required rate of return.

Step 3: Calculate and evaluate the net present value (NPV) of an investment.

• What does it mean to evaluate an investment?
• Describe the net present value (NPV) method for deciding whether it would be profitable to proceed with a given investment.

Review Net Present Value from Managerial Accounting.

Review the following four examples of how to calculate net present value:

Figure 8.1 Cash Flows for Copy Machine Investment by Jackson’s Quality Copies Figure 8.2 Net Present Value (NPV) Calculation for Copy Machine Investment by Jackson’s Quality Copies Figure 8.3 The Net Present Value (NPV) Rule Figure 8.4 Alternative Net Present Value (NPV) Calculation for Jackson’s Quality Copies ### 8d: Evaluate investments using the internal rate of return (IRR) approach.

When a cash flow has a net present value (NPR) of zero, investors call the rate used in the calculation the internal rate of return (IRR).

• Define the internal rate of return decision rule.
• Why do investors call the internal rate of return (IRR) a time-adjusted rate of return?

Review The Internal Rate of Return from Managerial Accounting.

### 8e: Explain the impact of cash flows, qualitative factors, and ethical issues on long-term investment decisions.

Many factors can affect capital budgeting.

• Why do companies use cash flow, rather than accrual basis of accounting, to calculate internal rate of return (IRR) and net present value (NPV)?
• Define inflation.
• How does inflation affect cash flow projections?
• Differentiate between quantitative and qualitative aspects of capital budgeting.
• List some consequences of evaluating management based on short-term results in the capital budgeting process.

Review Other Factors Affecting NPV and IRR Analysis from Managerial Accounting.

### 8f: Evaluate investments using the payback method.

The payback method calculates the number of years it will take to recover an investor’s initial investment.

• Explain how investors calculate the payback method.
• The payback method does not consider the time value of money. Why does this lack of consideration present a significant weakness for using the payback method?
• The payback method does not consider the cash flows after the initial investment is recovered. Why does this lack of consideration present a significant weakness for using the payback method?

Review The Payback Method from Managerial Accounting.

Review an example of the payback method in Figure 8.6.

Figure 8.6 Summary of Cash Flows for Copy Machine Investment by Jackson’s Quality Copies ### 8g: Explain the impact that income taxes, working capital, and investment cash outflows have on capital budgeting decisions.

Investors should consider working capital and investment cash outflows when:

• The timing of cash outflows during the investment period could be an important consideration when determining capital budgets.
• The impact of necessary working capital at the beginning of an investment could be an important consideration when determining capital budgets.

When calculating the internal rate of return (IRR) and net present value (NPV), investors should make adjustments to account for the effect income taxes have on certain items.

• Name four types of capital budgeting items that have income tax implications.
• How do investors calculate the after-tax revenue cash inflow?
• How do investors calculate the after-tax revenue cash outflows?
• How do investors calculate the depreciation tax savings cash inflow?

Review the impact of working capital and cash outflows in Additional Complexities of Estimating Cash Flows from Managerial Accounting.

Review The Effect of Income Taxes on Capital Budgeting Decisions from Managerial Accounting.

### Unit 8 Vocabulary

• Annuity
• Capital budgeting decision
• Cash flow
• Cost of capital
• Depreciation tax shield
• Discounted cash flows
• Future value
• Hurdle rate
• Internal rate of return
• Net present value
• Payback method
• Payback period
• Present value
• Working capital