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The process of making capital expenditure decisions in business. Capital budgeting involves choosing among various capital projects to find the one(s) that will maximize a company's return on its financial investment.
Corporate capital budget authorization process.
- 1. Project proposals are requested from departments, plants, and authorized personnel.
- 2. Proposals are screened by a capital budget committee.
- 3. Officers determine which projects are worthy of funding.
- 4. Board of directors approves capital budget.
Cash Flow Information.
Methods that help companies make effective capital budgeting decisions, most of these methods employ cash flow numbers. For purposes of capital budgeting, estimated cash inflows and outflows are the preferred inputs.
The capital budgeting decision, under any technique, depends in part on a variety of considerations:
- The availability of funds:
- Relationships among proposed projects:
- The company's basic decision-making approach:
- The risk associated with a particular project:
Cash payback technique.
- Identifies the time period required to recover the cost of the capital investment from the net annual cash flow produced by the investment. The formula for computing the cash payback period is:
- Cost of capital investment / net annual cash flow = cash payback period.
- The shorter the payback period, the more attractive the investment.
Discuss the capital budgeting evaluation process, and explain what inputs are used in capital budgeting.
Project proposals are gathered from each department and submitted to a capital budget committee, which screens the proposals and recommends worthy projects. Company officers decide which projects to fund, and the board of directors approves the capital budget. In capital budgeting, estimated cash inflows and outflows, rather than accrual-accounting numbers, are the preferred inputs.
Describe the cash payback technique.
The cash payback technique identifies the time period required to recover the cost of the investment. The formula when net annual cash flows are equal is: Cost of capital investment divided by estimated net annual cash flow equals cash payback period. The shorter the payback period, the more attractive the investment.
Explain the net present value method.
Under the net present value method, the present value of future cash inflows is compared with the capital investment to determine net present value. The NPV decision rule is: Accept the project if net present value is zero or positive. Reject the project if net present value is negative.
Identify the challenges presented by intangible benefits in capital budgeting.
Intangible benefits are difficult to quantify, and thus are often ignored in capital budgeting decisions. This can result in incorrectly rejecting some projects. One method for considering intangible benefits is to calculate the NPV, ignoring intangible benefits; if the resulting NPV is below zero, evaluate whether the benefits are worth at least the amount of the negative net present value. Alternatively, intangible benefits can be incorporated into the NPV calculation, using conservative estimates of their value.
Describe the profitability index.
The profitability index is a tool for comparing the relative merits of alternative capital investment opportunities. It is computed by dividing the present value of net cash flows by the initial investment. The higher the index, the more desirable the project.
Indicate the benefits of performing a post-audit.
A post-audit is an evaluation of a capital investment's actual performance. Post-audits create an incentive for managers to make accurate estimates. Post-audits also are useful for determining whether a project should be continued, expanded, or terminated. Finally, post-audits provide feedback that is useful for improving estimation techniques.
Explain the internal rate of return method.
The objective of the internal rate of return method is to find the interest yield of the potential investment, which is expressed as a percentage rate. The IRR decision rule is: Accept the project when the internal rate of return is equal to or greater than the required rate of return. Reject the project when the internal rate of return is less than the required rate of return.
Describe the annual rate of return method.
The annual rate of return uses accrual accounting data to indicate the profitability of a capital investment. It is obtained by dividing the expected annual net income by the amount of the average investment. The higher the rate of return, the more attractive the investment.