Objective: Compare and contrast the four capital budgeting methods
Mindset: Demonstrate the various methods used in capital budgeting
Instructions
After management makes the decision that it has adequate capital on hand to make the necessary investment for capital assets, additional assessments must be made on an informed basis to determine the Payback Period for the investment to recover the amount of the investment from net cash inflows, without regard to the profitability of the exercise. This method is useful only to serve as a simple screen for managers to consider and compare potential investments for this purpose.
Determination of the average annual rate of return (ARR) of capital investment is based upon anticipated operating income calculated by accrual accounting, but excluding non-cash expenses from net cash inflows, such as depreciation and amortization. Normalization of net cash inflows in computing ARR requires computation and elimination of residual value of the asset at the end of life.
Computation of the “Time Value of Money” is a critical factor in decisions of management to make capital investments. In addition, this calculus is useful in making other financial decisions including borrowing, lending and purchasing businesses, as well as financial planning for key personnel. Since the use of capital can earn money however deployed, the timing of cash flows received will affect those decisions. The key factors in determining the Time Value of Money are the amount invested (Principal Amount), the length of time from the beginning of the investment until termination (Number of Periods), and the annual percentage earned on the investment (interest rate calculation). This factor can be determined either as simple interest, which assumes that the only amount earning interest is the principal. Compound interest assumes that interest is calculated on both principal and all interest earned to date.
Neither “Payback Period” nor ARR incorporates the Time Value of Money. Discounted Cash Flow Methods “Net Present Value” and “Internal Rate of Return” (NPR or IRR) avoid this weakness. They incorporate compound interest by assuming that the companies will reinvest future cash flows as they are received.
Accordingly, most companies utilize discounted cash flow methods (NPR or IRR) to help make capital investment decisions. Both methods assess the comparison between cash flows expected and the price that must be paid presently to “purchase” these cash flows.
Review Chapter 12 of your textbook.
Read Exercise E12-54B on p. 771
Write a 2-page double-spaced paper that addresses the questions in the exercise and addressing the following:
Compare and Contrast the four capital budgeting methods.
Show Future Value examples of a) Lump Sum b) annuity.
Show Present value of a) Lump Sum and b) annuity
Compare Payback Period Method and ARR.
What is a valid criticism of the Payback Period Method
Rank the four projects in order of preference by the four methods in no. 1
Explain the rankings and which method is best for evaluating all capital investment projects
It is not necessary to apply a formatting style for this assignment except when using a source to support your writing.
Braun & Tietz. (2018). Managerial Accounting (Fifth Edition). Pearson Education, Inc.
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