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Capital Budgeting Techniques | |

GLOSSARY

Capital Budget: (1) The amount of money set aside for the purchase of fixed assets (e.g., equipment, buildings, etc.). Also, (2) a request for authorization to purchase new fixed assets.

Mutually Exclusive Proposals: Consideration of two or more assets that perform the same function. If one is chosen for purchase, the others are automatically rejected.

Profitability Index: A ratio of the present value of the benefits (PVB) to the present value of the costs (PVC). The index is used instead of Net Present Value (i.e., PVB - PVC) when evaluating mutually exclusive proposals that have different costs.

As the picture above illustrates, the ...view middle of the document...

The better methods use time value of money concepts. Older methods, like the payback period, have the deficiency of not using time value techniques and will eventually fall by the wayside and are replaced in companies by the newer, superior methods of evaluation.

Very Important: A capital budgeting analysis conducts a test to see if the benefits (i.e., cash inflows) are large enough to repay the company for three things: (1) the cost of the asset, (2) the cost of financing the asset (e.g., interest, etc.), and (3) a rate of return (called a risk premium) that compensates the company for potential errors made when estimating cash flows that will occur in the distant future.

Let's take a look at the most popular techniques for analyzing a capital budgeting proposal.

1. Payback Period

Alright, let's get this out of the way up front: the Payback Period isn't a very good method. After all, it doesn't use the time value of money principle, making it the weakest of the methods that we will discuss here. However, it is still used by a large number of companies, so we'll include it in our list of popular methods.

What is the payback period? By definition, it is the length of time that it takes to recover your investment.

For example, to recover $30,000 at the rate of $10,000 per year would take 3.0 years. Companies that use this method will set some arbitrary payback period for all capital budgeting projects, such as a rule that only projects with a payback period of 2.5 years or less will be accepted. (At a payback period of 3 years in the example above, that project would be rejected.)

The payback period method is decreasing in use every year and doesn't deserve extensive coverage here.

2. Net Present Value

Using a minimum rate of return known as the hurdle rate, the net present value of an investment is the present value of the cash inflows minus the present value of the cash outflows. A more common way of expressing this is to say that the net present value (NPV) is the present value of the benefits (PVB) minus the present value of the costs (PVC)

NPV = PVB - PVC

By using the hurdle rate as the discount rate, we are conducting a test to see if the project is expected to earn our minimum desired rate of return. Here are our decision rules:

If the NPV is: | Benefits vs. Costs | Should we expect to earn at least

our minimum rate of return? | Accept the

investment? |

Positive | Benefits > Costs | Yes, more than | Accept |

Zero | Benefits = Costs | Exactly equal to | Indifferent |

Negative | Benefits < Costs | No, less than | Reject |

Remember that we said above that the purpose of the capital budgeting analysis is to see if the project's benefits are large enough to repay the company for (1) the asset's cost, (2) the cost of financing the project, and (3) a rate of return that adequately compensates the company for the risk found in the cash flow estimates.

Therefore, if the NPV is:

* positive, the benefits are...

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