Chapter 13: Capital budgeting decisions

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Typical capital budgeting decisions

Types of capital budgeting

Plant expansion

Equipment selection - Lease or buy

Equipment replacement - Cost reduction

Two categories

Screening decisions: Does a proposed project meet some preset standard of acceptance?

Preference decisions: Selecting from among several competing courses of action

Methods for cash flows

Payback method

Net present value

internal rate of return

Typical cash outflows and inflows

Outflows

Repairs and maintenance

Incremental operating costs

Initial investment

Working capital

Inflows

Salvage value

Incremental revenues

Reduction of costs

Release of working capital

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Payback method

Payback period: Length of time that it takes for a project to recoup its initial cost out of the cash receipts that it generates

Payback period = Investment required / annual net cash inflow

Pros and cons of the payback method

Pros

Serves as a screening tool

Identifies investments that recoup cash investments quickly

Identified products that recoup initial investment quickly

Cons

Ignores the time value of money

Ignores cash flows after the payback period

Shorter payback period does not always mean a more desirable investment

Uneven cash flows

The un-recovered investment must be tracked year by year