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Capital budgeting involves evaluating long-term projects of an organization that entail large initial outflows of cash. Capital budgeting can be part of the master budgeting process. The projects are evaluated in hopes that they will increase net cash flow and positively impact the profitability of the entity. There are various capital budgeting techniques currently used in practice. Some of the techniques include the payback period, the accounting rate of return, the internal rate of return and net present value. The payback period and accounting rate of return do not use the time value of money where as the internal rate of return and net present value utilize present value techniques. The payback period is a quick and easy simple method for organizations to calculate when initial investment will be recouped. Net present value is a capital budgeting technique used to rank investment projects by calculating the financial value of the project. The internal rate of return is another method that uses the time value of money. This method determines the return the organization will receive on the project over its life.
Present Value – Susan Crosson
Net Present Value – Susan Crosson
Analytics for Managerial Decision Making
Chapter 10: Time Value of Money
Complete tutorials on Lump Sum, Annuities and Uneven Cash Flows
1. Complete the information requested in parts (a) and (b) of the Self-Study Review Problem on pg 467. Then answer the following questions related to capital investment proposals. (1) What is meant by the expression, time value of money? (2) Why should all capital investment proposals include time value of money (present value) calculations of future cash flows that are to be received from the alternative investments?
2. Some nonfinancial factors included in capital investment decisions are more important now than they were 20-25 years ago. Give some examples of the types of nonfinancial factors that managers would consider more important in today’s capital investment decisions than they were in the past.
3. What level of management would be involved in making capital investment decisions? Why? Why are these decisions more critical than day-to-day decisions made by individuals and companies?