I. Capital budgeting is making plan for investment decisions – usually acquisition of capital assets
II. Process: Identify, evaluate, select, and re-evaluate
III. Quantitative Factors
A. Amount of the investment
B. Amount of Cash flows
C. Timing of Cash Flow
D. Cost of capital
IV. Methods
A. Non-TVM (Time Value of Money)
1. Payback period
a. Decides the length of time necessary to recover its capital investment (based on net cost savings/cash inflows)
b. Fails to consider cash inflows over the entire life of the project
2. Average rate of return (Accounting Rate of Return)
a. Focuses on the expected future net income
b. Based on net income after taxes, initial investment or average level of investment
c. Average level of investment
B. TVM methods
1. Net Present Value: PV of inflows and savings - PV of outflows
Profitability Index:
PV of inflows
PV of initial investment
2. Internal rate of return
Adjusting interest until NPV = zero, then compare the internal rate of return with the cost of capital
C. Income tax effect
Income or Savings X (1 - tax rate) = Income or Savings after Taxes