Capital Budgeting - Long-Range Planning

Summary :

This chapter defines capital budgeting and explains the effects of poor capital-budgeting decisions, and shows how to determine net cash inflows after taxes for an asset addition and an asset replacement. It covers evaluating projects using the payback period, the unadjusted rate of return, the net present value, and the profitability index.

What capital budgeting decides

Capital budgeting is the process of planning and evaluating long-range decisions that commit a company's resources for several years, such as whether to add a new asset or replace an existing one, and poor decisions in this area can be costly and difficult to reverse. The starting point for any capital-budgeting evaluation is determining the net cash inflows, after taxes, that a project is expected to generate over its life, since these cash flows, not accounting income, drive the analysis.

Payback period and unadjusted rate of return

The payback period measures how long it takes a project's net cash inflows to recover the original investment, favoring projects that return cash sooner, while the unadjusted rate of return relates a project's average annual income to the investment required, without regard to when in the project's life that income arrives. Both methods are simple to apply but, unlike the methods that follow, neither accounts for the time value of money.

Net present value, profitability index, and working capital

The net present value method and the closely related profitability index discount a project's expected future cash inflows back to their present value using a required rate of return, allowing projects of different sizes and timing to be compared on a consistent basis; the time-adjusted rate of return instead finds the discount rate at which a project's net present value equals zero. Because many projects also require an investment in working capital, evaluators must include that investment, and its eventual recovery, in the cash flows being analyzed.