Capital Budget Exercise

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School

North Carolina A&T State University *

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6020

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Management

Date

Feb 20, 2024

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docx

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Uploaded by millern9

Capital Budget Exercise Management must assess capital assets after determining the Payback Period to recover the investment amount from net cash inflows, without considering the profitability of the exercise (Braun & Tietz, p. 849). The average annual rate of return (ARR) is determined by excluding non-cash expenses from net cash inflows, such as depreciation and amortization (Braun & Tietz, p. 849). Normalization of net cash inflows in computing ARR requires computation and eliminating residual asset value at the end of life. The Time Value of Money is a critical factor in capital investment decisions, as it is useful in borrowing, lending, purchasing businesses, and financial planning for key personnel. Key factors in determining the Time Value of Money include the amount invested, the length of time from the beginning of the investment until termination, and the annual percentage earned on the investment (Braun & Tietz, p.853). Neither the "Payback Period" nor ARR incorporates the Time Value of Money. Discounted Cash Flow Methods "Net Present Value" and "Internal Rate of Return" (NPR or IRR) avoid this weakness by incorporating compound interest by assuming that companies will reinvest future cash flows as they are received (Braun & Tietz, p. 853). Most companies use discounted cash flow methods to help make capital investment decisions, assessing the comparison between expected cash flows and the price to purchase these cash flows. The following table contains information about four projects ranked in order of preference by using the net present value, project profitability index, internal rate of return, payback period, and accounting rate of return in which Orion Corporation has the opportunity to invest (Braun & Tietz, p. 902).

Project Investment Required NPV Rank by NPV Life of Project IRR Rank by IRR Profitability Index Rank by Profitability Index Payback Period ARR A $215,000 $42,475 4 5 22% 2 1.20 1 2.87-2 17%-2 B $410,000 $72,724 3 6 25% 1 1.18 2 2.97-3 16%-3 C $1,020,000 $163,812 1 3 19% 3 1.16 3 2.14-1 13%-4 D $1,515,000 $85.850 2 4 13% 4 1.06 4 3.00-4 23%-1 Net present value is the method that indicates profitability by comparing the present value of the investment's net cash inflows with the cost of the investment (already stated at its present value. This method is superior because it incorporates the time value of money. The profitability index helps to compare the NPV across alternative investments of varying sizes. The internal rate of return also indicates profitability and incorporates the time value of money. This method will show us the actual rate of return being earned on the investment by equating the present value of the net cash inflows to the investment's cost. In other words, it is the interest rate that brings the investment's NPV to zero. The payback period will show the company how quickly it recoups its initial investment. This method will be good for screening out those potential investments that are too risky because the period is too long. However, the period will not be the sole criterion for accepting capital investments since it does not give the company any insight into the investment's profitability. Additionally, it does not incorporate the time value of money. The accounting rate of return will give the company an indication of how profitable the investment will be. However, since it does not consider the time value of money, it is not the best indicator of profitability. This method is the only method that uses accrual accounting figures.

Therefore, it will help the company assess the impact of investments on the financial statements. The other methods use net cash flows.

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Reference Braun, K., & Tietz, W. (2023). Managerial Accounting (7th ed.). Pearson.

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