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Unformatted text preview: Chapter 14 – Capital Budgeting Decisions • The term capital budgeting is used to describe how managers plan significant cash outlays on projects that have long-term implications, such as the purchase of new equipment and the introduction of new products. This chapter describes several tools that can be used by managers to help make these types of investment decisions. Capital Budgeting-Planning Investments • Capital budgeting analysis can be used for any decision that involves an outlay now in order to obtain some future return. Typical capital budgeting decisions include: o Cost reduction decisions. Should new equipment be purchased to reduce costs? o Expansion decisions. Should a new plant or warehouse be purchased to increase capacity and sales? o Equipment selection decisions. Which of several available machines should be purchased? o Lease or buy decisions. Should new equipment be leased or purchased? o Equipment replacement decisions. Should old equipment be replaced now or later? • There are two main types of capital budgeting decisions: o Screening decisions relate to whether a proposed project passes a preset hurdle. For example, a company may have a policy of accepting projects only if they promise a return of 20% on the investment. o Preference decisions relate to selecting among several competing courses of action. For example, a company may be considering several different machines to replace an existing machine on the assembly line. • In this chapter, we initially discuss ways of making screening decisions. Preference decisions are discussed toward the end of the chapter. • The time value of money concept recognizes that a dollar today is worth more than a dollar a year from now. Therefore, projects that promise earlier returns are preferable to those that promise later returns. • The capital budgeting techniques that best recognize the time value of money are those that involve discounted cash flows. Discounted Cash Flows – The Net Present Value Method • The net present value method compares the present value of a project’s cash inflows with the present value of its cash outflows. The difference between these two streams of cash flows is called the net present value . • The net present value is interpreted as follows: o If the net present value is positive, then the project is acceptable. Sales revenue 750,000 $ C ost of parts sold (400,000) Salaries, shipping, etc. (270,000) Annual net cash inflow s 80,000 $ o If the net present value is zero, then the project is acceptable. o If the net present value is negative, then the project is not acceptable....
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- Spring '07
- Net Present Value