Revised Summer 2010 Page 1 of 17 CHAPTER 12 CAPITAL BUDGETING DECISIONS Key Terms and Concepts to Know Capital budgeting: The process of planning significant investments in projects that have long lives and affect more than one future period, such as the purchase of new equipment. Cash Flows: Actual cash inflows received and actual cash outflows made for out-of-pocket costs such as salaries, advertising, repairs and similar costs. Net cash flows are cash inflows less cash outflows. Net cash flows are not the same as operating income: o Cash flow – depreciation expense = operating income o Operating income + depreciation expense = cash flow. Time Value of Money or Present Value: A dollar received today is worth more than a dollar received sometime in the future. Since the dollar cannot be invested until it is received, the sooner it is received, the sooner it can be invested and earning a return and the more it will be worth at any time in the future. Compound interest and present value are mirror images of each other: o Compound interest assumes that the current investment (present value) and interest rate are known and the future value is to be calculated. The future value is calculated as follows: FV = PV (1+i) n where i is the interest rate and n is the number of periods. o Present value assumes that the future value(s) and discount rate are known and the present value is to be calculated. The present value is calculated as follows: PV = FV / (1+i) n where i is the interest rate and n is the number of periods. o In other words, multiply to solve for future value because future value will be larger and divide to solve for present value because present value will be smaller. Present value table converts 1 / (1+i) n into a decimal to simplify the calculations. An annuity is a series of equal payments received or made with equal frequency. To eliminate the present value calculations for each payment in the series, the present value of an annuity table was developed. Using the distributive property
Revised Summer 2010 Page 2 of 17 [AB + AC = A(B+C)] the annuity tables sums the present value factors [B and C] for the number of periods to create an annuity factor which is multiplied by any one of the series of payments [A]. While this illustration has only two payments, the annuity table works for any number of periods and payments. The factor from the present value table will always be less than 1. The factor from the annuity table will be the same as the factor from the present value table for period 1 and will be greater than 1 for every period thereafter. Key Topics to Know Discounted Cash Flow Model Always considers the time value of money which makes this model superior to other methods of evaluating capital projects. Two separate approaches to capital investment analysis: Net Present Value
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