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CAPITAL BUDGETING DECISIONS
Key Terms and Concepts to Know
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.
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:
depreciation expense = operating income
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
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:
Compound interest assumes that the current investment (present value)
and interest rate are known and the future value is to be calculated.
future value is calculated as follows: FV = PV (1+i)
where i is the interest
rate and n is the number of periods.
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)
where i is the interest rate and n is the number of
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
Present value table converts 1 / (1+i)
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
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[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.
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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