Chapter_8_Handout__1

Chapter_8_Handout__1 - CHAPTER 8 CAPITAL BUDGETING I....

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CHAPTER 8 CAPITAL BUDGETING I. Capital Budgeting Process A. Capital budgeting is the process that managers use to make capital investment decisions. These decisions involve an investment in major capital assets, such as new machinery, replacement machinery, new plants, new products, and research and development projects. B. Capital Investment Decisions 1. In general, managers make two types of capital investment decisions. a. Screening decisions require mangers to evaluate a proposed capital investment to determine whether it meets some minimum criteria. Managers must decide whether a project is acceptable or not. b. Preference decisions require managers to choose from among a set of alternative capital investment opportunities. Because companies typically have limited funds, managers must prioritize and select from the available options. 2. Capital investment decisions can also be categorized based on whether the projects are independent or mutually exclusive: a. Independent projects are unrelated to one another, so that investing in one project does not preclude or affect the chose about other alternatives. b. Mutually exclusive projects require making a choice among competing alternatives. C. Methods used to evaluate capital investment decisions. 1. This chapter describes four different methods that can be used to evaluate capital investment decisions. a. Accounting rate of return b. Payback period c. Net present value d. Internal rate of return 2. The first two methods are commonly used and provide a useful screening tool for evaluating investment alternatives. They suffer from the limitations that they did not incorporate the time value of money. 3. The last two methods are considered superior because they do incorporate the time value of money. D. Cash Flows versus Accounting Net Income 1. Net income and cash flow are not the same thing. a. Revenue is recognized when it is earned, not when it is received. b. Expenses are recorded as they are incurred rather than when cash is paid. LO 1 - Calculate the accounting rate of return and describe its major weaknesses . E. Accounting Rate of Return 1. The accounting rate of return is calculated as annual net income as a percentage of annual investment in assets. This approach is also called annual rate of return , simple rate of return , or unadjusted rate of return . The accounting rate of return is calculated as follows. Net income ÷ Initial investment = Accounting Rate of return
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2. To determine whether the project is acceptable, managers would compare the accounting rate of return to the minimum required rate of return, or hurdle rate . If the minimum required rate of return is less than the accounting rate of return, then this project is acceptable. 3.
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This note was uploaded on 06/06/2011 for the course ACC 202 taught by Professor - during the Spring '11 term at SUNY Plattsburgh.

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Chapter_8_Handout__1 - CHAPTER 8 CAPITAL BUDGETING I....

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