Chapter 14 Notes
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Capital Budgeting
This chapter examines various tools used to evaluate potential
projects or investments.
Accountants advocate the use of the
Simple Rate of Return, which is based upon the accounting
concept of Net Income for this purpose.
This return is also
referred to as the Accounting Rate of Return.
Financiers do not
like to use Net Income as a basis for evaluating investments
because of the discretion that accountants have in determining
Net Income (
e.g.
, estimates of various allowances, useful lives,
and the choice of depreciation methods).
Financiers prefer to use
AfterTax Cash Flow as the basis for their analysis. Financiers
advocate the use of the Payback Period, Net Present Value, and
Internal Rate of Return for purposes of evaluating investments.
Simple Rate of Return and Payback period are referred to as nondiscounting models
because they do not utilize the time value of money.
Net Present Value and Internal
Rate of Return are referred to as discounting models because the time value of money
is part of their analysis.
All of these tools are used to evaluate the merits of a particular project or investment.
The way that the project or investment will be financed is not included in the evaluation
(
e.g.
, do not include interest costs).
It is assumed that the project or investment is
funded with available capital, and the source of that capital is not in issue.
Present Value
"I'll gladly pay you Tuesday for a hamburger today."
Instinctively, you
know that a dollar that Wimpy is willing to pay sometime in the future is
not as valuable as a dollar in your hand today. This inequality arises
because you can put the dollar that you currently have in the bank,
earn interest on that deposit, and have more than one dollar (the dollar
deposit plus the interest) in the future.
The Present Value tells you what you have to put in the bank today in order to have a
dollar in the future.
While you can use your calculator, Excel or a Present Value table,
you should be able to figure out the Present Value of one dollar to be receive at the end
of a given period by using the following formula:
PVIF =
__1___
(1+ d)
n
where “d” is the discount rate (the interest rate) and “n” is the number of periods until
you receive the one dollar. PVIF is the Present Value Interest Factor (PVIF) or discount
factor that is reported on a Present Value table.
If you treat “n” as the number of years
Capitol Investment?
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and “d” as the annual interest rate, then your Present Value is based on simple interest.
If you change the “n” to reflect the number of sixmonth periods, and the “d” to reflect
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 Fall '08
 JOHN
 Accounting, Depreciation, Net Present Value, aftertax cash flow

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