Which One of the Following Choices Is a Capital Budgeting Decision

A capital budgeting decision is a big deal for any business, as it involves investing in long-term assets that can have a significant impact on the company's future.

This type of decision typically involves large sums of money, such as purchasing a new factory or investing in a major research project.

Capital budgeting decisions are often made with the goal of increasing profits or improving efficiency over time.

These decisions are usually made after careful consideration and analysis of various factors, including cost, risk, and potential return on investment.

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Capital budgeting techniques are used to evaluate potential investments and determine which ones to pursue. These techniques help businesses make informed decisions by analyzing the potential returns on investment.

One technique is the accounting rate of return, which uses accounting earnings and rules to evaluate investments. However, economists consider this method improper.

Other techniques include the average accounting return, payback period, and net present value. These methods use incremental cash flows from each potential investment to determine their value.

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A payback period is the time it takes for an investment to break even, and it's often used for smaller investments. Estimating future cash flow is also important, especially for larger companies or bigger investments.

The NPV rule is a widely used technique that helps managers decide whether to proceed with an investment. If the NPV is greater than or equal to zero, the investment is accepted; otherwise, it's rejected.

Here are some common capital budgeting techniques:

Capital budgeting methods are used to evaluate and compare different investment projects. The equivalent annuity method is one such method that expresses the NPV as an annualized cash flow by dividing it by the present value of the annuity factor.

This method is often used when comparing projects of unequal lifespans, such as a 7-year project versus an 11-year project. The EAC method implies that the project will be replaced by an identical project.

The chain method can also be used to compare projects of unequal length, by chaining them together and comparing the cash flows. This method gives mathematically equivalent answers to the EAC method.

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The equivalent annuity method is a useful tool for assessing the costs of specific projects. It expresses the NPV as an annualized cash flow by dividing it by the present value of the annuity factor.

This method is often used when comparing investment projects of unequal lifespans, such as a 7-year project and an 11-year project. It's not fair to simply compare the NPVs of the two projects unless they can't be repeated.

The use of the EAC method assumes that the project will be replaced by an identical project. This means that the same cash flows will be repeated each time.

The chain method can be used with the NPV method under the assumption that the projects will be replaced with the same cash flows each time. This is essentially an assumption of zero inflation.

A real interest rate rather than a nominal interest rate is commonly used in the calculations, as it reflects the assumption of zero inflation.

The payback method is a simple and straightforward approach to evaluating investments, focusing on how long it will take to recover the initial investment. It's especially useful for managers who prioritize cash flow.

The payback period is the time it takes to generate enough cash receipts to cover the initial investment, typically stated in years. This calculation is relatively simple when annual cash inflows are identical, but more complex investments require a format to help calculate the payback period, such as Table 8.1 "Calculating the Payback Period for Jackson’s Quality Copies".

The payback method has two significant weaknesses: it doesn't consider the time value of money, and it only considers cash inflows until the investment cash outflows are recovered. This means managers need to use care when applying the payback method.

For example, Julie Jackson, the owner of Jackson's Quality Copies, may require a payback period of no more than five years, regardless of the net present value (NPV) or internal rate of return (IRR). The payback period for the proposed purchase of a copy machine at Jackson's Quality Copies is five years, calculated by dividing the initial $50,000 investment by the annual cash inflows of $10,000.

Here's a step-by-step guide to calculating the payback period using Table 8.1:

By following this format, you can easily calculate the payback period for more complex investments.

Capital Budgeting Principles are crucial for businesses to make informed decisions about investments. They involve estimating future cash flow and accounting for inflation.

Time plays a significant role in capital budgeting, as seen in the example of opening a new call center, which might take two years to implement and start returning its budgeted funds. This timeframe is a key consideration for executives.

The goal of capital budgeting is to determine whether a project is worthwhile by deciding how long it takes to begin returning its budgeted funds.

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The payback method has two significant weaknesses that managers should be aware of. It doesn't consider the time value of money, which means it can't accurately compare investments with different cash flow patterns.

One example that illustrates this weakness is the comparison between two investments, Investment I and Investment II. Both investments have a payback period of two years, but Investment I generates significantly more cash in year 1 than Investment II. This makes Investment I a better choice, but the payback method can't account for this difference.

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Ignoring the cash flows after the payback period is another weakness of the payback method. This means that investments with significant cash inflows after the payback period may be overlooked in favor of investments with shorter payback periods.

For instance, consider two investments with the following cash flows:

The payback period for Investment I is two years, while the payback period for Investment II is three years. However, Investment II generates significantly more cash after its payback period, making it a more profitable choice.

To avoid these weaknesses, managers should use the payback method with caution and consider using other capital budgeting methods, such as the NPV or IRR methods, to get a more accurate picture of an investment's profitability.

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Managers often face a conflict between their short-term incentives and the company's long-term goals.

A manager may be inclined to reject a project with a positive NPV if it doesn't generate significant revenues and cash inflows in the first two years, resulting in lower overall company net income.

This is because they're evaluated and compensated based on annual net income.

To mitigate this conflict, some companies offer managers part ownership in the company through stock options, creating an incentive to increase the company's value over the long run.

This aligns the manager's interests with the company's goals.

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Capital budgeting considerations are crucial for businesses looking to make long-term investments. Companies must consider various factors, including cash flows, inflation, qualitative factors, and ethical considerations.

Estimating future cash flows is essential, taking into account inflation and the time factor. For instance, opening a new call center might take $500,000 and two years to implement, with executives deciding how long is reasonable to see the project return its budgeted funds.

Cash flow projections must include adjustments for inflation to match the required rate of return, which is based on the company's weighted average cost of debt and equity.

Managers often evaluate and compensate executives based on annual financial results, typically measured using financial accounting data prepared on an accrual basis. However, capital budgeting decisions require considering cash flows, not just financial accounting data.

The NPV rule states that if the NPV is greater than or equal to zero, accept the investment; otherwise, reject the investment. This rule helps managers decide whether to proceed with a long-term investment.

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Larger companies or bigger investments use estimating to determine future cash flow, based on the investment. For example, a business might need $10,000,000 for construction of a new store, but also require $2,000,000 for expansion at the end of year 4.

Typical sources for financing projects include loans, investors, or retained earnings. Business executives need to balance the credit vs savings components in a financing decision.

The payback method evaluates how long it will take to "pay back" or recover the initial investment. However, this method ignores the time value of money and cash flows after the payback period.

Larger companies or bigger investments use estimating to determine future cash flow based on the investment. This process accounts for inflation and takes into consideration the time factor.

Estimating helps executives decide how long it's reasonable to wait for a project to start returning its budgeted funds. For example, opening a new call center might take $500,000 and two years to implement.

Executives must weigh the costs and potential returns of a project carefully, considering factors like inflation and time. This ensures that the investment is worthwhile and will eventually pay off.

As we wrap up this chapter on capital budgeting, it's essential to understand the key takeaways that will help you make informed decisions. One of the most critical aspects of capital budgeting is evaluating investments using various methods, including the payback method.

The payback method is a simple approach that calculates how long it will take to recover the initial investment. For example, in the case of Best Electronics considering opening a second store, the payback period would be a critical factor in their decision-making process.

However, it's worth noting that the payback method has its limitations. As Mike Haley, accountant, pointed out in the Jackson's Quality Copies example, the payback method doesn't measure the profitability of the investment, only when the initial investment is recovered. Unless there are cash flow problems anticipated, the payback period shouldn't be the sole deciding factor.

In the case of Environmental Engineering, Inc. (EEI), the management team used the payback method to calculate the payback period for opening a new office in Las Vegas. With a payback period of approximately 4.5 years, the investment seemed reasonable, considering the expected cash inflows and the required rate of return of 12 percent.

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Here's a summary of the payback periods for the examples we've discussed:

As you can see, the payback periods vary depending on the investment and the expected cash flows. It's essential to consider multiple factors, including the payback period, NPV, and IRR, when making capital budgeting decisions. By doing so, you'll be able to make informed decisions that benefit your business in the long run.

JCPenney Company has over 1,000 department stores in the United States, and Kohl's Corporation has over 800, catering to a "middle market." Both companies have made significant investments in opening new stores.

Opening new stores is an example of a capital budgeting decision, as management must analyze the cash flows associated with the new stores over the long term. This involves evaluating the cash outflows, such as the initial investment, and the cash inflows, like the revenue generated by the new stores.

To evaluate long-term investments, two methods are used: the net present value (NPV) method and the internal rate of return (IRR) method. The NPV method considers the time value of money by calculating the present value of all cash inflows and subtracting the present value of all cash outflows.

The future value of an investment can be calculated using the formula for compound interest. For example, if you invest $1,000 for 1 year at an interest rate of 5 percent per year, you will have $1,050 at the end of 1 year.

The present value calculations tell us the value of cash flows in today's dollars. The NPV method adds the present value of all cash inflows and subtracts the present value of all cash outflows related to a long-term investment.

Investments can have cash outflows at varying points throughout the life of the project. For instance, JCPenney Company's plan to open a new store requires a $10,000,000 investment at the beginning of the project for construction of the building, and an additional $2,000,000 cash outflow at the end of year 4 for expansion.

Projected cash flows must include an adjustment for inflation to match the required rate of return. The required rate of return is based on the company's weighted average cost of debt and equity, which already factors in inflation.

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Here's a summary of the key points: