Group 4 Topic: Chapter 14 “Capital Budgeting Decisions” Summary

Angelica Yap
Anne Santos
Beverly Bernalte
John Dominic Aldaba
Kyra Joyce Inarsolin
Kiara Cosca
Regina Mangampo

Everyone needs a good decision making skills in order to make fewer mistakes and obtain some
future returns. Each decision presents its own challenges, and we all have different ways of approaching
problems. Using Time Value of Money for Financial Decision-Making is important because it suggests
that there is a greater benefit of receiving money now rather than later. It is because money can earn
interest, any amount of money is worth more the sooner it is received. Normally, Accountants and
finance professionals utilize time value of money principles when making important investment and
budgeting decisions. In this topic, effective capital budgeting and different common approaches to
project selection is taught and analyzed.

Capital budgeting is the process of choosing between alternative investments/projects. There

are two kinds of capital budgeting decisions: screening and preference. A screening decision is made to
see if a proposed investment is worth the time and money. It determines whether a proposed
investment meets certain preset requirements. After that, preference capital budgeting decision will be
made. The alternatives being considered have already passed the test and have been shown to be
advantageous. The company then chooses between several alternatives that best meets the company
goals.

The project/investment evaluation methods we will consider are: Net Present Value Method
(NPV), Internal Rate of Return Method (IRR), Profitability Index (PI), Payback Method, and Simple Rate of
Return Method. But before we study theses methods, we should understand first the present value
concepts and the use of present value tables.

Present value describes how much a future sum of money is worth today. The formula for
present value is: PV = cash flow in future period / ( 1+ required rate of return )n , where n= number of
periods. An investment with series of identical cash flows at the end of each year is called an annuity.

Net Present Value of a project is the present value of net cash flows resulting from it,
discounted at the firm’s cost of capital, minus the project’s net investment. The formula of this method
is: NPV= present value of cash inflows – present value of cash outflows. If NPV is greater than or equal to
0, project is acceptable. If NPV is less than zero, project is not acceptable since it will earn less than the
required rate of return. An important advance of the NPV method is that it considers the time value of
money and that it uses discounted cash flows in evaluating a project. Although it does not provide the
project's actual rate of return, it does provide information on whether the project is greater, less, or
equal to the desired rate of return. A disadvantage of the NPV method is that it ignores the size of the
investment. It favors large projects over smaller ones.
 The Internal Rate of Return is the discount rate that causes the present value of the net cash
inflows to equal the present value of the net cash outflows. The higher the rate of return, the more
desirable the project. For a project with even cash inflows, IRR is computed by finding the discount rate
that will cause the net present value of a project to be zero. If the IRR is more than, or equal to, the
required rate, the project is accepted. Otherwise, the project is rejected. For a project with even cash
inflows, IRR is calculated as follows: PV factor for the internal rate of return = Investment required
divided by Net annual cash flows. Then locate the return in the PV annuity table at the intersection of
the factor and the life of the project.

The Profitability Index (PI) is a ratio comparing the net present value of a project's net cash
flows to the project's net investments. It is computed as follows: PI = Present value of cash inflows over
Investment required. To be acceptable, a project must have a Profitability Index of 1.0 or higher. This is
equivalent to an NPV equal to or greater than zero. Its advantage is it considers the time value of money
and the size of the investment; however, it does not indicate the project's expected rate of return.

The Payback Method measures the time required for a project's cash inflows to equal the initial
investment. The shorter the payback period the more attractive the project. The payback period for a
project having unequal cash inflows is determined by accumulating cash inflows until the original
investment is recovered. Payback period is calculated as follows: Investment over Net annual cash
inflow. One advantage of the payback method is its emphasis on cash and the recovery of cash.
However, this method has several disadvantages including it ignores the cash inflows occurring after the
payback period is reached; it ignores the time value of money, and it ignores the company's desired
rate of return.

Simple rate of return method is also known as the accounting rate of return. Unlike the other
capital budgeting methods, ARR method does not focus on cash flows. Rather, it focuses on accounting
net operating income. To get ARR, simply divide the Annual incremental net operating income by the
initial investment. This method satisfies the interest of the owners since they are much interested in
return on investment. However, it ignores time factor. The primary weakness of the average return
method of selecting alternative uses of funds is that the time value of money is ignored.

TOTAL COST & ICREMENTAL COST

REAL OPTIONS
Income Taxes in Capital Budgeting Decisions
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Understand present value concepts and the use of present value tables

Include income taxes in a capital budgeting analysis

In conclusion, Capital investment decisions are a constant challenge to all levels of financial managers.
That’s why Capital budgeting is important in every business because its theory and practice shows you
how to confront them using different methods/techniques.
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https://www.accountingdetails.com/screening_decisions_and_preference_decisions.htm

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https://investinganswers.com/financial-dictionary/stock-valuation/present-value-926

https://nscpolteksby.ac.id/ebook/files/Ebook/Accounting/Cost%20Accounting/Chapter%2014%20-
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