Accounting Principles II – Capital Budgeting - Quick Guides | Accounting

Preview (4 of 13 Pages)

100%

Accounting Principles II – Capital Budgeting - Page 1 preview image

Loading page ...

Study GuideAccounting Principles II–Capital BudgetingCapital Budgeting TechniquesCapital budgeting is the process companies use to decide whether to invest in long-term projects,such as new equipment, buildings, or technology. These projects usually involvelarge amounts ofmoney, so companies must be very careful when making these decisions.Because companies usually havelimited capital, each potential project is carefully evaluated using:•Quantitative analysis(numbers and calculations), and•Qualitative factors(such as risk, strategy, and future growth).Most capital budgeting decisions focus oncash inflows and cash outflows, not net income fromaccrual accounting. This is because cash flows show the actual movement of money.Some companies simplify cash flow calculations by addingnet income + depreciation andamortization. Others take a more detailed approach and separately estimate:•Cash inflows from customers•Cost savings•Proceeds from selling assets•Salvage value•Cash outflows for equipment, operating costs, interest, and repairsExample: The Cottage GangTheCottage Gang is considering purchasing new equipment for its boat rental business.Key details of the project:•Equipment cost:$150,000•Useful life:7 years•Salvage value:$5,000

Accounting Principles II – Capital Budgeting - Page 2 preview image

Loading page ...

Study Guide•Annual cash inflows:$250,000•Annual cash outflows:$200,000•Annual net cash flow:$50,0001.Payback TechniqueWhat is the Payback Period?Thepayback periodmeasures how long it takes for a company torecover its initial investment incash. In simple terms, it tells us how quickly the project “pays back” the money invested.1.Payback Formula (Equal Cash Flows)2.Payback Period for the Cottage GangThe Cottage Gang invested$150,000and expects$50,000in net cash inflow each year.Calculation:•$150,000 ÷ $50,000 =3.0 yearsThis means the company will recover its investment inthree years.Why Shorter Payback Is BetterAshorter payback periodmeans the company gets its money back faster. Whether a paybackperiod is acceptable depends on company policy.For example:•Some companies require payback withintwo years

Accounting Principles II – Capital Budgeting - Page 3 preview image

Loading page ...

Study Guide•Others require the payback period to beshorter than the asset’s useful life3.Payback with Unequal Cash FlowsWhen annual cash flows arenot the same each year, the payback period is found usingcumulativenet cash flows.Example:A project costs$150,000, with the following net cash inflows:The investment is recoveredpartway through Year 4, giving a payback period of3.25 years.4.Limitations of thePayback MethodAlthough easy to use, the payback method has weaknesses:•Itignores the timingof cash flows•Itignores cash flows after payback•Itdoes not consider the time value of moneyTwo projects may have the same payback period but verydifferent cash flow patterns and projectlives.

Accounting Principles II – Capital Budgeting - Page 4 preview image

Loading page ...

Study Guide2.Net Present Value (NPV)Why NPV MattersMoney received today is worth more than money received in the future. This idea is called thetimevalue of money.TheNet Present Value (NPV)method accounts for this bydiscounting future cash flowsback totoday using the company’srequired rate of return.NPV BasicsTo calculate NPV, you need:•Cash inflows•Cash outflows•Required rate of return (discount rate)NPV for the Cottage Gang (Equal CashFlows)Assume a required rate of return of12%.•Annual net cash flow:$50,000•Useful life:7 years•Present value annuity factor at 12% for 7 years:4.5638Present value of annual cash flows:•$50,000 × 4.5638 =$228,190Present value of salvage value:•$5,000 × 0.4523 =$2,262Total present value of inflows:

Preview Mode

This document has 13 pages. Sign in to access the full document!

Report

Accounting Principles II – Capital Budgeting

Study Now!

Document Details

Related Documents

Accounting Principles II – Traditional Cost Systems

Accounting Principles II – Statement of Cash Flows

Accounting Principles II – Partnerships

Accounting Principles II – Managerial and Cost Accounting Concepts

Accounting Principles II – Long-Term Liabilities

Accounting Principles II – Investments

Accounting Principles II – Incremental Analysis

Accounting Principles II – Flexible Budgets and Standard Costs

Accounting Principles II – Financial Statement Analysis

Accounting Principles II – Current Liabilities

Company

Explore

Study Tools