My video lectures about capital budgeting techniques such as payback method, the net present value method, the internal rate of return method, and the simple rate of return method can be found in my cost accounting course, managerial accounting course and CPA exam lessons.
The term capital budgeting is used to describe how managers plan significant cash outlays on projects that have long-term implications such as the purchase of new equipment and the introduction of new products. This chapter describes four methods for making these types of investment decisions—the payback method, the net present value method, the internal rate of return method, and the simple rate of return method.
Cash Flows versus Net Operating Income
The first three capital budgeting methods discussed in the chapter—the payback method, the net present value method, and internal rate of return method—all focus on analyzing the cash flows associated with capital investment projects, whereas the simple rate of return method focuses on incremental net operating income. To better prepare you to apply the payback, net present value, and internal rate of return methods, we’d like to define the most common types of cash outflows and cash inflows that accompany capital investment projects.
Typical Cash Outflows Most projects have at least three types of cash outflows. First, they often require an immediate cash outflow in the form of an initial investment in equipment, other assets, and installation costs. Any salvage value realized from the sale of old equipment can be recognized as a reduction in the initial investment or as a cash inflow. Second, some projects require a company to expand its working capital. Working capital is current assets (e.g., cash, accounts receivable, and inventory) less current liabilities. When a company takes on a new project, the balances in the current asset accounts often increase. For example, opening a new Nordstrom’s department store requires additional cash in sales registers and more inventory. These additional working capital needs are treated as part of the initial investment in a project. Third, many projects require periodic outlays for repairs and maintenance and additional operating costs.
Typical Cash Inflows Most projects also have at least three types of cash inflows. First, a project will normally increase revenues or reduce costs. Either way, the amount involved should be treated as a cash inflow for capital budgeting purposes. Notice that from a cash flow standpoint, a reduction in costs is equivalent to an increase in revenues. Second, cash inflows are also frequently realized from selling equipment for its salvage value when a project ends, although the company may actually have to pay to dispose of some low-value or hazardous items. Third, any working capital that was tied up in the project can be released for use elsewhere at the end of the project and should be treated as a cash inflow at that time. Working capital is released, for example, when a company sells off its inventory or collects its accounts receivable.