Lesson on Capital Budgeting



CapitalBudgeting - Capital budgeting is aprocess used by companies for evaluating and ranking potential expenditures orinvestments that are significant in amount. The large expenditures couldinclude the purchase of new equipment, rebuilding existing equipment, purchasingdelivery vehicles, constructing additions to buildings, etc. The large amountsspent for these types of projects are known as capital expenditures.

CapitalBudgeting Methods. In order to be as informed as possiblein making these hard decisions the owners can use different methods tofacilitate this process. Some may use one (1) while others use more than one.There are many methods such as:

        PaybackPeriod This is the length of time to recoverthe cost of an investment. This is an important determinant of whether toundertake the position or project as longer payback periods are typically not desiredfor investment options.Initial Cash/ AnnualCash Flow

 Accounting Rate of Return  The amount of profit or return, which an individual can expect based on the investment made. Accounting Rate of return divides the average profit by initial investment in order to get the ratio.Net Income / Average Investment

       Internal Rate of return - The discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero. Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project. As such, IRR can be used to rank several prospective projects a firm is considering. Assuming all other factors are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first. Amount Invested / Net Cash Flow

 Net Present Value - The difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or project.

Profitability Index - ProfitabilityIndex is an investment appraisal technique calculates by dividing the presentvalue of future cash flows of a project by initial investment required for theproject. If a project profitability index is greater than 1 then the project Iconsidered to be profitable. However, if the project is less than 1 then thecompany is likely to lose. Profitabiltiy Index (PI) = Present Value of FutureCash Flow / Initial Investment Required 

Please see attachment below for the following: Assured Model Lesson Plans, Powerpoint Presentation on Capital Budgeting and Annuity Table


Drury,C. (2008). Management and Cost Accounting, (7th ed.)Andover, HA: CengageLearning 





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