In Addition to the Net Present Value Method We Have the Following Capital Budgeting Methods

Transcript T8M6

In addition to the net present value method we have the following capital budgeting methods: . Internal rate of return method . Payback period method . Simple rate of return method

The internal rate of return is simply the yield on the project. In other words it is were the discounted inflows equal the discounted outflows or where net present value equals zero.

Calculating the internal rate of return can be done by hand but is NOT recommended. The best options for calculating the internal rate of return is either with a spreadsheet program like Excel or with a financial calculator. The way the calculator calculates the internal rate of return is it takes the discounted inflows and outflows and compares them with rates of return until it finds a match that gives an NPV of zero. This all happens in the blink of an eye with a spreadsheet program or financial calculator however by hand not so easy.

The payback period is an easy capital budgeting method and just a few years ago was a dominant capital budgeting method. However, in recent years net present value has gained more favor in providing more complete information. The payback period does not take into account future cash flows after the required payback period nor does it take into account the time value of money. This is a major drawback for this method.

Here we have an example for making payback period calculations. Cosmos International has decided to update some equipment. After reviewing all the bids submitted by vendors they have decided that Bid 172a and Bid 274b meet their basic requirements. Bid 274b is a bit more expensive but has some time saving features which might equate to some serious cost savings. The only way to know for sure is to make some estimates on cost savings and determine if the fancier machine can pay for itself as fast or faster than the bare bones machine.

Once the calculations are made it is clear that the bare bones machine can pay for itself nearly a full year before the fancier machine. Now, remember the cost savings were estimated and thus may not take into account all cost saving opportunities. Cost savings such as employee retention due to better work conditions and less employee injury from repetitive tasks may not have been considered in the analysis

The simple rate of return also known as the unadjusted rate of return or accounting rate of return focuses on incremental operating income. It does not take into consideration the time value of money. Thus it is not considered as rigorous as the internal rate of return method or net present value method.

Here we have two variations on the equation to calculate the simple rate of return. The first focus more on incremental operating income which is essentially incremental revenue minus incremental expenses, and the second focuses on cost savings. They both have an operating income perspective but with separate twists on the idea.

Here we have a simple rate of return example where Scott Inc. is considering the addition of a new processing line to increase capacity. In making the calculation, straight line depreciation is assumed when calculating depreciation. Depreciation is a non cash expense that needs to be included in the calculation. Once the information is input into the equation it is determined that the project returns 10%.

This is another simple rate of return example where Dallas John Corp has begun to review whether automating the packaging division would make sense. Once again straight line depreciation is assumed in the depreciation calculation. It is determined that automating the packaging division would return 20% to the company.