An Evaluation Of Capital Budgeting

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An evaluation of capital budgeting will give a concise view of the process management takes to determine the return on a potential investment. After analyzing this concept, the following methods used in making capital budgeting decisions will be discussed: internal rate of return, net present value, and payback period. For each of these three methods, an explanation of the strengths and weaknesses, how they are used, and decisions rules will be given.
Capital Budgeting
When management of a company is deciding on developing a new product or process, buying a new machine or a new building, or acquiring an entire company, the goal is to earn a satisfactory return on their investment. The process of analyzing long-term investments and deciding
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There are many potential calculations management can use. The three methods discussed below are: internal rate of return, net present value, and payback period.
Internal Rate of Return The internal rate of return is measured by calculating the interest rate at which the present value of future cash flows equals the required capital investment. The advantage is that the timing of cash flows in all future years is considered and, therefore, each cash flow is given equal weight by using the time value of money. In short, it shows the return on the original money invested. Since the hurdle rate can be a subjective figure and typically ends up as a rough estimate, it can be considered a positive that the internal rate of return does not use it in the calculation, which mitigates the risk of determining the wrong rate. A disadvantage of using the internal rate of return is that it does not consider the project size when comparing projects. Cash flows are simply compared to the amount of capital outlay generating those cash flows. This can be troublesome when two projects require a significantly different amount of capital outlay, but the smaller project returns a higher internal rate of return. Also, it only concerns itself with the projected cash flows generated by a capital injection and ignores the potential future costs that may affect profit. If management is considering an investment in
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