Capital Budget: (1) The amount of money set aside for the purchase of fixed assets (e.g., equipment, buildings, etc.). Also, (2) a request for authorization to purchase new fixed assets.
Mutually Exclusive Proposals: Consideration of two or more assets that perform the same function. If one is chosen for purchase, the others are automatically rejected.
Profitability Index: A ratio of the present value of the benefits (PVB) to the present value of the costs (PVC). The index is used instead of Net Present Value (i.e., PVB - PVC) when evaluating mutually exclusive proposals that have different costs.
As the picture above illustrates, the capital budgeting decision may be thought of as a…show more content… Here are our decision rules: If the NPV is: | Benefits vs. Costs | Should we expect to earn at least our minimum rate of return? | Accept the investment? | Positive | Benefits > Costs | Yes, more than | Accept | Zero | Benefits = Costs | Exactly equal to | Indifferent | Negative | Benefits < Costs | No, less than | Reject |
Remember that we said above that the purpose of the capital budgeting analysis is to see if the project 's benefits are large enough to repay the company for (1) the asset 's cost, (2) the cost of financing the project, and (3) a rate of return that adequately compensates the company for the risk found in the cash flow estimates.
Therefore, if the NPV is: * positive, the benefits are more than large enough to repay the company for (1) the asset 's cost, (2) the cost of financing the project, and (3) a rate of return that adequately compensates the company for the risk found in the cash flow estimates. * zero, the benefits are barely enough to cover all three but you are at breakeven - no profit and no loss, and therefore you would be indifferent about accepting the project. * negative, the benefits are not large enough to cover all three, and therefore the project should be rejected.
3. Internal Rate of Return
The Internal Rate of Return (IRR) is the rate of return that an investor can expect to earn on the investment. Technically, it