{"id":253,"date":"2021-01-26T22:30:46","date_gmt":"2021-01-26T22:30:46","guid":{"rendered":"https:\/\/courses.lumenlearning.com\/wm-managerialaccounting\/?post_type=chapter&p=253"},"modified":"2021-05-17T23:14:22","modified_gmt":"2021-05-17T23:14:22","slug":"introduction-to-basic-capital-budgeting-tools","status":"publish","type":"chapter","link":"https:\/\/courses.lumenlearning.com\/suny-clinton-managerialaccounting\/chapter\/introduction-to-basic-capital-budgeting-tools\/","title":{"raw":"Introduction to Basic Capital Budgeting Tools","rendered":"Introduction to Basic Capital Budgeting Tools"},"content":{"raw":"

What you will learn to do: Use basic capital budgeting tools to analyze investment options<\/h2>\r\nAll investments in capital assets are expected to earn a return, which is evaluated by comparing the project's forecasted cash outflows to cash inflows. A number of different methods are used to gauge the capital project's earnings potential including the payback period, net present value, profitability index, internal rate of return, and accounting rate of return. These methods determine a cash flow stream that consists of all cash outlays for and inflows from the proposed capital investment. Cash inflows<\/strong> include operating profits and cash shielded by tax savings and depreciation. Cash outflows<\/strong> include the principal and interest and possible tax repayments associated with the project.\r\n\r\nThe simplest tools used by businesses to analyze capital investment options are the payback method and the accounting rate of return.\r\n\r\n\"AImagine you are a member of a local cover band. You have gained a reputation for being on time, professional, and playing good music. You normally play very small venues, like wineries and small gatherings. You and your band-mates have been turning down bigger gigs because you don\u2019t have a large enough sound system to play weddings and parties. As a group, you have identified a PA setup that will allow you to accept larger engagements that pay on average $1,000 more than what you are getting now (you currently split your $400 fee four ways). The sound system costs $5,000 and you can finance it through the online vendor with 0% interest for 6 months. You figure that you can easily book five gigs between now and the end of the six-month period, and five gigs pay for the system.\r\n\r\nYou have just done a simple payback analysis. The sound system pays for itself within 6 months (5 new gigs at $1,000 additional revenue each). After that, the additional $1,000 in cash flow can be split between the band members. Of course, the band could decide to pay it off either sooner or later, but the point is that it pays for itself within six months.\r\n\r\nA manufacturing firm faces a much more complicated scenario, but the basic idea is the same. In addition, in this section, we\u2019ll discuss some of the drawbacks of the payback method and a few ways to address those drawbacks.\r\n\r\nWhen you are done with this section, you will be able to:\r\n