What you will learn to do: use basic capital budgeting tools to analyze investment options

All 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 include operating profits and cash shielded by tax savings and depreciation. Cash outflows include the principal and interest and possible tax repayments associated with the project.

The simplest tools used by businesses to analyze capital investment options are the payback method and the accounting rate of return.

Imagine 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’t 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.

You have just done a simple payback analysis. The sound system pays for itself within 6 months (five 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.

A manufacturing firm faces a much more complicated scenario, but the basic idea is the same. In addition, in this section, we’ll discuss some of the drawbacks of the payback method and a few ways to address those drawbacks.

When you are done with this section, you will be able to:

• Calculate the payback period on a steady flow of cash
• Calculate the payback period using discounted cash flows
• Calculate the accounting rate of return

Learning Activities

The learning activities for this section include the following:

• Reading: Simple Payback
• Self Check: Simple Payback
• Reading: Discounted Payback
• Self Check: Discounted Payback
• Reading: Accounting Rate of Return
• Self Check: Accounting Rate of Return