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Student Centre Managerial Accounting
5th Canadian Edition
Garrison/Noreen/Chesley/Carroll

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Chapter 14: Capital Budgeting Decisions

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    Chapter Summary

    Investment decisions should take into account the time value of money since a dollar today is more valuable than a dollar received in the future. The net present value and internal rate of return methods both reflect this fact. In the net present value method, future cash flows are discounted to their present value so that they can be compared on a valid basis with current cash outlays. The difference between the present value of the cash inflows and the present value of the cash outflows is called the project's net present value. If the net present value of the project is negative, the project is rejected. The discount rate in the net present value method is usually a minimum required rate of return such as the company's cost of capital.

    The internal rate of return is the rate of return that equates the present value of the cash inflows and the present value of the cash outflows, resulting in a zero net present value. If the internal rate of return is less than the company's minimum required rate of return, the project is rejected.

    After rejecting projects whose net present values are negative or whose internal rates of return are less than the minimum required rate of return, the company may still have more projects than can be supported with available funds. The remaining projects can be ranked using either the profitability index or their internal rates of return. The profitability index is computed by dividing the present value of the project's cash inflows by the required investment.

    Some companies prefer to use either payback or the simple rate of return to evaluate investment proposals. The payback period is the number of periods that are required to recover the initial investment in the project. The simple rate of return is determined by dividing a project's accounting net income by the initial investment in the project.


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