November 19, 2012
Capital budget evaluation techniques are used to determine if cash inflows are enough to repay the company for the cost of assets, cost of financing the asset, and a rate of return that would compensate the company for any errors made during the estimation of cash flows (“Capital Budgeting Techniques”, n.d.). When using evaluation techniques it is best to use more than one perspective so as not to produce biased results (Edmonds, Chapter 24, 2007).
The time value of money assumes that the present value of a dollar in the future is less than a dollar today (Edmonds, Chapter 24, 2007). To make sure that cash outflows and cash inflows are comparable the present value of the future cash flows are restated to “today’s dollars” (“Capital Budgeting Techniques”, n.d.). This in turn allows a company to determine if the investment will be beneficial considering the cost.
The present value technique uses a discount rate and the present value of future cash inflows minus the present value of cash outflows to determine the net present value of the investment. If the net present value is determined to be positive, the investment is considered to yield a rate of return higher than the anticipated percent, thus, providing the company more than enough to repay the investment (Edmonds, Chapter 24, 2007). If the net present value is determined to be negative, the investment is less than the anticipated percentage. Therefore, the investment will not yield a rate of return, and would be a bad investment for the company. If the net present value is zero, the company would break even on the investment so it would then be at their discretion to determine whether they would invest or not (“Capital Budgeting Techniques”, n.d.).
According to “Capital Budgeting Techniques” , (n.d.) “The internal rate of return method is the most commonly used method for evaluating capital budgeting proposals” (24). The...