Alternative Approaches to Capital Budgeting Decisions

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  • 0:03 Budgeting Alternatives
  • 0:41 Payback Method
  • 1:39 Disadvantages
  • 2:25 Simple Rate of Return
  • 3:52 Cons of Simple Rate
  • 4:26 Lesson Summary
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Lesson Transcript
Instructor: Deborah Schell

Deborah teaches college Accounting and has a master's degree in Educational Technology.

Purchasing capital assets requires a significant expenditure, and it must be timed to ensure it does not adversely impact cash flows. In this lesson, you will learn about capital budgeting decisions.

Budgeting Alternatives

Mr. U. Brew owns the Aroma Coffee Company, and he's evaluating the purchase of a piece of machinery that will allow him to double his current capacity. Mr. Brew would like some help evaluating this purchase.

Capital assets are usually items that are acquired specifically to help the business make more money. Such property, like machinery and equipment, typically require a business to spend some serious cash. Companies must determine whether the money spent will pay for itself over time by generating cash flow for the company.

Let's examine two methods to assess Mr. Brew's decision: the payback method and the simple rate of return method.

Payback Method

The payback method or 'payback period' calculates how long (in years) it will take the company to recover its original investment. It also considers the amount of cash inflow that the company expects to generate as a result of the investment. The shorter the payback period, the better the investment. The formula for calculating payback method or payback period is:

Payback Method = Cost of the investment / Annual cash inflow

Let's assume that the coffee machine Mr. Brew wants to buy costs $750,000, and he anticipates that the new machine will result in annual cash inflow of $125,000. Let's calculate the payback period for this investment.

We want to divide the cost of the investment by the annual cash inflow:

$750,000 / $125,000 = 6

Therefore, it would take Mr. Brew six years to recover his investment in the coffee machine.

Disadvantages to Payback Method

While this method represents a quick way to determine how long an investor's money is at risk, it does have some shortcomings.

For example,

  • It does not consider the time value of money. We know that $1 today is not the same as $1 six years from now.
  • It also does not consider future profitability generated by the capital asset. Once Mr. Brew reaches the six year mark, we can assume that the machine will still contribute to this company's overall profitability. This is not reflected in the payback method's calculation.
  • Lastly, this method assumes that cash flows will be the same over the life of the asset. Assets are generally more efficient and productive when they are new, meaning that the contribution to cash flow would be greater in the earlier years of the asset's use.

Simple Rate of Return

The simple rate of return, also known as the 'accounting rate of return,' measures the amount of profit generated as a percentage of the original investment. The calculation considers the incremental revenue and costs of the investment. Revenue represents the amount of money generated by selling a company's products.

For Mr. Brew's company, this is the money from selling the additional coffee beans that can be processed using the new machine. The formula for calculating the simple rate of return is:

Simple Rate of Return = ((Incremental revenue - Incremental costs) / Amount of investment) x 100

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