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Evaluating a Budget Using the Net Present Value Method

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  • 0:00 Net Present Value and…
  • 0:37 Capital Projects
  • 1:14 Net Present Value Calculation
  • 1:37 Decision Rules
  • 2:50 Lesson Summary
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Lesson Transcript
Instructor: Jennifer Botterbusch

Jennifer has been in the accounting profession for 25 years and is a Florida licensed Certified Public Accountant.

Explore the net present value method of capital budgeting and the associated decision rules for accepting or rejecting capital projects. Evaluate a capital budget and decide which projects should be accepted.

Net Present Value and Capital Budgets

In order to maintain a competitive edge, companies invest in new technologies and business assets. These investments should either reduce future costs or increase future cash flows to the enterprise, and ultimately add value to the company. Capital budgeting is a way for a business to evaluate if acquisitions of new assets add value to the enterprise. The net present value method is considered the best method to estimate and compare investment returns for asset investments because it includes time value of money components; time and risk.

Capital Projects

Sheldon is the finance manager for a comic book store and is responsible for the development and allocation of the $250,000 capital budget. Howard, the store manager, believes increasing entertainment options for customers will lead to increased sales for the store. He submits project proposals for a new coffee bar, slot machine, and wifi system for Sheldon to evaluate for inclusion in the budget. Sheldon uses the net present value (NPV) method, which adjusts future cash flows to today's dollars using the weighted average cost of capital, to determine if the investment adds value to the enterprise.

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Net Present Value Calculation

Sheldon uses 8% as the weighted average cost of capital (WACC) in the NPV calculation. The WACC represents the cost of capital or interest rate the comic book store pays to finance the company's assets. It also represents the investment rate of return over the five year useful life the new assets must achieve to add value to the company.

Net Present Value Calculation
net present value

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