Revlon Inc. 2007 by M.Jill Austin
Capital Budgeting Techniques | |
GLOSSARY
Capital Budget: (1) The amount of money set aside for the purchase of fixed assets (e.g., equipment, buildings, etc.). Also, (2) a request for authorization to purchase new fixed assets.
Mutually Exclusive Proposals: Consideration of two or more assets that perform the same function. If one is chosen for purchase, the others are automatically rejected.
Profitability Index: A ratio of the present value of the benefits (PVB) to the present value of the costs (PVC). The index is used instead of Net Present Value (i.e., PVB - PVC) when evaluating mutually exclusive proposals that have different costs.
As the picture above illustrates, the capital budgeting decision may be thought of as a cost-benefit analysis. We are asking a very simple question: "If I purchase this fixed asset, will the benefits to the company be greater than the cost of the asset?" In essence, we are placing the cash inflows and outflows on a scale (similar to the one above) to see which is greater.
A complicating factor is that the inflows and outflows may not be comparable: cash outflows (costs) are typically concentrated at the time of the purchase, while cash inflows (benefits) may be spread over many years. The time value of money principle states that dollars today are not the same as dollars in the future (because we would all prefer possessing dollars today to receiving the same amount of dollars in the future). Therefore, before we can place the costs and benefits on the scale, we must make sure that they are comparable. We do this by taking the present value of each, which restates all of the cash flows into "today 's dollars." Once all of the cash flows are on a comparable basis, they may be placed onto the scale to see if the benefits exceed the costs.
The Major Capital Budgeting Techniques
A variety of measures have evolved over time to analyze capital budgeting requests. The better methods use time value of money concepts.
GLOSSARY
Capital Budget: (1) The amount of money set aside for the purchase of fixed assets (e.g., equipment, buildings, etc.). Also, (2) a request for authorization to purchase new fixed assets.
Mutually Exclusive Proposals: Consideration of two or more assets that perform the same function. If one is chosen for purchase, the others are automatically rejected.
Profitability Index: A ratio of the present value of the benefits (PVB) to the present value of the costs (PVC). The index is used instead of Net Present Value (i.e., PVB - PVC) when evaluating mutually exclusive proposals that have different costs.
As the picture above illustrates, the capital budgeting decision may be thought of as a cost-benefit analysis. We are asking a very simple question: "If I purchase this fixed asset, will the benefits to the company be greater than the cost of the asset?" In essence, we are placing the cash inflows and outflows on a scale (similar to the one above) to see which is greater.
A complicating factor is that the inflows and outflows may not be comparable: cash outflows (costs) are typically concentrated at the time of the purchase, while cash inflows (benefits) may be spread over many years. The time value of money principle states that dollars today are not the same as dollars in the future (because we would all prefer possessing dollars today to receiving the same amount of dollars in the future). Therefore, before we can place the costs and benefits on the scale, we must make sure that they are comparable. We do this by taking the present value of each, which restates all of the cash flows into "today 's dollars." Once all of the cash flows are on a comparable basis, they may be placed onto the scale to see if the benefits exceed the costs.
The Major Capital Budgeting Techniques
A variety of measures have evolved over time to analyze capital budgeting requests. The better methods use time value of money concepts.