For sustenance and growth, businesses require assets which will be usable for the foreseeable future. To acquire assets, businesses must often make large expenditures. Capital expenditures are purchases made on long-term assets, such as buildings, equipment, property, and intangible assets. Whenever a major purchasing decision is made, a meeting of shareholders or board of directors takes place to vote on the purchase. Capital expenditures are often located in a cash flow statement under investments. While determining taxes, note that capital expenditures cannot be deducted in the same year that the expense was incurred, or if the expenditure will last longer than a year. Capital expenditures depreciate over time and must be accounted for as such.
Capital budgeting, also known as investment appraisal, is a process by which capital expenditures are selected by a company among a pool of expenditure projects. Because many companies do not have the time or resources to take on multiple capital expenditures at once, these projects are ranked, with some given higher precedence than others. There are several methods of capital budgeting used to calculate capital expenditure choices.
The first method is known as accounting rate of return, which is a ratio calculating percentage returns gained from capital expenditures of net income. If the rate of return on investment is higher than an established standard, then the project is considered acceptable. If it is less than an established amount, the project is not accepted. The majority of companies dealing in capital expenditures utilize the accounting rate of return. However, detriments of this method include the fact that it does not adjust well to risks such as depreciation and the potential for bad debts.
The second method of capital budgeting is known as payback. This method analyzes the time it will take for a company to regain its investment money. For example, if a company makes a $100 investment which earns $25 returns each year, the payback time would be four years. While this method is simple to use and understand, it has limitations. It does not take into account time value of money, the idea that money of the same amount is worth more today than in the future, considering interest and inflation rates. Also, it does not account for a project’s profitability as a whole, only for how soon investments will be recouped. Therefore, investments which have a low initial payback but a higher overall profitability may be declined using the payback method.
The third method of capital budgeting is known as net present value, or the present value model. This method estimates benefits and costs from a project’s investments, with the amounts discounted to the present day to reflect time value of money and the rate of return as determined by the market. Net present value stands as the amount left after anticipated cash flows are reduced. If a net present value is positive, the investment will be a profit. If a net present value is negative, the investment will be a loss. So, if an investment is expected to return a certain amount of cash over a period of time, based on interest and dividends, that future currency is discounted to the present cash value by a required percentage. If the amount left over is higher than the initial investment, there is a positive net present value. If the amount left over is lower than the initial investment, there is a negative net present value. One problem with net present value is that it does not adequately track potential gains or losses for a project.
The fourth method of capital budgeting is known as internal rate of return, or discounted cash flow rate of return. This method calculates what it will take for the net present value to equal zero. By doing so, this method is used to determine the rate of return which a project might gain. Like the net present value method, this method discounts estimated cash flows to the present and considers any and all estimated cash flows. The higher the rate of return, the more cash will be yielded as a result. Note that internal rate of return is not used to compare different projects, only to decide if a single project is a viable investment.