Question

Regarding Capital Expenditure Decisions, how does a manager go about evaluating an investment proposal? (from Ch 16 of Managerial Accounting: Creating Value in a Dynamic Business Environment (10th Edition)

Answer 1

In making Capital Expenditure Decisions, a manager evaluates an investment proposal by appraising whether the investment made in the particular proposal would yield more than the amount invested in it. The decision can be made using many models, three of which are stated as follows:

• NPV Model: Net present value (NPV) refers to the difference between the present value (P.V) of cash inflows and the present value of cash outflows over a period of time.

-If the P.V. of cash inflows is greater than P.V. of cash outflows, this'll be a situation of positive NPV.

-If the P.V. of cash inflows is equal to P.V. of cash outflows, this'll be a situation of zero NPV.

-If the P.V. of cash inflows is lesser than P.V. of cash outflows, this'll be a situation of negative NPV.

- Thus a proposal must be accepted if the NPV is Positive.

• IRR Model:The Internal Rate of Return (IRR) is a measure used while making capital budgeting decisions in order to calculate the profitability of a given proposal. IRR basically is a discount rate that equates the NPV of all cash inflow from a particular proposal equal to zero. Thus, it can be said that at IRR, P.V. of cash inflows is equal to P.V. of cash outflows. If the IRR from a proposal is greater than its cost of capital, then the same shall be accepted.
• Profitability Index: Profitability index (PI) is a ratio of P.V. of cash inflows to P.V. of cash outflows.

-If the P.V. of cash inflows is greater than P.V. of cash outflows, PI will be greater than 1. This'll be a situation of positive NPV.

-If the P.V. of cash inflows is equal to P.V. of cash outflows, PI will be equal 1. This'll be a situation of zero NPV.

-If the P.V. of cash inflows is lesser than P.V. of cash outflows, PI will be lesser than 1. This'll be a situation of negative NPV.

- Thus a proposal must be accepted if the PI is >1