University:
Grand Rapids Community College
Course:
Financial and Managerial Accounting: Information for Decisions - John J. Wild
Academic year:

2024
Views:

392

Pages:

2
Author:

stud_ice13

Comparing Capital Budgeting Methods (Exhibit 24.12) Exhibit 24.12 provides an overview of four capital budgeting methods, highlighting each method’s strengths and practical considerations for project evaluation. 1. Payback Period: o Description: The simplest method, which calculates how long it takes to recover the initial investment based on cash inflows. o Use: Preferred for its simplicity, especially when liquidity is a concern, but it does not account for the time value of money or cash flows beyond the payback period. 2. Accounting Rate of Return (ARR): o Description: Computes an investment’s annual income as a percentage of the average investment. o Use: Although straightforward, ARR is less commonly used in practice due to limitations in accounting for cash flow timing and the time value of money. 3. Net Present Value (NPV): o Description: Considers all cash flows, discounting them to present value and subtracting the initial investment to calculate the project’s profitability. o Strengths: Accounts for the time value of money, handles both equal and unequal cash flows, and can reflect changing risk levels. o Limitation: Because NPV is expressed in dollar terms, it can be challenging to compare projects with different initial investments directly. The Profitability Index is often used to address this limitation. 4. Internal Rate of Return (IRR): o Description: Determines the discount rate at which an investment’s NPV equals zero, expressed as a percentage. o Strengths: IRR facilitates comparisons between projects of different sizes and provides a clear return rate. o Limitation: IRR does not account for varying risk levels throughout the project. Preferred Methods in Practice Surveys indicate that IRR is the most popular method, valued for its intuitive rate of return metric. Payback Period and NPV follow in popularity due to their simplicity and comprehensiveness, respectively. Though ARR is rarely used alone, many companies apply multiple methods for a balanced evaluation. Application Example in Sustainable Energy Investment Capital budgeting methods, particularly NPV, can support investments in sustainable energy. For instance, an $11,000 investment in a solar panel system in Phoenix, expected to generate annual savings by offsetting electricity costs, yields a positive NPV of $1,898 (at a 6% discount rate), suggesting profitability and aligning with long-term sustainability goals. Gecko Robotics’ Use of Capital Investment Gecko Robotics invests in technology (robots for inspecting power plants) that not only increases profitability but also enhances employee safety and job satisfaction. This aligns with corporate social responsibility by improving workplace conditions while adding economic value.