Course Outline
Join PRO

What are some of the methods for evaluating capital expenditures?

Author:
Harold Averkamp, CPA, MBA

Definition of Evaluating Capital Expenditures

Capital expenditures involve large amounts of money spent on assets that have a useful life of more than one year.

Capital expenditures may vary in necessity and profitability:

  • Some capital expenditure projects are required and may not increase a company’s profits…think OSHA or environmental mandates
  • Some of projects will provide cost savings through faster operations or reductions in manual labor
  • Other capital expenditures allow for product enhancements, additional quality, etc. for which the company will obtain higher revenues from its customers

Since companies generally have limited amounts of money and employees to implement new projects as well as limits to the amount of disruptions to their existing operations, the potential projects are rank/prioritized through a process known as capital budgeting.

Examples of Methods for Evaluating Capital Expenditures

Of course, capital expenditures that are necessary to continue operating are identified first. These could be government mandates as well as other necessities such as a new sewer line, upgrading the electrical service, etc.

When deciding which of the non-necessary projects should be undertaken, companies likely use various techniques for ranking the projects from a financial point of view. The following are four common techniques:

  • Payback calculates the number of years it will take to recoup the cash spent on a project. There are two weaknesses with the payback method: 1) the time value of money is not considered, and 2) the cash flows occurring after the cash is paid back is ignored.
  • Accounting rate of return or return on investment divides the increase in accounting profit by the amount of the increased investment. This technique also ignores the time value of money.
  • Internal rate of return considers both the time value of money and cash flows occurring throughout the entire life of the project. The internal rate of return technique computes the interest rate that will discount the future cash flows so that the present value of those cash flows is equal to the cash outlay for the project.
  • Net present value discounts the project’s future cash flows by a predetermined rate, such as the rate needed or the targeted rate. If the present value of the cash flows (resulting from the discounting by the targeted rate) exceeds the amount of the cash investment, the project is accepted since it provides the required return (or more).
Join PRO to Track Progress
Must-Watch Video

Advance Your Accounting and Bookkeeping Career

  • Perform better at your job
  • Get hired for a new position
  • Understand your small business
  • Pass your accounting class
Watch the Video

Join PRO or PRO Plus and Get Lifetime Access to Our Premium Materials

Read all 2,645 reviews

Features

PRO

PRO Plus

Features
Lifetime Access (One-Time Fee)
Explanations
Quizzes
Q&A
Word Scrambles
Crosswords
Bookkeeping Video Training
Financial Statements Video Training
Flashcards
Visual Tutorials
Quick Tests
Quick Tests with Coaching
Cheat Sheets
Business Forms
All PDF Files
Progress Tracking
Earn Badges and Points
Certificate - Debits and Credits
Certificate - Adjusting Entries
Certificate - Financial Statements
Certificate - Balance Sheet
Certificate - Income Statement
Certificate - Cash Flow Statement
Certificate - Working Capital
Certificate - Financial Ratios
Certificate - Bank Reconciliation
Certificate - Payroll Accounting

About the Author

Harold Averkamp

For the past 52 years, Harold Averkamp (CPA, MBA) has
worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. He is the sole author of all the materials on AccountingCoach.com.

Learn More About Harold

Certificates of
Achievement

Certificates of Achievement

We now offer 10 Certificates of Achievement for Introductory Accounting and Bookkeeping:

  • Debits and Credits
  • Adjusting Entries
  • Financial Statements
  • Balance Sheet
  • Income Statement
  • Cash Flow Statement
  • Working Capital and Liquidity
  • Financial Ratios
  • Bank Reconciliation
  • Payroll Accounting
Badges and Points
  • Work towards and earn 30 badges
  • Earn points as you work towards completing our course
View PRO Plus Features
Course Outline
Take the Tour Join Pro Upgrade to Pro Plus