tion among alternatives and the maintenance of timeliness in the capital resource allocation process.
Capital Investment Decision Methods
There are a number of methods by which the capital budgeting concept may be applied. All of the methods, however, must provide some basis for the consideration of two significant factors. These two factors are (1) the time value of money, and (2) risk. Additionally, consideration must be given to the cost of capital, and financial leverage.
The use of simple rate of return analysis for the evaluation of alternative investment projects is unsatisfactory because the simple process does not account for either the timing of capital outlays or for the time value of money. In order to account for these two factors, one or more of a number of more sophisticated procedures may be employed in conjunction with the rate of return concept.
The time value of money is rooted in an assumption that funds in hand today are worth more than money which will be in hand at some future point in time. An additional assumption associated with the time value of money concept is that the more distant is the future time when funds will be held, the less will be the present value of those funds. Consistent with these two assumptions, in some capital budgeting methods, the amount of funds expected to be held at a future point in time is discounted at a rate of interest at which the funds could be invested today, if they were held today. It should be noted that a variety of interest rates are typically available at a given point in time, and, thus, that risk factors must also be considered in the selection of the appropriate interest rate for use in the discounting process.
The time adjusted rate of return on an investment is, thus, a variable of the appropriate discount interest rate which would cause the present value of all cash outlays for an investment to be equal to the present value of all of ...