Capital budgeting is the analysis that a business undertakes when evaluating new projects and new opportunities for investment. Firms use capital budgeting to determine if these opportunities are worth investing in. However, when a firm uses a capital budgeting model such as net present value, it might come up with several projects, all with a positive net present value.

To compare these projects, or provide additional information about a single project, there are a number of analysis tools available other than net present value. We call these tools capital budgeting ratios. The most popular capital budgeting ratio is the internal rate of return (IRR) and payback period.

For example, the internal rate of return can be used (1) to evaluate whether a project should be accepted or not. We might do this by comparing the internal rate of return of a project to a hurdle rate that the firm's managers agree should be passed in order to accept a project. We might also (2) use IRR to compare potential projects. For example, two mutually exclusive projects might have an identical net present value, but one project might have a higher IRR than another. In this case, we might chose to accept the project with the higher IRR.

Mutually exclusive projects include projects that are considered to perform the same function. If one is chosen, the others are automatically rejected.

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# Capital Budgeting Ratios

## Categories within Capital Budgeting Ratios

### Accounting Rate of Return (ARR)

The ratio of the average return during the period an the average investment.

### Payback Period and Discounted Payback Period

The time period needed to break even on an investment.

### Profitability Index (PI)

An index used to rank the profitability of various investments.

### Internal Rate of Return (IRR)

A discount rate that is calculated such that if applied to all future cash flows, the net present value will be zero. This is used to compare investment projects.

### Modified Internal Rate of Return (MIRR)

A modification of the internal rate of return used to deal with some of the problems that are evident with the IRR.

### Equivalent Annual Annuity (EAA)

An approach that is used to compare two separate projects that have cash flows lasting for different period of time.

### Green Restaurant Financials: Comparative Analysis

Compare the financial statements of the previous and the current year to create a comparative income statement and balance sheet into a new Microsoft Excel document. Use horizontal analysis to calculate the differences in dollars and percentages and explain the possible reasons for the differences. Calculate the following ratios

### What is the activity rate for the activity cost pool?

Maxx Inc. has provided the following data from its activity-based costing system: Activity Cost Pools Total Cost Total Activity Designing products $370,600 6,550 product design hours Setting up batches $52,678 7366 batch set-ups Assembling products

### NPV and IRR Sensitivity Analysis

The chapter opener talked about Diamond Comic Distributor's attempt to reduce the cost of opening a retail comic book store. Suppose that the current cost of opening such a store is $400,000 and that $250,000 of that initial investment is the cost of stocking the shelves with new inventory. Suppose also that the annual operating

### Payback Period and Average Rate of Return

Refer to the following Web page, which has an example of another project selection method called the weighted scoring model: http://www.atwebo.com/calculators.htm#Weighted_Scoring_Model%20 Unlike the payback period and the average rate of return, this method considers non-financial criteria as well. Besides the criteria given