Capital investments involve allocating resources to long-term assets or projects with the expectation of generating future financial returns. These investments are critical for business growth and can include expenses like purchasing equipment, infrastructure, or new technology.
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Capital investments often require significant initial expenditure and are evaluated using the time value of money principles.
Net Present Value (NPV) is a common method used to assess the profitability of a capital investment by comparing the present value of cash inflows to outflows.
Internal Rate of Return (IRR) is the discount rate that makes the NPV of an investment zero, helping in evaluating the efficiency of a capital investment.
Payback period calculates how long it will take for an investment to repay its initial cost from its cash inflows.
Timing of cash flows is crucial in capital investments as earlier cash inflows are generally more valuable due to the time value of money.
Review Questions
What is Net Present Value (NPV) and why is it important in evaluating capital investments?
How does Internal Rate of Return (IRR) help in assessing capital investments?
Why is the timing of cash flows important when considering capital investments?
Related terms
Net Present Value (NPV): The difference between the present value of cash inflows and outflows over a period.
Internal Rate of Return (IRR): The discount rate at which the net present value (NPV) of all cash flows from an investment equals zero.
Payback Period: The amount of time required for an investment to generate enough cash flows to recover its initial cost.