Page 94 - Encyclopedia of Business and Finance

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CAPITAL higher rate of return. If a company earns 10 percent in six
months, that is a higher rate of return than 10 percent
SEE Factors of Production
earned in one year. So an investment’s rate of return also
depends on when the company expects to get the money
back.
CAPITAL BUDGETING
Risk. For most capital investments, the amount of money
SEE Budgets and Budgeting; Finance; Government
Accounting and/or the time at which the company expects to get it
back are uncertain. What are the chances it will get exactly
what it expects? What are the chances it will get more or
less? What are the chances it will get a lot more or a lot
CAPITAL INVESTMENTS less—or even lose all the money invested and get nothing
back? The risk of the investment depends on these
Companies make capital investments to earn a return.
chances, and, in turn, how the investment’s rate of return
This is like individuals wanting to make money when they is calculated depends on this risk. So the third important
invest in stocks and bonds. The amount of money made
dimension of an investment’s rate of return is the risk con-
or lost is measured as the investment’s rate of return.
nected with the amount of money a company expects to
When making an investment, the expected rate of return get back from the investment.
is determined by the amount, timing, and riskiness of the
funds expected from the investment.
Time value of money. When a company evaluates a capi-
tal investment, the amount of money expected back from
RATE OF RETURN the investment is adjusted for its timing and risk. For
Amount. An investment’s rate of return is expressed as a example, suppose a company expects to get $100 one year
percentage. For example, if a company invests $1,000 and from today. If it had that $100 now, it could invest the
expects to get back $1,100 one year from today, it expects money—for example, earn interest from a bank—and
to earn 10 percent (= (1,100 – 1,000)/1,000). If the com- have more than $100 next year. If the money earned 5
pany expects $1,200, it expects to earn 20 percent. So a percent, the company would have $105 next year. If the
rate of return depends first on the amount of money process is reversed, the $100 the company expects to get
expected back from the investment. next year is worth less than $100 today. At 5 percent inter-
est, next year’s $100 is worth only $95.24 (=$100/1.05)
Timing. Just as getting more money produces a higher today. (This is because if the company had $95.24 now
rate of return, getting the money sooner also produces a and earned 5 percent on the money, it would have $100

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