When Regina McDermott opened her auto repair shop, she thought her 15 years of experience with cars was all she would need. To a degree, she was right—within six months, her shop had more work than it could handle, thanks to her widening reputation. At the same time, however, Regina has found it necessary to spend more and more time dealing with financial planning.

Three weeks ago, her accountant came by to discuss a number of finance-related matters. One of these is the need for cash budgeting. “I can work up a cash budget for you,” he explained. “However, I think you should understand what I’m doing so you will realize the importance of the cash budget and be able to visualize your cash inflows and outflows. I think you also need to make a decision regarding the new equipment you are planning to purchase. This machinery is state of the art, but, as we discussed last week, you can buy a number of different types of machinery. You are going to have to decide which is the best choice.”

Regina explained to her accountant that she was indifferent about which equipment to buy. “All of this machinery is good. Perhaps I should purchase the cheapest.” At this point, the accountant explained to her that she could use a number of ways to evaluate this type of decision. “You can base your choice on the payback method—how long it takes to recover your investment in each of these pieces of equipment. You can base it on net present value by discounting future cash flows to the present. Or you can base it on internal rate of return, under which the cash flows are discounted at a rate that makes the net present value of the project equal to zero.”

Regina listened quietly; when the accountant was finished, she said, “Let me think about the various ways of evaluating my capital investment, and I’ll get back to you. Then, perhaps you and I can work out the numbers together.” Her accountant said this sounded fine to him, and he left. Regina began to wish that she had taken more accounting courses while in college. As she explained to her husband, “When the accountant begins to talk, it’s all Greek to me.”

QUESTIONS

1. What is the purpose of a cash-flow budget? What does it reveal? Of what value would it be to Regina?

2. How does the payback method work? How does the net present value method work? How would you explain each of these methods to Regina?

3. How does the internal rate of return method work? How would you explain it to Regina?