Abstract

Evaluation of the profitability of any investment rests on many factors the bulk of which can be reduced to mathematical formulae. This article tells how to do it, recognizing the effects of income taxes and the cost of capital. The literature of capital budgeting has presented a fair number of different formulae, which range from the simplest financial tabulations to fairly complicated patterns. There have been attempts to compare the results obtained from the use of various formulae. Some writers give the impression that specific formulae are applicable to given circumstances; some others attribute various biases or inadequacies to the different approaches; still others try to relate various formulae to each other in more or less direct ways. This paper is an attempt to set up the basic pattern of relationships in a general formula of which the special methods are restricted cases or special applications. In the attempt to measure income for a year or a quarter, there must necessarily be some adjustment of cash receipts and payments to reflect economic events. The accountant must recognize that the liming of receipts and disbursements does not coincide with economic service flows.