Capital Budgeting Techniques / Methods

Capital Budgeting Techniques / Methods

Capital Budgeting Techniques / Methods
Capital Budgeting Techniques / Methods
Capital Budgeting Techniques / Methods
Capital Budgeting Techniques / Methods
Capital Budgeting Techniques / Methods
Capital Budgeting Techniques / Methods
Capital Budgeting Techniques / Methods
Capital Budgeting Techniques / Methods
Capital Budgeting Techniques / Methods
Capital Budgeting Techniques / Methods
Capital Budgeting Techniques / Methods
Capital Budgeting Techniques / Methods
Capital Budgeting Techniques / Methods
Capital Budgeting Techniques / Methods
Capital Budgeting Techniques / Methods
Capital Budgeting Techniques / Methods
Capital Budgeting Techniques / Methods
Capital Budgeting Techniques / Methods
 in tons of gold

Capital Budgeting Techniques / Methods

Capital Budgeting Techniques / Methods
Capital Budgeting Techniques / Methods
Capital Budgeting Techniques / Methods
Capital Budgeting Techniques / Methods
Capital Budgeting Techniques / Methods
Payback Period
Capital Budgeting Techniques / Methods
A Quick Recap
Few Tips to Remember
Future Value (FV) and Present Value (PV)
Future value (FV) measures the nominal future sum of
money that a given sum of money is “worth” at a
specified time in the future assuming a certain interest
rate, or more generally, rate of return. The FV is
calculated by multiplying the present value by the
accumulation function.
Present value is the result of discounting future
amounts to the present.
For example, a cash amount of $10,000 received at the
end of 5 years will have a present value of $6,210 if the
future amount is discounted at 10% compounded
annually.
 Net Present Value - NPV
Net present value method (also known as discounted cash flow method)
is a popular capital budgeting technique that takes into account the time
value of money. Net Present Value (NPV) is the difference between the
present value of cash inflows and the present value of cash outflows. NPV is
used in capital budgeting to analyze the profitability of a projected investment
or project.
The following is the formula for calculating NPV:

where
Ct = net cash inflow during the period t
Co = total initial investment costs
r = discount rate, and
t = number of time periods
 Net Present Value - NPV
A positive net present value indicates that the
projected earnings generated by a project or
investment (in present dollars) exceeds the anticipated
costs (also in present dollars). Generally, an
investment with a positive NPV will be a profitable one
and one with a negative NPV will result in a net loss.
This concept is the basis for the
Net Present Value Rule, which dictates that the only
investments that should be made are those with
positive NPV values.
Apart from the formula itself, net present value can
often be calculated using tables, spreadsheets such
as Microsoft Excel.
 Internal Rate of Return (IRR)
Internal rate of return (IRR) is a metric used in capital budgeting measuring
the profitability of potential investments. Internal rate of return is a discount
rate that makes the net present value (NPV) of all cash flows from a
particular project equal to zero. IRR calculations rely on the same formula as
NPV does.
To calculate IRR using the formula, one would set NPV equal to zero and
solve for the discount rate r, which is here the IRR. Because of the nature of
the formula, however, IRR cannot be calculated analytically, and must instead
be calculated either through trial-and-error or using software programmed to
calculate IRR.
Generally speaking, the higher a project's internal rate of return, the more
desirable it is to undertake the project. IRR is uniform for investments of
varying types and, as such, IRR can be used to rank multiple prospective
projects a firm is considering on a relatively even basis. Assuming the costs of
investment are equal among the various projects, the project with the highest
IRR would probably be considered the best and undertaken first.
IRR is sometimes referred to as "economic rate of return” (ERR).
 Payback Reciprocal
• What is the payback reciprocal?
• The payback reciprocal is a crude estimate of the rate of return
for a project or investment. The payback reciprocal is
computed by dividing the digit "1" by a project's payback period
expressed in years. For example, if a project's payback period
is 4 years, the payback reciprocal is 1 divided by 4 = 0.25 =
25%.
The payback reciprocal overstates the true rate of return
because it assumes that the annual cash flows will continue
forever. It also assumes that the annual cash flows are
identical in amount. Since these two conditions are unrealistic
one should avoid the use of the payback reciprocal. Instead,
one should compute the internal rate of return or the net
present value because they will discount each of the actual
cash amounts to reflect the time value of money.
 Non-discount Method in Capital Budgeting?

A non-discount method of capital budgeting does not explicitly

consider the time value of money. In other words, each dollar
earned in the future is assumed to have the same value as each
dollar that was invested many years earlier. The payback
period is one of the non-discount methods used in capital
budgeting. The payback period is calculated by counting the
number of years it will take to recover the cash invested in a
project. The payback period simply computes how fast a
company will recover its cash investment.The payback method is
considered to be flawed because it does not consider the time
value of money and ignores the cash flows occurring after the
payback period.The payback method simply computes the
number of years it will take for an investment to return cash
equal to the amount invested.
 Non-discount Method in Capital Budgeting?
An Example of the Payback Method
For example, if an investment of $100,000 is made and it
generates cash of $50,000 for two years followed by $10,000
per year for four additional years, its payback is two years
($50,000 + $50,000). If another investment of $100,000
generates cash of $20,000 per year for two years and then
provides cash of $40,000 per year for six additional years, its
payback is approximately 3.5 years ($20,000 + $20,000 +
$40,000 + 0.5 times $40,000).
The accounting rate of return or return on investment
(ROI) are two more examples of methods used in capital
budgeting that does not involve discounting future cash
amounts.
 Discount Method in Capital Budgeting
To overcome the shortcomings of payback, accounting rate of
return, and return on investment, capital budgeting should
include techniques that consider the time value of money. Two of
these methods include (1) the net present value method, and (2)
the internal rate of return calculation. Under these techniques,
the future cash flows are discounted. This means that each dollar
in the distant future will be less valuable than each dollar in the
near future, and both of these will have less value than each
dollar invested in the present.