CAPITAL BUDGETINGTECHNIQUES

BY:SHANTANU MISHRA

Capital budgeting (or investment appraisal) is the process of determining the viability to long-term investments on purchase or replacement of property plant and equipment, new product line or other projects.

Capital budgeting consists of various techniques used by managers such as:

Net Present Value

Payback Period

Internal Rate of Return

Net Present Value

Net present value (NPV) of a project is the potential change in an investor's wealth caused by that project while time value of money is being accounted for. It equals the present value of net cash inflows generated by a project less the initial investment on the project. It is one of the most reliable measures used in capital budgeting because it accounts for time value of money by using discounted cash flows in the calculation.

NPV = R × 1 − (1 + i)-n− Initial Investmenti

NPV =R1

+R2

+R3

+ ...− Initial Investment

(1 + i)1

(1 + i)2

(1 + i)3

When cash inflows are uneven:Where,i is the target rate of return per period;R1 is the net cash inflow during the first period;R2 is the net cash inflow during the second period;R3 is the net cash inflow during the third period, and so on ...

When cash inflows are even:In the above formula,R is the net cash inflow expected to be received in each period;i is the required rate of return per period;n are the number of periods during which the project is expected to operate and generate cash inflows.

Payback Period

Payback period is the time in which the initial cash outflow of an investment is expected to be recovered from the cash inflows generated by the investment. It is one of the simplest investment appraisal techniques.

Payback Period =Initial

InvestmentCash Inflow per

Period

The formula to calculate payback period of a project depends on whether the cash flow per period from the project is even or uneven. In case they are even, the formula to calculate payback period is:

Payback Period = A +

BC

When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period and then use the following formula for payback period:

In the above formula,A is the last period with a negative cumulative cash flow;B is the absolute value of cumulative cash flow at the end of the period A;C is the total cash flow during the period after A

Internal Rate of Return

Internal rate of return (IRR) is the discount rate at which the net present value of an investment becomes zero. In other words, IRR is the discount rate which equates the present value of the future cash flows of an investment with the initial investment. It is one of the several measures used for investment appraisal.

 

CF1

 + 

CF2

 + 

CF3

 + ...   - Initial Investment

( 1 + r )1

( 1 + r )2

( 1 + r )3

The calculation of IRR is a bit complex than other capital budgeting techniques. We know that at IRR, Net Present Value (NPV) is zero, thus:NPV = 0; orPV of future cash flows − Initial Investment = 0; or

=0

Where,   r is the internal rate of return;   CF1 is the period one net cash inflow;   CF2 is the period two net cash inflow,   CF3 is the period three net cash inflow, and so on ...

THANK YOU!