Capital budgeting techniques

Capital budgeting techniques

    Net present value (NPV)
    • The NPV method is used for evaluating the desirability of investments or projects.
    Net present value (NPV)
    Where:
    Ct = the net cash receipt at the end of year t
    Io = the initial investment outlay
    r = the discount rate/the required minimum rate of return on investment
    n = the project/investment's duration in years.
    • The discount factor r can be calculated using:
    Discount factor
    • Decision rule: If NPV is positive (+): accept the project, If NPV is negative (-): reject the project
    The internal rate of return (IRR)
    • The IRR is the discount rate at which the NPV for a project equals zero. This rate means that the present value of the cash inflows for the project would equal the present value of its outflows. The IRR is the break-even discount rate. The IRR is found by trial and error.
    Internal rate return
    Where,
    r = IRR
    IRR of an annuity
    IRR
    Where,
    Q (n,r) is the discount factor, Io is the initial outlay,
    C is the uniform annual receipt (C1 = C2 =....= Cn).
    Payback
    • Small businesses use this method because it is simple. It requires calculation of number of years required to pay back original investment
    Payback-based decisions
    • Between two mutually exclusive investment projects, choose project with shortest payback period
    • Set a predetermined standard
    • Ex. “Accept all projects with payback of less than 5 years and reject all others”

Last modified: Saturday, 23 June 2012, 7:44 AM