Horti-Business Management (2+0)

Capital budgeting techniques

Net present value (NPV)

• The NPV method is used for evaluating the desirability of investments or projects.


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:


• 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.


Where,

r = IRR
IRR of an annuity



Where,

Q (n,r) is the discount factor, I_o 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”