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    Capital Budgeting Unit2

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    Syed Kinza Ali
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    Capital Budgeting Unit2

    Uploaded by

    Syed Kinza Ali
    2 views4 pages
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    © © All Rights Reserved

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    C

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    2 views4 pages

    Capital Budgeting Unit2

    Uploaded by

    Syed Kinza Ali
    C

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    of 4

    What Is Capital Budgeting?

    Capital budgeting involves choosing projects that add value to a company. The capital
    budgetingprocess can involve almost anything including acquiring land or purchasing
    fixed assets like a new truck or machinery. Companies use different metrics to track the
    performance of a potential project, and there are various methods to capital budgeting.

    Key Takeaways
    ● Capital budgeting is the process by which investors determine the value of a
    potential investment project.
    ● The three most common approaches to project selection are payback period
    (PB), internal rate of return (IRR), and net present value (NPV).
    ● The payback period determines how long it would take a company to see enough
    in cash flows to recover the original investment.

    Why Do Businesses Need Capital Budgeting?


    Capital budgeting is important because it creates accountability and measurability. Any
    business that seeks to invest its resources in a project without understanding the risks
    and returns involved would be held as irresponsible by its owners or shareholders.
    Furthermore, if a business has no way of measuring the effectiveness of its investment
    decisions, chances are the business would have little chance of surviving in the
    competitive marketplace.

    Companies are often in a position where capital is limited and decisions are mutually
    exclusive. Management usually must make decisions on where to allocate resources,
    capital, and labor hours. Capital budgeting is important in this process, as it outlines the
    expectations for a project. These expectations can be compared against other projects
    to decide which one(s) is most suitable.

    Methods Used in Capital Budgeting


    Discounted Cash Flow Analysis
    Because a capital budget will often span many periods and potentially many years,
    companies often use discounted cash flow techniques to not only assess cash flow
    timing but implications of the dollar. As time passes, currencies often become devalued.
    A central concept in economics facing inflation is that a dollar today is worth more a
    dollar tomorrow as a dollar today can be used to generate revenue or income tomorrow.
    Payback Analysis
    Instead of strictly analyzing dollars and returns, payback methods of capital budgeting
    plan around the timing of when certain benchmarksare achieved. For some companies,
    they want to track when the company breaks even (or has paid for itself). For others,
    they're more interested on the timing of when a capital endeavor earns a certain amount
    of profit.

    Throughput Analysis
    A dramatically different approach to capital budgeting is methods that involve throughput
    analysis. Throughput methods often analyze revenue and expenses across an entire
    organization, not just for specific projects. Throughput analysis through cost accounting
    can also be used for operational or non-capital budgeting.

    Nature of Investment Decisions


    ● The investment decisions of a firm are generally known as the capital budgeting,
    or capital expenditure decisions.
    ● The firm's investment decisions would generally include expansion, acquisition,
    modernisation and replacement of the long-term assets. Sale of a division or
    business (divestment) is also as an investment decision.
    ● Decisions like the change in the methods of sales distribution, or an
    advertisement campaign or a research and development programme have
    long-term implications for the firm'expectations and benefits,and therefore they
    should also be evaluated as investment decisions

    Net Present Value


    The Net Present Value (NPV) method involves discounting a stream of future cash flows
    back to present value. The cash flows can be either positive (cash received) or negative
    (cash paid). The present value of the initial investment is its full face value because the
    investment is made at the beginning of the time period. The ending cash flow includes
    any monetary sale value or remaining value of the capital asset at the end of the
    analysis period, if any. The cash inflows and outflows over the life of the investment are
    then discounted back to their present values.
    Internal Rate of Return
    Another method of analyzing capital investments is the Internal Rate of Return (IRR).
    The Internal Rate of Return is the rate of return from the capital investment. In other
    words, the Internal Rate of Return is the discount rate that makes the Net Present Value
    equal to zero. As with the Net Present Value analysis, the Internal Rate of Return can be
    compared to a Threshold Rate of Return to determine if the investment should move
    forward.

    Profitability Index
    Another measure to determine the acceptability of a capital investment is the Profitability
    Index (PI). The Profitability Index is computed by dividing the present value of cash
    inflows of the capital investment by the present value of cash outflows of the capital
    investment. If the Profitability Index is greater than one, the capital investment is
    accepted. If it is less than one, the capital investment is rejected.

    Payback Period
    A simple method of capital budgeting is the Payback Period. It represents the amount of
    time required for the cash flows generated by the investment to repay the cost of the
    original investment.
    What is Accounting Rate of Return (ARR)?
    Accounting Rate of Return (ARR) is a formula used to calculate the

    net income expected from an investment or asset compared to the

    initial cost of investment.

    Typically, ARR is used to make capital budgeting decisions. For

    example, if your business needs to decide whether to continue with

    a particular investment, whether it’s a project or an acquisition, an

    ARR calculation can help to determine whether going ahead is the

    right move.

    Formula

    ARR = average annual profit / average investment

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