Capital Budget - Choose better investment option.

Capital budgeting or investment appraisal, in contrast with normal budgeting techniques, capital budgeting is something which has nothing to do with vast calculation, though, it is very important tool of financial planning and analysis. It is a planning process to determine whether the long term investment such as setup a new project, Buying / replacement machinery and new plant is worth the funding through the company’s capital.

Capital budgeting is the process of allocating resources for major capital investment or capital expenditures.

Capital budgeting is a decision making tool which helps investors for long term investment such as land, building, machinery and other equipment. The process evaluates the strategic viability of investments in terms of costs and benefits to be achieved.

There are many techniques that can be use used in capital budgeting, including,

ü  Internal rate of return, 

ü  Payback period, 

ü  Discounted payback period,

ü  Net present value,

ü  Accounting rate of return,

ü  Profitability index,

Internal rate of return

IRR is the discount rate at which net present value of the project becomes zero. It is used to compare the profitability of capital investment against other kinds of investment. It is also known as discounted cash flow rate of return or Effective interest rate.  Higher IRR should be preferred.

0= (-Investment)+CF₁/(1+IRR)¹ + CF₂/(1+IRR)² + CF_n/(1+IRR)ⁿ

IRR= Project's internal rate of return

Payback period

Payback period here refer to the period of time required to recover the fund an investor has invested. According to this method investment can be reject or accept on the basis of payback time. Minimum is better.

Payback period= Investment /Net annual cash inflow

(OR)

Years full recovery+ (non-recovered cost at beginning of last year/ cash flow in last year)

Discounted payback period

In discounted payback period Analyst has to calculate the present value of each cash inflow right from the start of the first period.

For this purpose the Analyst has to be care full while setting up discount rate.

The process to calculate discounted payback period is quite similarly to simple payback period except that it required to discount the cash flow instead of using actual cash flow.

(Number of years with a negative discounted cumulative cash flow) + ((Last negative value of discounted cumulative cash flow)/ (Absolute value of Discounted cash flow for the very next year of Last negative value of discounted cumulative cash flow))

= A + B/C

Decision Rule

Accept the project, If the discounted payback period < the target period.

Discounted Cash Inflow = Actual Cash Inflow / (1 + r)ⁿ

Where,

r is the discount rate,

n is the period to which the cash inflow relates.

Net present value

Net present value represent the cash inflow or cash outflow over the period of time. It describes the time value of money as time has an impact on the value of cash flow.

The Net present value (NPV) of an investment is determined by calculating the present value (PV) of the total benefits and costs which is achieved by discounting the future value of each cash flow. NPV>0 is better as this will add value to the company.

PV = FV / (1+r)ⁿ

NPV= (-Initial Investment) + FV₁/ (1+r)¹ + FV₂/ (1+r)²+ FV_n/ (1+r)ⁿ

Accounting rate of return

Accounting rate of return (ARR) is the amount of profit which an investor expect based on his investment. It is the simplest form of profit percentage calculation over the initial investment.

For Single period of time:-

ARR=Return/ Investment

For Multiple period of time:-

ARR= Average Return / Average Investment

Profitability index

It is an index to identify the relationship between the cost and benefits of a proposed project. Some time it is also called Benefits-cost ratio.

Decision Based on PI:-

Always remember the thumb rule i.e. Greater is better.

Profitability index > 1, Accept a project.

= Present Value of Future Cash Flows / Initial Investment Required

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Reference:-

http://en.wikipedia.org/wiki/Capital_budgeting

http://accountingexplained.com/managerial/capital-budgeting/