Ww2.justanswer.com



Capital Budgeting

Capital Budgeting Techniques and its Evaluation

Abstract

The aim is to consider and evaluate different ways of appraisal of capital budgets. The ways are like NPV, ARR, IRR and Payback. By the help of an example these techniques and decision based on these techniques has been discussed.

Techniques of Capital Budgeting

For a success of company the decision and capital expenditure budget is very crucial. To make any decision on it, it is very important that is must be correctly evaluated. By the help of following four techniques we can evaluate the project.

• Accounting Rate of Return

• Payback Period Method

• Net Present Value Method

• Internal Rate of Return Method.

ARR is simply based on profit and it helps us to know that how much profit per year will be in terms of percentage of total average investment. Cash flows are not considered in Accounting Rate of Return.ARR also do not consider the time value of money and it also do not give any importance to the size of the investment due to the form of given which is in percentage, hats why ARR is not appropriate in decision making and it is not used for such purposes.

How quickly the initial investment can be recovered is calculated by the help of payback period. It is in the form of number of years. As in ARR it also does not consider the time value of money. Some time the payback is calculated by considering the time value of money, but still the decision cannot be taken because it do not consider the cash flow after the payback period.

Basis for the Net present value is the present value of future cash inflows of the project. It will be positive if it is more than the initial investment else negative. IF the NPV is positive the projected can be accepted if there is only one project, but if there are more than one and the investor can accept only one project then the highest NPV project should be accepted. And if the company is strong enough to invest in different project so than the NPV index should be made and invest according to ranks of NPV. Highest project NPV will be rank one and so on.

Internal rate of return provides you a rate at which the NPB is zero or the present value of outflows is equal to the present value of inflows. It also does not consider the size of the investment.

The final decision of project is based on NPV, but for that the cash flows of the project should be found out. If the equipment has to be changed or replaced with the previous one the respected cash flows or cost should be found out. For decision all those cost which will affect the decision are relevant. In this case the cost of equipment will be relevant; the cash inflows will be relevant. When the relevant cost or cash flows are found then the incremental cash flow to be determined this will take place due to the purchase of new equipment. Cost of capital will be used once the cash flows are available to discount them to achieve at present value of future cash inflows, the equipment should be purchased if the NPV is postive.

Decision:-

As the NPV is positive so the project will be accepted based on the NPV, but others factor such as ARR, IRR, PI, Payback and Discounted Payback period are also showing good indication as they are also good enough. ARR for the company is 13.03% while the IRR is 19.8% both are good enough to accept the project. The Initial investment will be recovered in 4 years and 5.78 years according to Payback and Discounted Payback period respectively .The profitability Index is 1.30. Although all the above factors are good but these are not helpful in the decision making due to their limitation, so the final decision is taken based on the positive NPV which is 15824 and the project should be accepted according to this NPV.

Reference:



................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download