Q.NO.8 Discuss the Three Common Capital Budgeting Decision Techniques with Examples and Formulas.
Three Common Capital:
Capital budgeting is the process of evaluating and selecting long-term investments that are in line with the firm’s goal of maximizing owner wealth. Here are three common capital budgeting decision techniques, along with examples and formulas:
1. Net Present Value (NPV)
Definition:
NPV calculates the difference between the present value of cash inflows generated by a project and the present value of cash outflows over time. It helps determine whether a project will add value to the company.
Formula:
Where:
Example:
Suppose a project requires an initial investment of $100,000 and is expected to generate cash inflows of $30,000, $40,000, and $50,000 over the next three years. If the discount rate is 10%, the NPV would be calculated as follows:
Calculating this gives an NPV of approximately $5,420. Since the NPV is positive, the project would be considered acceptable.
2. Internal Rate of Return (IRR)
Definition:
IRR is the discount rate at which the NPV of a project becomes zero. It represents the expected annual rate of return of the project.
Formula:
The IRR is found by solving the NPV equation for rrr where NPV = 0:
Example:
Using the same project from the NPV example, the cash flows are $30,000, $40,000, and $50,000. To find the IRR, we would typically use financial software or a calculator. For this project, let’s assume the IRR is calculated to be 12%. If this is higher than the company’s required rate of return, the project would be accepted.
3. Payback Period
Definition:
The payback period measures the time it takes for a project to recover its initial investment from its cash inflows. This method does not consider the time value of money.
Formula:
If cash inflows are uniform:
For non-uniform cash inflows, add cash inflows until the initial investment is recovered.
Example:
For the same project with cash inflows of $30,000, $40,000, and $50,000, the payback period can be calculated as follows:
- Year 1: Cash inflow = $30,000 (Cumulative = $30,000)
- Year 2: Cash inflow = $40,000 (Cumulative = $70,000)
- Year 3: Cash inflow = $50,000 (Cumulative = $120,000)
The payback period would be between year 2 and year 3. Specifically, the payback occurs at:
Summary
- NPV is preferred for its consideration of cash flow timing and cost of capital.
- IRR provides a rate of return but may give conflicting signals with NPV in some cases.
- Payback Period is simple to understand and useful for liquidity assessment, though it ignores the time value of money.
These methods can provide valuable insights into the viability of capital investments.
