Capital budgeting is the process of evaluating and appraising long term investments and finding out if they are worthwhile. There are different capital budgeting techniques which are used to determine potential investments and expenses in the long run. Examples of long run investment plans include; purchase or replacement of fixed assets, introduction of a new product and market expansion. Investment appraisal provides the best way in which the limited organization funds can be invested to generate maximum benefits or profits.
Understanding capital budgeting is key to effective financial planning in an organization. Students undertaking financial management are normally presented with different investment alternatives then are required to rank them. Knowledge of capital finance is key to understanding the fundamentals of corporate finance. We are dedicated at ensuring that you find quality and easy to follow capital budgeting assignment help. Our team of qualified experts have deep experience when it comes to use and application of different capital budgeting techniques.
The process of capital budgeting involves the following
This is the presentation of ideas about the new project. The idea may vary from introduction of new product, market expansion or purchase or replacement of a fixed asset; but basically revolves around proposal for a new project.
Project evaluation is the analysis of the costs and benefits while considering the different risks and uncertainties that might arise in the future. You should select a project that s in line with your aims and goals.
It is important to note that we do not have a standard procedure that we can use to approve a project; it varies from one organization to another. Depending on the administrative structure of the organization the project is then passed through the necessary capital expenditure approval stages prior to financing and implementation.
After project approval, it is the duty of the financial manager to seek for the appropriate source of funds. At this stage, you should use the available channels to raise finance. You should also be conscious about the costs that will be involve to get the financing.
Capital budgeting techniques
According to EDUPRISTINE, Capital budgeting techniques can be broadly classified into two; discounting and non- discounting capital budgeting techniques.
Discounting capital budgeting techniques
It is important to note that discounting budgeting techniques is also known as time adjusted or modern method of capital budgeting technique; since it considers the time value in capital budgeting calculations. The following are the commonly used discounting capital budgeting techniques.
Net present value (NPV)
Net present value discounts the cash inflows at different time intervals using a particular rate and then deducting the initial cash outflow or investment. Decision rule while using NPV is to accept all projects with positive NPV value. Mathematically, the formula for calculating NPV is:
Internal rate of return (IRR)
The internal rate of return of a project is that rate of return that results to a zero NPV. In other words, IRR makes the present value of cash inflows to be equal to cash outflows. Decision rule when using IRR is to accept a project where the IRR is greater than the cost of capital.
Where r = internal rate of return
Profitability index (PI)
Profitability index is the ratio of the present value of profits at a required rate of return to initial cost of investment. The decision rule when using profitability index is to accept projects with a profitability index greater than one. The formula for calculating PI is:
Non discounting capital budgeting techniques
Non discounting capital budgeting techniques are also known as traditional capital budgeting techniques; since they don’t factor in the time value for money. It comprises of the following two techniques
Accounting rate of return
We will express the rate of return as a fraction of percentage of the projects earnings. The decision rule under accounting rate of return is to select the project with the highest accounting rate of return. Mathematically expressed as shown below
ARR = Average annual income
Where Average annual income = Average cash flows – Average Depreciation
Average investment = 1/2 (Cost of investment – Salvage value)
(assuming straight line depreciation method).
This is the period of time that the project will take to generate cash equivalent to your investment value . The decision rule is to select a project with a shorter payback period. Below is the formula you can use to calculate payback period.
Payback period = Cash outlay (investment) / Annual cash inflow
Capital budgeting assignment help
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