Techniques of Capital Budgeting

This article discusses the different techniques of capital budgeting, including Net Present Value (NPV), Payback Period, Internal Rate of Return (IRR), and Average Accounting Rate of Return (ARR). It explains how these techniques are used to evaluate the profitability and viability of projects and investments. The concept of time value of money is also explained, highlighting the importance of considering the value of money over time in decision making. Examples and calculations are provided to illustrate the application of these techniques.

Topic 1
All the 4 mentioned terms are techniques of capital budgeting which is being used for decision
making and assessing the viability of the given option.
Net present value (NPV) is basically the difference between the present value of all the inflows and
outflows over the given period of time. The same is calculated by applying the appropriate
discounting factor o the streams of the cash flows. It is the most widely used technique and is used
for determining the profitability of the given project or investment. It considers the concept of the
time value of money. For example, let us assume an investment which is going to return $10000 for
10 years and the discounting rate is 10%, then the NPV in this case would be $61446 (Alexander,
2016).
Payback period is another measure of capital budgeting which shows the time or period required to
recover the initial funds invested in the project or to reach the break even. It is represented in years
and is computed by dividing the cost of the asset or the initial investment by the sum of cash inflows
over the years. For example, if the company invest $40000 in machinery which gives the positive
cash flow of $10000 per year, then the payback period is 4 years.
Internal rate of return (IRR) is that particular rate at which the present value of all the inflows is
equal to the present value of the outflows and thus the NPV in such a scenario is zero. It is generally
used to evaluate the profitability or attractiveness of the project and if IRR is found to be greater
than or equals to the required rate of return then the project is accepted. Suppose a machinery is
purchases for $300000 is being made which gives return of $150000 per year and has a scrap value
of $10000 and the required return (in terms of interest) is 10%. The IRR in this case will be 24.3% and
hence the project would be accepted (Alieid, 2016).
Average accounting rate of return (ARR) is computed by dividing the average profit by average
capital investment. It is expressed in percentage terms. Suppose the company earns $100000 per
year and the annual expenses are $50000 and the total investment is $500000, then the accounting
rate of return will be 10%.
Topic 2
The theory of Time value of money (TVM) is value of money that is present today is worth more than
the same amount to be received in future. This is because the sooner the amount received, the more
value it holds simply because of the fact that the same can be invested to earn returns or profit in
future. It is for this reason that the concepts like discounting, compounding and annuities is used.
For example, if $100000 is received for five continuous years then it may seem to be $500000 in
value but in real terms, when the same is discounted using appropriate rate of return say 10%, then
the value becomes $416987. Similarly, compounding is used when the future streams of cash flows
is to be calculated like in the case of interest on bank deposit (Kew & Stredwick, 2017).
Years 1 2 3 4 5
Cash inflows 100000 100000 100000 100000 100000
Discounting at 10% 1.0000 0.9091 0.8264 0.7513 0.6830
Discounting cash flow 100000 90909.09 82644.63 75131.48 68301.35
Present Value today 416987

Topic 3
Memo
To: XYX, Colleague, ZZZ Company
From: ABC, ZZZ Company
Date: 5th June 2019
Subject: Weeks’s reading topic: Time Value of Money
The idea of time value of money (TVM) is very significant with respect to financial management and
decision making when it comes to capital budgeting. Time value of money represents the greater
value of money received now as compared to the same amount being received later (Choy, 2018).
There can be various reasons for the difference in value like inflation, interest, etc. and that is the
reason why concepts like discounting, compounding and annuities is being used for decision making
purposes. It is often seen that people only consider the actual outflows and inflows and fail to
consider the time value of money and this can result in wrong investment decisions and hence this
concept is critical. Some of the popular terms associated with it include present value, present value
of the annuity, future value, future value of annuity (Bennouna, Meredith, & Marchant, 2010).
For example, the future value is computed by the following formula:
FV = PV x [1 + (I/ N)] (N*T), where, F is future value, PV is present value, N is the number of periods,
T is the number of years and I is the interest rate.
Now suppose $100000 is being invested for 5 years at the interest rate of 10%, then the future value
of the same would be $161051 (Goldmann, 2016).
Thus, the understanding and application of time value of money is very important.

References
Alexander, F. (2016). The Changing Face of Accountability. The Journal of Higher Education, 71(4),
411-431.
Alieid, E. E. (2016). The Role of Accounting Information Systems in Making Investment Decisions.
Internal Auditing & Risk Management, 11(2), 233-242.
Bennouna, K., Meredith, G., & Marchant, T. (2010). Improved capital budgeting decision making:
evidence from Canada. SCHOOL OF BUSINESS AND TOURISM, 48(2), 225-247.
Choy, Y. K. (2018). Cost-benefit Analysis, Values, Wellbeing and Ethics: An Indigenous Worldview
Analysis. Ecological Economics, 3(1), 145.
doi:https://doi.org/10.1016/j.ecolecon.2017.08.005
Goldmann, K. (2016). Financial Liquidity and Profitability Management in Practice of Polish Business.
Financial Environment and Business Development, 4(3), 103-112.
Kew, J., & Stredwick, J. (2017). Business Environment: Managing in a Strategic Context (2nd ed.).
London: Chartered Institute of Personnel and Development.