Techniques of Capital Budgeting

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