The Management
Subject: Various techniques of capital budgeting
Capital budgeting is the process in which the company plans whether to purchase or do investment in certain projects or long term assets such as new machinery, equipment, new products, research and development etc. There are many techniques which can be use make decision more easy and reliable.
For all of these techniques company need the incremental cash flows which will be generate from the investment or the project. Then these cash flows are discounted according to the company cost of capital rate which is also known as weighted average cost of capital (WACC).
Following are the techniques which are normally used in capital budgeting:-
1. Net Present Value
2. Internal Rate of Return
3. Payback Period
4. Profitability Index
5. Discounted Payback Period
Net Present Value (NPV):-
Net present Value is the sum of all the cash flows incoming or outgoing of the present value of the same entity. In NPV the cash flows are discounted by using the WACC as described above and then the Present value of incoming cash flows are adjusted with the present value of outing, result we get the net present value. If the net present value of any project or investment is positive then only that project is accepted otherwise it should not be accepted, as the NPV is negative. If the NPV is zero than it is assumed that it is positive. It is the best technique available in these days and is most reliable one as it gives more accurate results. If the discount rate do change then the result will also be change, as in the case c the present value of both the discount rate differ like NPV at 10% is 20979 and NPV at 11% 40252.
If cash flow changes then also it will change the NPV. Cash flows which are taken in these techniques must be net cash flows like the effect of depreciation is adjusted.
The formula to calculate the PV is as follows:-
1/1+r^n
By the help of this we can calculate the PV of all the cash...