Capital budgeting (or investment appraisal) is the planning process used to determine whether an organization's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is budget for major capital, or investment, expenditures. Many formal methods are used in capital budgeting, including the techniques such as :
Accounting rate of return Net present value Profitability index Internal rate of return Modified internal rate of return Equivalent annuity
These methods use the incremental cash flows from each potential investment, or project. Techniques based on accounting earnings and accounting rules are sometimes used - though economists consider this to be improper - such as the accounting rate of return, and "return on investment." Simplified and hybrid methods are used as well, such as payback period and discounted payback period.
higher the ARR, the more attractive the investment. Over one-half of large firms calculate ARR when appraising projects.
Basic formula:
where
Formula:
Each cash inflow/outflow is discounted back to its present value (PV). Then they are summed. Therefore NPV is the sum of all terms,
Where: t - the time of the cash flow i - the discount rate (the rate of return that could be earned on an investment in the financial markets with similar risk.); the opportunity cost of capital Rt - the net cash flow (the amount of cash, inflow minus outflow) at time t. For educational purposes, R0 is commonly placed to the left of the sum to emphasize its role as (minus) the investment.
3. Profitability index
Profitability index (PI), also known as profit investment ratio (PIR) and value investment ratio (VIR), is the ratio of payoff to investment of a proposed project. It is a useful tool for ranking projects because it allows you to quantify the amount of value created per unit of investment. The ratio is calculated as follows:
Calculation:
Given a collection of pairs (time, cash flow) involved in a project, the internal rate of return follows from the net present value as a function of the rate of return. A rate of return for which this function is zero is an internal rate of return.
Given the (period, cash flow) pairs (n, Cn) where n is a positive integer, the total number of periods N, and the net present value NPV, the internal rate of return is given by r in: