Capital Budgeting

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It can be readily calculated using the accounting data and uses the entire stream of incomes in calculating the accounting rate. It ignores the time value of money, profits occurring in different periods are valued equally and does not allow for the fact that the profit can be reinvested.

MODERN METHODS OF CAPITAL BUDGETING:

- NET PRESENT VALUE (NPV) – It is a process of calculating the present value of cash flows (inflows and outflows) of an investment proposal, using the cost of capital as the appropriate discounting rate, and finding out the net profit value, by subtracting the present value of cash outflows from the present value of cash inflows.

It recognizes the time value of money and considers all cash flows over the entire life of the project in its calculations. It presupposes that the discount rate which is usually the firm’s cost of capital is known. But in practice, to understand cost of capital is quite a difficult concept as it may involve different amounts of investments.

Net Present Value = Present Value of Cash Inflow- Actual investment

- INTERNAL RATE OF RETURN (IRR) – It is the process that equates the present value cash inflows with the present value of cash outflows of an investment. It considers cash flows over the entire life of the project and satisfies the users in terms of the rate of return on capital. It implies that the intermediate cash inflows generated by the project are reinvested at the internal rate unlike at the firm’s cost of capital under NPV method. The latter assumption seems to be more appropriate.

- PROFITABILITY INDEX (PI) - It is the ratio of the present value of future cash benefits, at the required rate of return to the initial cash outflow of the investment. It can also be used to choose between mutually exclusive projects by calculating the incremental benefit cost ratio.

Profitability Index = present value of cash inflow

Present value of cash outflow[pic 21]

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