- Net Present Value as a Capital Budgeting Method
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- Capital Budgeting – 5 Investment Appraisal Techniques
- Acquisition and management of fixed assets
The equivalent annuity method expresses the NPV as an annualized cash flow by dividing it by the present value of the annuity factor. It is often used when assessing only the costs of specific projects that have the same cash inflows. In this form it is known as the equivalent annual cost EAC method and is the cost per year of owning and operating an asset over its entire lifespan.
Net Present Value as a Capital Budgeting Method
It is often used when comparing investment projects of unequal lifespans. For example, if project A has an expected lifetime of 7 years, and project B has an expected lifetime of 11 years it would be improper to simply compare the net present values NPVs of the two projects, unless the projects could not be repeated.
Alternatively the chain method can be used with the NPV method under the assumption that the projects will be replaced with the same cash flows each time. To compare projects of unequal length, say 3 years and 4 years, the projects are chained together , i. The chain method and the EAC method give mathematically equivalent answers. The assumption of the same cash flows for each link in the chain is essentially an assumption of zero inflation , so a real interest rate rather than a nominal interest rate is commonly used in the calculations. Real options analysis has become important since the s as option pricing models have gotten more sophisticated.
The discounted cash flow methods essentially value projects as if they were risky bonds, with the promised cash flows known. But managers will have many choices of how to increase future cash inflows, or to decrease future cash outflows. In other words, managers get to manage the projects - not simply accept or reject them. Real options analysis tries to value the choices - the option value - that the managers will have in the future and adds these values to the NPV. The real value of capital budgeting is to rank projects. Most organizations have many projects that could potentially be financially rewarding.
Once it has been determined that a particular project has exceeded its hurdle, then it should be ranked against peer projects e.
The highest ranking projects should be implemented until the budgeted capital has been expended. Capital budgeting investments and projects must be funded through excess cash provided through the raising of debt capital, equity capital, or the use of retained earnings. Debt capital is borrowed cash, usually in the form of bank loans, or bonds issued to creditors. Equity capital are investments made by shareholders, who purchase shares in the company's stock. Retained earnings are excess cash surplus from the company's present and past earnings.
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Main article: Net present value. Main article: Internal rate of return. Main article: Equivalent annual cost.
Main article: Real options analysis. Economics: Principles in Action.
- CAPITAL BUDGETING TECHNIQUES / METHODS!
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Maheshwari Ideally, businesses would pursue any and all projects and opportunities that enhance shareholder value. However, because the amount of capital any business has available for new projects is limited, management uses capital budgeting techniques to determine which projects will yield the best return over an applicable period. Throughput analysis is the most complicated form of capital budgeting analysis but also the most accurate in helping managers decide which projects to pursue. Under this method, the entire company is considered as a single profit-generating system.
Throughput is measured as an amount of material passing through that system. The analysis assumes that nearly all costs are operating expenses , that a company needs to maximize the throughput of the entire system to pay for expenses, and that the way to maximize profits is to maximize the throughput passing through a bottleneck operation. A bottleneck is the resource in the system that requires the longest time in operations. This means that managers should always place a higher priority on capital budgeting projects that will increase throughput passing through the bottleneck. Discounted cash flow DCF analysis looks at the initial cash outflow needed to fund a project, the mix of cash inflows in the form of revenue, and other future outflows in the form of maintenance and other costs.
These costs, except for the initial outflow, are discounted back to the present date.
Capital Budgeting – 5 Investment Appraisal Techniques
Projects with the highest NPV should rank over others unless one or more are mutually exclusive. Payback analysis is the simplest form of capital budgeting analysis but it's also the least accurate. It's still widely used because it's quick and can give managers a "back of the envelope" understanding of the real value of a proposed project. This analysis calculates how long it will take to recoup the costs of an investment.
Acquisition and management of fixed assets
The payback period is identified by dividing the initial investment in the project by the average yearly cash inflow that the project will generate. Corporate Finance. Financial Analysis. Financial Ratios. Tools for Fundamental Analysis.