Capital Budgeting Assignment Help
Capital budgeting is a process that makes a company or business organization to evaluate which investment they should prefer to have betterment of the organization. It relates with the worth funding investments. These investments could be purchasing of new machinery, replacing of old machinery, projects, products formation or introduction of new products, etc. and to decide whether it would be correct to spent on these investments through the fund of company. Because it will ultimately affect the company’s processing which could also include employees understanding. For instance, a company wants to spend on purchasing of new and innovative machines. The company would have to work on the knowledge of the employees. The employees might not be familiar with such machines and the company would have to spend more on teaching the technical know-how to the employees. And if the company will hire new employees (having skills to work with such machines), it will further take time to create trustworthy relationship between company’s owner and the employees including the satisfaction on both sides.
Increasing the value of a firm to shareholders is one of the major goals of capital budgeting. It focuses on the allocation of resources and having major investments. There are variety of methods and techniques that are involved in capital budgeting and some of these are:
- NET PRESENT VALUE (NPV): NET PRESENT VALUE is the measurement of profit. It is measured by subtraction of present value of cash outflows and the present value of cash inflows in a particular period of time. Present Value is the most important term of time value of money and is considered to be ‘more worth’ or valuable than the future value because the sum of future value is included with the interest rate or amount and can possess the same value as that of present value. Higher the discount rate, lower is the present value and vice versa. Following the capital budgeting process, net present value should be positive to gain profits and if it is negative it marks loss. This NPV is an important tool to calculate profit or loss of a company.
- EQUIVALENT ANNUAL COST (EAC): Equivalent Annual Cost is calculated as:
EAC = NPV/A (t, r)
Where A (t, r) = 1 - 1
where, r = annual interest rate and t = number of years.
EAC is a cost of operating and owing an asset over its entire life span. EAC is the another tool of capital budgeting when it’s about comparing of such assets or projects of unequal lifespans but if the projects or assets doesn’t possess equal risk then EAC is not used. Further, EAC IS also used to determine the cost savings that can be further used to purchase new product or equipment for the company that could justify the purchasing.
- PAYBACK PERIOD: In capital budgeting, payback period is the time period when the company gets the pay back of the investments being made. For example, a company invests $50, 000 in an investment and after the completion of time period of investment, the company get $100,000 as a payback. And the time period when the company get the payback is pay back period which is one year payback period and if this payback is made in 2 years or 3 or so on then it will be two-year pay back period or three-year pay back period and so on. Payback period is an important tool to make analysis of investments made not only for companies and business authorities but also for individuals.
- PROFITABILITY INDEX (PI): profitability index is also known as Profit Investment Ratio (PIR) and Value Investment Ratio (VIR) which is calculated by the division of PV of future cash flows and Initial investment (keeping initial investment in denominator). And this formula comes with a rule that if PI > 1 then the project is accepted and if PI < 1 then the project is rejected. Thus, it helps in ranking the projects and calculating the amount of value created per unit of investment. Profitability index, therefore, becomes important for starting and spending expenses on any new project.
- AVERAGE ACCOUNTING RETURN (AAR): AAR is the average project earnings. AAR is defined in different forms and the basic definition for Average Accounting Return is the measure of average accounting profit (AAP)divided by the measure of average accounting value (AAV). Thus, higher the values of average accounting profit higher will be the average accounting return.
In capital budgeting process handles the calculation of large amount of money influencing profit or loss of a company. Generally, it prefers those tasks that could lead to profitability of company. And to handle such tasks, team need to be highly coordinated and lots of knowledge in hand.
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