capital budgeting techniques

• in this chapter the focus will be on investment i terms of real assets for e.g a company need to purchase a new machine or buy a factory. before undertaking the investment it must assess whether it is a good investment or not . the simplying assumptions that would be used are that we know exactly future cash flows are obtained from the investment . the amount and time at which it occurs are known with certainty. and the return are interest rate used for such an assets would be a risk free of return
• there are 2 categories of method used fo assessing such investment. the first one takes into consideration the aspects of time vaue of money [NPV] and [IRR]

  the second category is which does not account for the aspect at time value of money is payback period and accounting rate of return[ARR]
• Net present value (NPV)

  To assess the investment in real asset the NPV can be used
• Calculating NPV


  1. Know the future cash flow of the real assets

  2. Convert the future cash flow into their present value

  3. Use a discount rate/interest rate

  4. Opportunity cost of capital is the specific interest rate used

  5. Estimate the return the company wants from real assets

  6. Find the difference between the present value of the future cash flow and the initial amount investment
• When the NPV is positive


  The investment has allowed the company to generate a profit or the investment is value-creating for the company, therefore it should be accepting the project
• When the NPV is negative

  The investment decreases the value of the company and it should be rejected
• NPV FORMULAE: $X/(1+RATE) +$$X2/(1+RATE)2 +$$X3/(1+RATE)3+$$X4/(1+RATE)4 - I0$
• INTERNAL RATE OF RETURN

  IRR is the discount rate at which the NPV would be equal to 0.the IRR represents the interst rate that the real assets will actually be offering . to take an investment decisions the opportunity cost will be compared with the IRR.

  FORMULAE: $X/(1+IRR) +$$X2/(1+IRR)2 +$$X3/(1+IRR)3+$$X4/(1+IRR)4 - I0=$$0$