Core Concept of the Topic
– Executive summary
– Mission and strategy statement
– Market analysis
– Operations (of the business)
– Management and staffing
– Financial projections
When a business makes a capital investment, it incurs a current cash outlay in the expectation of future benefits. Usually, these benefits extend beyond one year in the future. Investment is asset such as equipment, buildings and land as well as the introduction of a new product, a new distribution system, or a new program for research and development. The firms future success and profitability depend on long-term decisions currently made. An investment proposal should be judged in relation to whether or not it provides a return equal to, or greater than, that required by the investors. The selection of an investment project may affect the rate of return required by investors. One of the most important task in capital budgeting is estimating future cash flows for a project. The final result we obtain from our analysis are no better than the accuracy of cash flow estimates. The firms invest cash now in the hope of receiving even greater cash returns in the future.
There are four widely used methods available for project evaluation and capital budgeting. 1.Payback period
2.Internal rate of return
3.Net present value
The first is a simple additive method for assessing the worth of a project. The remaining methods are more complicated discount cash flow techniques. Discounted cash flow methods enable us to capture differences in the timing of cash flows for various projects through the discounting process. In addition, through our choice of the discount (hurdle rate), we can also account for project risk.
Payback period (PBP)-
The payback period (PBP) of an investment project tells us the number of years required to recover the initial cash investment based on the project’s expected cash flows. Acceptance criteria- If the payback period calculated is less than some maximum acceptable payback period, the proposal is accepted; if not, it is rejected.
Internal rate of return (IRR)-
Because of the various shortcomings in the payback method, it is generally felt that discounted cash flow methods provide a more objective basis for evaluating and selecting investment proposals. IRR take account of both the magnitude and timing of expected cash flows in each period of a project’s life. Internal rate of return for an investment proposal is the discount rate that equates the present value of the expected net cash flows with the initial cash outflows. Acceptance criteria- The acceptance criteria generally employed with the internal rate of return method is to compare the internal rate of return to a required rate of return, known as cut-off or hurdle rate. If the internal rate of return exceeds the required rate of return, the project is accepted: if not, the project is rejected.
Net present value (NPV)-
Like the internal rate of return method, the net present value method is a discounted cash flow approach to capital budgeting. The net present value (NPV) of an investment proposal is ths present value of the proposal’s net cash flows less the proposal’s initial cash outflow. Acceptance criteria- If an investment project’s net present value is zero or more, the project is accepted; if not, it is rejected. Another way to express the expectance criterion is to to say that the project will be accepted if the present value of cash inflows exceeds the present value of cash outflows.
Profitability Index (PI)-
The profitability index (PI), or benefit-cost ratio, of a project is the ratio of the present value of future net cash flows to the initial cash out flows. Acceptance criteria- As long as the profitability index is 1.00 or greater, the investment proposal is acceptable. For any given project, the...