Meaning –

Capital budgeting (or investment appraisal) is the planning process used to determine whether an organization's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth the funding of cash through the firm's capitalization structure (debt, equity or retained earnings). It is the process of allocating resources for major capital, or investment, expenditures. One of the primary goals of capital budgeting investments is to increase the value of the firm to the shareholders.

Formal methods are used in capital budgeting, including the techniques such as-

Payback Period

Payback period in capital budgeting refers to the period of time required for the return on an investment to "repay" the sum of the original investment. Payback period intuitively measures how long something takes to "pay for itself." All else being equal, shorter payback periods are preferable to longer payback periods.

The payback period is considered a method of analysis with serious limitations and qualifications for its use, because it does not account for the time value of money, risk, financing, or other important considerations, such as the opportunity cost.

Formula

The formula to calculate payback period of a project depends on whether the cash flow per period from the project is even or uneven. In case they are even, the formula to calculate payback period is:

Payback Period =

Initial Investment

Cash Inflow per Period

When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period and then use the following formula for payback period:

Payback Period = A +

B

C

In the above formula,

A is the last period with a negative cumulative cash flow;

B is the absolute value of cumulative cash flow at the end of the period A;

C is the total cash flow during the period after A

Net Present Value:

Net present value (NPV) is used to