Capital Budgeting Techniques

4009 WordsAug 5, 200817 Pages
ABSTRACT This report describes capital budgeting techniques such as NPV (The NPV of an investment is the difference between its market value and its cost, IRR (The IRR is the discount rate that makes the estimated NPV of an investment equal to zero. PAYBACK (The payback period is the length of time until the sum of an investment’s cash flows equals its cost), discounted payback period (The discounted payback period is the length of time until the sum of an investment’s discounted cash flows equals its cost). There are some notable differences between capital budgeting processes in developing and developed countries. Canadian firms tend to formally evaluate all investment opportunities, while US managers do a thorough analysis of only he…show more content…
However, if NPV is negative, the project should probably be rejected because cash flows will also be negative. For example, if a retail clothing business wants to purchase an existing store, it would first estimate the future cash flows that store would generate, and then discount those cash flows into one lump-sum present value amount, say $565,000. If the owner of the store was willing to sell his business for less than $565,000, the purchasing company would likely accept the offer as it presents a positive NPV investment. Conversely, if the owner would not sell for less than $565,000, the purchaser would not buy the store, as the investment would present a negative NPV at that time and would, therefore, reduce the overall value of the clothing company. Often used in capital budgeting, it's the interest rate that makes net present value of all cash flow equal zero. Essentially, this is the return that a company would earn if they expanded or invested in themselves, rather than investing that money abroad. (Web: investopedia.com) Payback Period The length of time required to recover the cost of an investment. Calculated as: All other things being equal, the better investment is the one with the shorter payback period. For example, if a project cost $100,000 and was expected to return $20,000 annually, the payback period would be $100,000 / $20,000, or 5 years. There are two main problems with the payback
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