The Management

Subject: Various techniques of capital budgeting

Capital budgeting is the process in which the company plans whether to purchase or do investment in certain projects or long term assets such as new machinery, equipment, new products, research and development etc. There are many techniques which can be use make decision more easy and reliable.

For all of these techniques company need the incremental cash flows which will be generate from the investment or the project. Then these cash flows are discounted according to the company cost of capital rate which is also known as weighted average cost of capital (WACC).

Following are the techniques which are normally used in capital budgeting:-

1. Net Present Value

2.
*…show more content…*

The formula for this is as follows:-

Present value of future cash flows / Initial investment required.

The rule about the decision taking in profitability index is that if the profitability index is 1 then accepts the project, if zero then stay indifferent and if negative then do not accept the project.

Profitability also uses sometimes in capital rationing process as to rank the project according to the Profitability index. As in this case the profitability index for both the corporation is 1.08 and 1.16 respectively.

Discounted Payback Period:-

This is similar to the payback period but more reliable and accurate as the cash flows use in it are discounted by using the company’s cost of capital which is described as above. All the other things are same for the calculation part as like payback period but the cash flows will be different. As in this case we can see the different answers for both the corporation in both the scenarios of Payback period and Discounted Pay back periods. Results for both the corporation A and Corporation B is 4.6 years and 4.24 years respectively.

Conclusion:-

According to the analysis the corporation B should be selected, as it NPV is greater. All the other factors must also be put in consideration for the decision such as IRR, Payback periods etc to compare the better result from both the corporation, but final decision should be based on NPV because this give the more accurate and

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