These lectures cover capital budgeting technique such as payback method, internal rate of return, net present value, simple rate of return, discount payback period, discounting cash flow.
Time Value of Money for Capital Budgeting
Net Present Value NPV Capital Budgeting
Internal Rate of Return IRR Capital Budgeting
Payback Period for Capital Budgeting
Simple Rate of Return for Capital Budgeting
Cash Flow Preference Decisions for Capital Budgeting
The payback method of evaluating capital investment projects focuses on the payback period. The payback period is the length of time that it takes for a project to recover its initial cost from the net cash inflows that it generates. The basic premise of the payback method is that the more quickly the cost of an investment can be recovered, the more desirable is the investment.
Investment decisions should take into account the time value of money because a dollar received today is more valuable than a dollar received in the future. The net present value and internal rate of return methods both reflect this fact. In the net present value method, future cash flows are discounted to their present value. The difference between the present value of the cash inflows and the present value of the cash outflows is called a project’s net present value. If the net present value of a project is negative, the project is rejected. The discount rate in the net present value method is usually based on a minimum required rate of return such as a company’s cost of capital.
The internal rate of return is the rate of return that equates the present value of the cash inflows and the present value of the cash outflows, resulting in a zero net present value. If the internal rate of return is less than a company’s minimum required rate of return, the project is rejected.
After rejecting projects whose net present values are negative or whose internal rates of return are less than the minimum required rate of return, more projects may remain than can be supported with available funds. The remaining projects can be ranked using either the project profitability index or internal rate of return. The project profitability index is computed by dividing the net present value of the project by the required initial investment.
The simple rate of return is determined by dividing a project’s annual incremental net operating income by the initial investment in the project. While this method has important limitations, it can influence the decision-making process of investment center managers who are evaluated and rewarded based on their return on investment (ROI).