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CAPITAL BUDGETING – by Prateek Gupta

CAPITAL BUDGETING

Investment appraisal alternate for Capital budgeting , is the  process of planning which is used to determine whether a company’s  long term investment such as machinery, replacement machinery, equipment, new plants, 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 investment and expenditure.

Primary goals of capital budgeting investments are to increase the value of the firm to the shareholder.

SOME USEFUL METHODS FOR CAPITAL BUDGETING

1) Payback period

2) Net present value

3) Internal rate of return

4) Real options valuation

1) PAYBACK PERIOD

Payback period refers to the time which is needed to recover the funds spent on an investment. For example- A $500 investment returns $100 per month so to recover we require 5 months.

It measures the time something takes to pay for itself. It is used as a tool of analysis as it is easy to apply. It is useful for comparing similar investments.

2)  NET PRESENT VALUE

Net present worth is basically the sum of the present values of total incoming and outgoing of cash flows for a period of time in an organization.

It is calculated by taking the figures for cost (negative flows) and profit(positive flows) during the period of investment. It can be measured yearly, quarterly or monthly.

It is very helpful for a firm as it helps to determine if an investment is successful or not by calculating the profit or loss.

A positive NPV will mean profit otherwise loss.

3)  INTERNAL RATE OF RETURN

Internal rate of return also known as economic rate of return is used in capital budgeting to compare and measure the extent up to which an investment is profitable.

4) REAL OPTIONS VALUATION

Real options is used in capital budgeting decisions. Real options is the right to undertake a certain business initiatives such as- expanding , staging , contracting etc.

They actually are not traded as securities and do not involve a decision regarding an asset that is treated as a security.

USES OF CAPITAL BUDGETING

1) A large sum is invested by the firm which influences the profit thus capital budgeting is needed.

2) Sometimes long term investment are made in a hurry that they can’t be reversed without a loss of capital invested , thus it ensures safer investments.

3) Profits are determined by the kind of investment and the return capacity of that investment. It make sure that returns are sound and results in profit.

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