capital budgeting Definition The process of determining which potential long-term projects are worth undertaking, by comparing their

expected discounted cash flows with their internal rates of return.

Net present value

Main article: Net present value Each potential project's value should be estimated using a discounted cash flow (DCF) valuation, to find its net present value (NPV). (First applied to Corporate Finance by Joel Dean in 1951; see also Fisher separation theorem, John Burr Williams: Theory.) This valuation requires estimating the size and timing of all the incremental cash flows from the project. (These future cash highest NPV(GE).) The NPV is greatly affected by thediscount rate, so selecting the proper rate - sometimes called the hurdle rate - is critical to making the right decision. The hurdle rate is theMinimum acceptable rate of return on an investment. This should reflect the riskiness of the investment, typically measured by the volatility of cash flows, and must take into account the financing mix. Managers may use models such as the CAPM or the APT to estimate a discount rate appropriate for each particular project, and use the weighted average cost of capital (WACC) to reflect the financing mix selected. A common practice in choosing a discount rate for a project is to apply a WACC that applies to the entire firm, but a higher discount rate may be more appropriate when a project's risk is higher than the risk of the firm as a whole. [edit]Internal

rate of return

Main article: Internal rate of return The internal rate of return (IRR) is defined as the discount rate that gives a net present value (NPV) of zero. It is a commonly used measure of investment efficiency. The IRR method will result in the same decision as the NPV method for (non-mutually exclusive) projects in an unconstrained environment, in the usual cases where a negative cash flow occurs at the start of the project, followed by all positive cash flows. In most realistic cases, all independent projects that have an IRR higher than the hurdle rate should be accepted. Nevertheless, for mutually exclusive projects, the decision rule of taking the project with the highest IRR - which is often used - may select a project with a lower NPV. In some cases, several zero NPV discount rates may exist, so there is no unique IRR. The IRR exists and is unique if one or more years of net investment (negative cash flow) are followed by years of net revenues. But if the signs of the cash flows change more than once, there may be several IRRs. The IRR equation generally cannot be solved analytically but only via iterations. One shortcoming of the IRR method is that it is commonly misunderstood to convey the actual annual profitability of an investment. However, this is not the case because intermediate cash flows are almost never reinvested at the project's IRR; and, therefore, the actual rate of return is almost certainly going to be lower. Accordingly, a measure calledModified Internal Rate of Return (MIRR) is often used. Despite a strong academic preference for NPV, surveys indicate that executives prefer IRR over [citation needed] NPV , although they should be used in concert. In a budget-constrained environment, efficiency

measures should be used to maximize the overall NPV of the firm. Some managers find it intuitively more appealing to evaluate investments in terms of percentage rates of return than dollars of NPV. Profitability index (PI), also known as profit investment ratio (PIR) and value investment ratio (VIR), is the ratio of payoff to investment of a proposed project. It is a useful tool for ranking projects because it allows you to quantify the amount of value created per unit of investment. The ratio is calculated as follows:

Assuming that the cash flow calculated does not include the investment made in the project, a profitability index of 1 indicates breakeven. Any value lower than one would indicate that the project's PV is less than the initial investment. As the value of the profitability index increases, so does the financial attractiveness of the proposed project. Rules for selection or rejection of a project: If PI > 1 then accept the project If PI < 1 then reject the project

For example, given:

Investment = $40,000 Life of the Machine = 5 Years CFAT 18000 12000 10000 9000 6000

CFAT Year 1 2 3 4 5

Calculate Net present value at 10% and PI: Year 1 2 3 4 5 CFAT 18000 12000 10000 9000 6000 PV@10% 0.909 0.827 0.752 0.683 0.621 PV 16362 9924 7520 6147 3726

Total present value (-) Investment NPV PI = =

43679 40000 3679

43679 / 40000 1.091

= >1 = Accept the project

Accounting rate of return

From Wikipedia, the free encyclopedia

This article is about a capital budgeting concept. For other uses, see ARR. Accounting rate of return, also known as the Average rate of return, or ARR is a financial ratio used in capital budgeting. [1] The ratio does not take into account the concept oftime value of money. ARR calculates the return, generated from net income of the proposed capital investment. The ARR is a percentage return. Say, if ARR = 7%, then it means that the project is expected to earn seven cents out of each dollar invested. If the ARR is equal to or greater than the required rate of return, the project is acceptable. If it is less than the desired rate, it should be rejected. When comparing investments, the higher the ARR, the more attractive the investment.[2] Over one-half of large firms calculate ARR when appraising projects.
[3]

[edit]Basic

formulae

where

Payback period
From Wikipedia, the free encyclopedia

This article does not cite any references or sources. Please help improve this article by adding citations to reliable sources. Unsourced material may be challenged and removed. (March 2009)
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. For example, a $1000 investment which returned $500 per year would have a two year payback period. The time value of money is not taken

into account. 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. Payback period is widely used because of its ease of use despite the recognized limitations described below.

The term is also widely used in other types of investment areas, often with respect to energy efficiency technologies, maintenance, upgrades, or other changes. For example, acompact fluorescent light bulb may be described as having a payback period of a certain number of years or operating hours, assuming certain costs. Here, the return to the investment consists of reduced operating costs. Although primarily a financial term, the concept of a payback period is occasionally extended to other uses, such as energy payback period (the period of time over which the energy savings of a project equal the amount of energy expended since project inception); these other terms may not be standardized or widely used.

Payback period as a tool of analysis is often used because it is easy to apply and easy to understand for most individuals, regardless of academic training or field of endeavour. When used carefully or to compare similar investments, it can be quite useful. As a stand-alone tool to compare an investment to "doing nothing," payback period has no explicit criteria for decision-making (except, perhaps, that the payback period should be less than infinity).

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, financingor other important considerations, such as the opportunity cost. Whilst the time value of money can be rectified by applying a weighted average cost of capital discount, it is generally agreed that this tool for investment decisions should not be used in isolation. Alternative measures of "return" preferred by economists are net present value and internal rate of return. An implicit assumption in the use of payback period is that returns to the investment continue after the payback period. Payback period does not specify any required comparison to other investments or even to not making an investment.

Payback period is usually expressed in years. Start by calculating Net Cash Flow for each year: Net Cash Flow Year 1 = Cash Inflow Year 1 - Cash Outflow Year 1. Then Cumulative Cash Flow = (Net Cash Flow Year 1 + Net Cash Flow Year 2 + Net Cash Flow Year 3 ... etc.) Accumulate by year until Cumulative Cash Flow is a positive number: that year is the payback year.

To calculate a more exact payback period: Payback Period = Amount to be Invested/Estimated Annual Net Cash Flow 1{[1]}

Additional complexity arises when the cash flow changes sign several times; i.e., it contains outflows in the midst or at the end of the project lifetime. The modified payback period algorithm may be applied then. First, the sum of all of the cash outflows is calculated. Then the cumulative positive cash flows are determined for each period. The modified payback

Capital Budgeting
Capital Budgeting is the process by which the firm decides which long-term investments to make. Capital Budgeting projects, i.e., potential long-term investments, are expected to generate cash flows over several years. The decision to accept or reject a Capital Budgeting project depends on an analysis of the cash flows generated by the project and its cost. The following three Capital Budgeting decision rules will be presented:

Payback Period Net Present Value (NPV) Internal Rate of Return (IRR)

A Capital Budgeting decision rule should satisfy the following criteria:

Must consider all of the project's cash flows. Must consider the Time Value of Money Must always lead to the correct decision when choosing among Mutually Exclusive Projects.

Project Classifications Capital Budgeting projects are classified as either Independent Projects or Mutually Exclusive Projects. An Independent Project is a project whose cash flows are not affected by the accept/reject decision for other projects. Thus, all Independent Projects which meet the Capital Budgeting critierion should be accepted. Mutually Exclusive Projects are a set of projects from which at most one will be accepted. For example, a set of projects which are to accomplish the same task. Thus, when choosing between "Mutually Exclusive Projects" more than one project may satisfy the Capital Budgeting criterion. However, only one, i.e., the best project can be accepted.

Of these three, only the Net Present Value and Internal Rate of Return decision rules consider all of the project's cash flows and the Time Value of Money. As we shall see, only the Net Present Value decision rule will always lead to the correct decision when choosing among Mutually Exclusive Projects. This is because the Net Present Value and Internal Rate of Return decision rules differ with respect to their Reinvestment Rate Assumptions. The Net Present Value decision rule implicitly

assumes that the project's cash flows can be reinvested at the firm's Cost of Capital, whereas, the Internal Rate of Return decision rule implicitly assumes that the cash flows can be reinvested at the projects IRR. Since each project is likely to have a different IRR, the assumption underlying the Net Present Value decision rule is more reasonable.
Cost of Capital The firm's Cost of Capital is the discount rate which should be used in Capital Budgeting. The Cost of Capital reflects the firm's cost of obtaining capital to invest in long term assets. Thus it reflects a weighted average of the firm's cost of debt, cost of preferred stock, and cost of common stock.

Concepts
http://www.zenwealth.com/BusinessFinanceOnline/CB/CapitalBudgeting.html

The Time Value of Money

A dollar on hand today is worth more than a dollar to be received in the future because the dollar on hand today can be invested to earn interest to yield more than a dollar in the future. The Time Value of Money mathematics quantify the value of a dollar through time. This, of course, depends upon the rate of return or interest rate which can be earned on the investment. The Time Value of Money has applications in many areas of Corporate Finance including Capital Budgeting, Bond Valuation, and Stock Valuation. For example, a bond typically pays interest periodically until maturity at which time the face value of the bond is also repaid. The value of the bond today, thus, depends upon what these future cash flows are worth in today's dollars. The Time Value of Money concepts will be grouped into two areas: Future Value and Present Value. Future Value describes the process of finding what an investment today will grow to in the future. Present Value describes the process of determining what a cash flow to be received in the future is worth in today's dollars.
Investment Decisions are the decisions wherein the decisions are made to deploy / invest funds in asset / investment instrument with objective to earn either valuation increase of returns in form of %.

Financing Decisions, are the decisions wherein the decisions are made to acquire certain Inverstment / Equipment / or a property with the help of outside means of finance like loans, issue of shares, bonds, etc. Even capital issuance is called Financing Decisions. The difference is that the Investment decision results in out-go of Cash, Financing decisions results into in-flow of Cash and Distributions decisions involves both but not direct as cash is used to set up distribution channels and networks.

payback period using bail-out method?

Initial Net Investment / (Annual expected cash flow + salvage value)

bailout payback method payback period

method incorporating the salvage value of the asset into the calculation. It measures the length of the payback period when the periodic cash inflows are combined with the salvage value.