Capital Budgeting

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Capital BudgetingYou have been asked by a manager in your organizationto put together a training program explaining NetPresent Value (NPV) and Future Value (FV) and howthey are used to

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DefinitionsThere are many capital budgeting techniques:NPV: First and the most used one is the net Present value that calculates the present value of the cashflows from a project. The advantage is in the simplicity and the usefulness of this technique. This is oneof the most widely used tools in the financial industry since it takes into account the time value ofmoney. But the problem lies in the difficulty and many assumptions that need to be taken whilepredicting the cash flows in the future. Hence the approach might not yield correct results.IRR: Internal rate of return calculates the rate of return of the project. There is a problem related toIRR. There is a possibility that there are no or multiple IRR for a given project.Profitability Index: It calculates the profitability of a project for the company.Breakeven analysis: In this case, the firm tries to find out the number of products to be sold so thatthere is no loss for the company. Breakeven units of products are calculated.FV: It calculates the future value of a stream of cash flows.

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Calculation of NPVFirst of all traditional method of NPV can be used. The NPV for the project can becalculated using the cash outflows and inflows over the period of the project andthen using the cost of capital. If this NPV is positive, the project can be accepted elseit would be rejected. Similarly other methods of capital budgeting like IRR,profitability index, and payback period can be used to take a proper decision.Another way is using the real option approach. In this approach, delays in the projectsare also factored in and hence this is a better method. But this is very complexapproach and hence should only be used when the project is large enough.A go decision is taken when the probability of success is greater than the assumedprobability.

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