Capital budgeting

Importance of capital budgeting It is important because, it helps the manager in making decision. Capital budgeting will help the manager to make a decision in choosing which project should company invest in order to maximize the company’s profit.

Method There are three methods used in order to give managers guidelines whether to accept or reject the projects. Three methods are: Payback period Net Present Value Internal Rate of Return

Payback period (PB) It shows the amount of time required for a firm to recover its initial investment in a project, as calculated from cash flows. Involves two situations: Constant cash inflows (annuity) Mixed stream cash inflow

Io = Initial investment Ct = Cash inflow Constant cash inflows The formula: PB = Initial investment (I0) cash inflow (Ct) PB = payback period Io = Initial investment Ct = Cash inflow

Mixed stream cash inflow To get the PB, the yearly cash inflows must be accumulated until the initial investment is recovered. Although popular, payback period is generally viewed as unsophisticated capital budgeting because it not consider the time value of money.

The decision criteria When the payback period is used to make accept-reject decisions, the decision criteria are as follows: If the payback period is less than the maximum acceptable payback period, accept the project. If it greater than the maximum acceptable payback period, reject the project.

Pro and Cons of payback period Widely used by large firms to evaluate small project Give implicit considerations to the timing of cash flows rather than accounting profit. Can used as a decision criterion /supplement to other decisions technique It not link to the wealth maximization goals. It fails to take fully into account the time value of money. Failure to recognize cash flow that occur after the payback period.

Net Present Value (NPV) It is a sophisticated capital budgeting technique, found by subtracting a project investment from the present value of its cash inflows discounted at a rate equal to the firm’s cost of capital. NPV gives explicit consideration to the time value of money.

NPV (Cont’d) NPV = CFt - CF0 (1+K) NPV = Present Value of Cash inflow – Initial investment

The decision criteria: a) If NPV is greater than 0, accept the project b) If NPV less than 0, reject the project.

Internal Rate of Return A sophisticated capital budgeting technique , the discount rate that equates the NPV of an investment opportunity with $0 ( because the NPV of cash flows equals the initial investment.

The decision criteria: If the IRR used to make accept-reject decisions, the decision criteria are as follows: If the IRR is greater than the cost of capital, accept the project. If IRR less than the cost of capital, reject the offer. These criteria guarantee that the firm earns at least its required rate of return.

CAPITAL RISING

Sources To Consider When Looking For Financing: Personal Savings The primary source of capital for most new businesses comes from savings and other forms of personal resources. While credit cards are often used to finance business needs, there may be better options available, even for very small loans.

Sources To Consider When Looking For Financing (cont): Friends And Relatives Many entrepreneurs look to private sources such as friends and family when starting out in a business venture. Often, money is loaned interest free or at a low interest rate, which can be beneficial when getting started.

Sources To Consider When Looking For Financing (cont): Banks And Credit Unions The most common source of funding, banks and credit unions, will provide a loan if you can show that your business proposal is sound. Venture Capital Firms These firms help expanding companies grow in exchange for equity or partial ownership.