Capital budgeting (Under Certainty) in finance

The
principle of capital budgeting
Capital
budgeting can be defined as a firm’s decision to inves6t its current funds most
efficiently in long – term activities in anticipation of a flow benefits over a
particular period

Generally,
capital budgeting decisions includes additions, modification and replacement of
long term assets. The following features of capital budgeting can be identified
1.     
It involves the exchange of current funds for possible future benefits
2.     
It involves investment in long term assets
3.     
The future benefits would occur over a particular period of time
Capital
budgeting evaluation techniques
Qualities
of good evaluation technique
Capital
budgeting decisions affects the wealth of shareholder. Thus, an investment
proposal should be evaluated using a technique, which is compatible with the
objective of maximizing the market value of the firm. Such concept will
involved the use of the minimum rate of return required by investors
The
market value of the firm would increase if the investment proposal yields a
rate of return higher than the minimum required by investors
For
an investment evaluation technique to be desirable or accepted, it must posses
the following characteristics
1.     
It should provide a means of distinguishing between acceptable and
unacceptable projects
2.     
It should use all the cash flow associated with the project
3.     
It should recognize the time value of money and also the fact that early
benefits are better than later benefits and that benefits are better than smelter
benefits
4.     
It should also salve the problem of choosing among alternative projects
by making projects in order of desirability
The widely used evaluation techniques can be
grouped into two, these are:
        
i.           
The traditional techniques or non discounted cash flow techniques:
a.    
The payback period (PP)
b.    
The accounting rate of return (ARR)
      
ii.           
Discounted cash flow techniques
a.    
Net present valve method (NPV)
b.    
Internal rate of return method (IRR)
c.    
Profitability index method (PI)
Payback
period
The
payback period is the number of years or periods it takes to recover the amount
originally invested in the project. It is more of a risk evaluation technique
rather than a profit evaluation technique if projects generate constant annual
or periodic cash flows the payback period can be calculated as follows
Payback
period = Co/ A
Where
Co = Initial outlay (investment)
              
A = Annual or periodic net cash inflow
Example
A
boy plans to undertake capital investment that will involve spending N50, 000
now. The project will generate N12, 500 at the end of each year for 7 years.
Calculate the payback period of the project
Payback
period = Co/A = 50,000/12,500
                                    = 4years
This
question does not recognize the 7years period
In
his case of an un-even cash flow, the pay-back period can be derived by adding
up the net cash inflows until the total is equal to the initial outlay
Example
Years
Net cash flows
1
2
3
4
5
`-15000
30,000
10,000
5,000
2,000
A
machine that cost N50, 000 and is expected to generate net cash flows as
follow:
Your
are required to calculate the payback period of the project
Solution:
Years
Net cash flows
Cumulative cash flow
0
1
2
3
4
5
50,000
15,000
30,000
10,000
5,000
2,000
2years
6months

-50,000

-35,000
-5,000
(500×12)/10,000
2years 6 months
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