Answer to Question #295017 in Management for Unknown346144

Question

Discuss capital budgeting techniques

Investment

. payback period

.net present value

.

Answer 1

Capital budgeting techniques are the methods used to evaluate an investment proposal in order to help the company decide upon the desirability of such a proposal. Capital budgeting focuses on cash flows rather than profits. Capital budgeting involves identifying the cash in flows and cash out flows rather than accounting revenues and expenses flowing from the investment. There are several capital budgeting analysis methods that can be used to determine the economic feasibility of a capital investment which include the Payback Period, Discounted Payment Period, Net Present Value, Profitability Index, Internal Rate of Return, and Modified Internal Rate of Return.

Payback period- This represents the amount of time required for the cash flows generated by the investment to repay the cost of the original investment. For instance, if an investment of $1000 will generate annual cash flows of $200 per year for 10 years. The number of years required to recoup the investment is five years. The Payback Period analysis provides insight into the liquidity of the investment that is length of time until the investment funds are recovered. However, the analysis does not include cash flow payments beyond the payback period. In the example given above, the investment generates cash flows for an additional five years beyond the five-year payback period. The value of these five cash flows is not included in the analysis. 

Net present value- This method involves discounting a stream of future cash flows back to present value. The cash flows can be either be positive that is cash received or negative that is cash paid. The present value of the initial investment is its full face value because the investment is made at the beginning of the time period. The ending cash flow includes any monetary sale value or remaining value of the capital asset at the end of the analysis period, if any. The cash inflows and outflows over the life of the investment are then discounted back to their present values. The Net Present Value is the amount by which the present value of the cash inflows exceeds the present value of the cash outflows. Again, if the present value of the cash outflows exceeds the present value of the cash inflows, the Net Present Value is negative. From a different point of view, a positive or negative Net Present Value means that the rate of return on the capital investment is greater or less than the discount rate used in the analysis.