Capital Budgeting: The Approach To The Capital Budgeting Process

The word “capital” implies long term. Capital funds are long-term sources of funds. Capital budgeting is investing in long-lived assets. (Financial-dictionary)Capital Budgeting (also known as investment appraisal) is the most important tool in corporate finance to determine whether a company’s long term investment are worthwhile or not. It is also known as investment a Working capital is the funds necessary to support the operation of the long-lived assets. Various examples will be used to illustrate Capital Budgeting procedure is the way toward arranging and controlling capital consumption inside a firm.

Capital Budgeting is over a period more prominent than the period considered under a working spending plan. Capital planning includes the

Example: Apple’s initial introduction of the iPhone Regulatory, safety, and environmental projects: Generally are mandatory projects, but the company may have choices in how to satisfy requirements. If sufficiently costly, shutdown is an alternative. Also referred to as mandated projects. Other: These may include projects that are difficult to analyze (e.g., research and development [R&D). Note: R&D expenses are sunk costs, but the decision to embark on R&D for the development of a project is itself a capital project.

Basic Principles of Capital Budgeting Principles Decisions are based on cash flow, not accounting income. The timing of cash flows is crucial; that is, the time value of money is important. Cash flows are incremental; that is, cash flows are based on opportunity costs. Cash flows are on an after-tax basis because cash flows related to taxes (payments or benefits) are part of the cash flows that must be analyzed. Financing costs are ignored in the cash flow analysis. Financing costs enter the decision making through the required rate of return.

Costs:

The most important methods of capital budgeting are:

1. Accounting Rate of Return

2. Payback Period

3. Profitability Index

4. Net Present Value

5. Internal Rate of Return

Accounting rate of return is the rate of return from the net income of the proposed capital investment.

Formula Accounting Rate of Return is calculated using the following formula:

ARR = Average Accounting Profit Average Investment

Average accounting profit is the arithmetic mean of accounting income expected to be earned during each year of the project 's life time. Average investment may be calculated as the sum of the beginning and ending book value of the project divided by 2. Another variation of ARR formula uses initial investment instead of average investment.

(Capital-budgeting) arr

Examples

Example 1: An initial investment of $130,000 is expected to generate annual cash inflow of $32,000 for 6 years. Depreciation is allowed on the straight line basis. It is estimated that the project will generate scrap value of $10,500 at end of the 6th year. Calculate its accounting rate of return assuming that there are no other expenses on the project.