Example Of Capital Budgeting

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: Wal-Mart opens a new retail outlet new products and services: These create greater uncertainties; hence, more attention may be required in the analysis of these projects. 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

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.
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.
Solution
Annual Depreciation = (Initial Investment − Scrap Value) ÷ Useful Life in Years
Annual Depreciation = ($130,000 − $10,500) ÷ 6 ≈ $19,917
Average Accounting Income = $32,000 − $19,917 = $12,083
Accounting Rate of Return = $12,083 ÷ $130,000 ≈ 9.3%
Payback Period is the time in which the initial cash outflow of an investment is expected to be recovered from the cash inflows generated by the investment. It is one of the simplest investment appraisal