Steps for capital budgeting:

Mr. Ram is working as Engineer in ABC Company and Earns Rs. 40000 per month and after some time; he saved Rs. 10,00,000. Now he wants to invest it.

Saving and investment is two distinct things. Saving means save the money in your pouch or saving account at 3.5% annual interest however investment means to give money to big corporate public and private companies for getting shares , debentures, mutual funds, public deposits and purchasing of machines for production . All such projects can provide you high profit however as well risk of loss of money also comprises in such projects. Capital budgeting aids you to select best investment project out of various choices with high gain at minimum risk. When you do not know the methods of Capital budgeting, please consult Chartered Accountant or Financial Management before investing your high savings in any project. In simple words, capital budgeting is a method in which; investor compares profitability with the cost of projects. For this assessment he can use traditional and time adjusted or discounted cash flow techniques. After assessment of different proposals, final approval for project is given.

Tradition method:

In tradition method, Investor computes payback period of investment. Investor accepts that project whose reimbursement period is less than the other project.

For illustration: There are two projects A and B. Each project needs an investment of $ 20000. You are needed to rank such projects according to the payback period technique from the information given below: (pay back means estimated net profit from the investment)

Project A: Estimated Net Profit from project A 1st year = $ 1000, 2nd year = $ 2000, 3rd year = $ 4000, 4th year = $ 5000 and 5th year = $ 8000

Project B: Estimated net profit from project B 1st year = $ 2000, 2nd year = $ 4000, 3rd year = $ 6000 , 4th year = $ 8000 and 5th year = Nil

Solution:

Project A: First of all we have to calculate annual net profit from project:-
= Total net profit from A project / no. of years = 20000 / 5 = $ 4000

Now the payback period for project A
= total cost of project / Annual net profit from project
= $ 20000 / $ 4000 = 5 years

Project B: First of all we have to calculate annual net profit from project:-
= Total net profit from B project / no. of years = 20000 / 4 = $ 5000

Now the payback period for project B
= total cost of project / Annual net profit from project
= $ 20000 / $ 5000 = 4 years

We must give project B as first rank since , investor gets his cost of project in 4 years that is less than project A’s payback period , since that investment proposal is best which provides our invested money in the short period .

Time adjusted or discounted Cash flow method:

Net present Value method:

When you operate ms excel or Google docs in your everyday life, then you have seen functions or formula of Financial with NPV. Its full name is net present value technique. From my personal knowledge, most of the professional accountants employ this technique for choosing best investment proposal out of numerous investment schemes. Net present value method is based on supposition, that today earned one rupees’ value is more than tomorrow one rupees earning. Below this technique, we computed present value of cash out flow (that is, present value of cost of investment) and remove it from the present value of cash inflow (i.e., present value of all future net profit). After this what we receive will be the total present value of any project. We should select that proposal of investment whose total present value is more than other project. Present value is computed on the basis of discount rate that is available in market; it might 8% to 20 % on the nature of investment. When you do not use ms excel or Google docs, you have to find the current value from present value tables; it is just similar to log tables that are available on book shop.

For illustration from the following information compute the net present value of the two projects and propose which of the two projects must be accepted supposing , i discount rate is 10 %

Formula of computing NPV of investment projects
= Present value of Cash inflows - Present value of Cash out flows

or = PV of net profits - PV of total cost of investment

Assume that there are two projects A and B

Project A:
Initial investment: $ 20000
Estimated life: 5 years
Scrap value: $ 1000

The profit prior to depreciation and after taxes (cash flows in $) is as follows:-
1st year 5000, 2nd year 10000, 3rd year 10000, 4th year 3000 and 5th year $ 2000

Project B:
Initial investment: $ 30000
Estimated life: 5 years
Scrap value: $ 2000

The profit prior to depreciation and after taxes (cash flows in $) is as follows:-
1st year 20000, 2nd year 10000, 3rd year 5000, 4th year 3000 and 5th year $ 2000

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