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Capital Budgeting Techniques - Coggle Diagram
Capital Budgeting Techniques
Payback Period
(easy)
Measures the time it takes to earn back the cost of the project through the cash inflow it generates.
Rough measure of risk
Easy - just use the timeline to see how long it takes for the investment to be returned.
Disadvantages: not appropriate for long-term investments, ignores time-value of money
Discounted Payback Period
(difficult)
Takes time-value of money into consideration.
"The time it will take for the PV of the cash inflow of a project to = the cost of investment"
The method is difficult. It uses the Weighted Average Cost of Capital (WACC) from Ch4 to calculate the
discounted cash inflow
of the project. Then the payback is determined using a timeline - how long does it take to pay back the investment?
Net Present Value (NPV)
(easy)
Estimate a project's future cash flows
Discounting them at the required rate of return (cost of capital)
Subtracting the cost of the investment from the PV
If the NPV is positive, project accepted, as it increases the organization's value
NPV = [Cash inflow in period t / (1+ r) ^t ] + [ repeat for each period ] - Cost of Investment
They will usually give you a
timeline
with the cash inflows for each period. Use the period number (t) and the cash inflow in the formula. Do this for each period; just add them up. Finally, subtract the cost so you get the net value.
Internal Rate of Return (IRR)
(difficult - algebra)
"The discount rate that = the present value of the expected cash inflows with the present value of the project costs"
PV (inflow) = PV (outflow/costs)
IRR = [net cash inflow in period t / (1+r)^t - Investment = 0]
Difficult as equation. Need to use algebra.
You will get a timeline with cash inflows for multiple periods. Sub in values. Use algebra calculator just to make it easy. Your answer is
r
, the
internal rate of return
.
Must be %.
Accounting Rate of Return (ARR)
(reasonably complex)
The ratio between the average incremental net income and the average investment.
Average incremental net income
= expected annual average increase in net income if the project is accepted.
= [Total net income of project] / [its economic life expectancy]
Average investment
= [Investment costs] / [Residual value]
The ARR influences how profitable the organisation is, so projects that create a certain ARR are chosen.
ARR
= (average incremental net income) / (average investment)
First you calculate
average net income
, then
average investment
. Finally, you use the ARR formula.
Profitability Index (PI)
(easy)
"measures the return of the project in relation to the costs"
If greater than 1, accepted. Less than 1, not accepted.
(PI) = PV / I
PV = present value of future cash inflow
I = present value of the costs of the project
Economic Value dd (EVA)
(v. difficult)