Finance

CAPITAL BUDGETING

Capital budgeting is the process of planning before making a long term investment of capital in various projects, equipments or any other profit generating expenditure. There are many techniques which are utilized in capital budgeting. List of techniques is as follows:

1. Net present value

2. Internal rate of return

3. Profitability Index

4. Payback period

5. Accounting rate of return

In this case, we will use the following techniques in order to make investment in new manufacturing equipment.

1. Net Present Value – It is the most suitable method in capital budgeting as it determines the value of the project/investment on the present day taking into consideration the cash flows and the rate of return over the time period of the project/investment. If the present value comes out to be positive, then the investment should be made as it will add something to the value of the firm. But if it comes out to be negative, the project should be rejected as it will take away something from the net value of the firm. The major drawbacks of net present value method is that the future cash flow and the rate of return are difficult to be determined over a longer period of time due to uncertainties and economic factors.

2. Internal rate of return – It is the most complex method in capital budgeting as it requires to find out the interest rate which equates the present value of future cash flows and the present investment which the firm is making. If this interest rate is more than the required rate of return set by the firm, then the investment should be made, otherwise it should be rejected. The complexity arises by the fact that in solving the equations, sometimes two rates come as a result which makes the method confusing. The required rate of return in this case is 14 percent.

3. Payback Method – It is the simplest method in capital budgeting which determines the period in which the project will return back the initial...