CAPITAL BUDGETINGCAPITAL BUDGETING
(or investment appraisal) is the planning process used todetermine whether a firm's long term investments such as new machinery, replacementmachinery, new plants, new products, and research development projects are worth pursuing. Itis budget for major capital, or investment, expenditures.
Many formal methods are used in capital budgeting, including the techniques such as
ccounting rate of return
et present value
Internal rate of return
ACCOUNTING RATE OF RETURN
Accounting rate of return
, also known as the
Average rate of return
is afinancial ratio used in capital budgeting.
The ratio does not take into account the conceptof time value of money.
calculates the return, generated from net income of the proposedcapital investment. The
is a percentage return. Say, if
= 7%, then it means that the project is expected to earn seven cents out each dollar invested. If the
is equal to or greater than the required rate of return, the project is acceptable. If it is less than the desired rate, itshould be rejected. When comparing investments, the higher the
, the more attractive theinvestment.
Average Rate of Return is calculated by using the formula:(Net return per year / initial investment) x 100NET PRESENT VALUE
Net Present Value
Net Present Worth
) of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values (
s) of the individualcash flows. In the case when all future cash flows are incoming (such as coupons and principal of a bond) and the only outflow of cash is the purchase price, the
is simply the
of futurecash flows minus the purchase price (which is its own
is a central tool in discountedcash flow (DCF) analysis, and is a standard method for using the time value of money toappraise long-term projects. Used for capital budgeting, and widelythroughout economics, finance, and accounting, it measures the excess or shortfall of cash flows,in present value terms, once financing charges are met.