FINANCE 5 : Capital Budgeting (NPV and other methods)

Payback period rule

A particular cutoff date, say two years, is selected. All investment projects that have payback peri-ods of two years or less are accepted, and all of those that pay off in more than two years—if at all—are rejected. Useful for small decision.

net present value

is a measurement of the profitability of an undertaking that is calculated by subtracting the present values (PV) of cash outflows (including initial cost) from the present values of cash inflows over a period of time. Accept a project if the NPV is greater than zero. Reject a project if NPV is less than zero.

The internal rate of return

is the discount rate at which the Net Present Value (NPV) of a project equals zero. The IRR decision rule specifies that all independent projects with an IRR greater than the cost of capital should be accepted. Accept the project if the IRR is greater than the discount rate. Reject the project if the IRR is less than the discount rate

Capital rationing

is the process of putting restrictions on the projects that can be undertaken by the company or the capital that can be invested by the company. This aims in choosing only the most profitable investments for the capital investment decision.

Profitability index

is the ratio of the present value of the future expected cash flows after initial investment divided by the amount of the initial investment. Accept an independent project if PI > 1. • Reject it if PI<1.

Capital budgeting

the decision-making process for accepting or rejecting projects.