various capital budgeting methods - wiki _ the motley fool

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9/7/2013



Various Capital Budgeting Methods

Original post by Justin Johnson of Demand Media

Capital expenditures such as buildings and equipment should undergo a capital budgeting process.Comstock Images/Comstock/Getty Images

Capital budgeting is an important function of the finance department within a business. It is the process of

allocating funds for the purchase of property, factories and equipment. While the importance of capital budgetingis not disputed, the methods of capital budgeting enjoy support from a wide array of finance professionals.

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Contents1 Payback Period2 Net Present Value3 Internal Rate of Return4 Spreadsheets in Capital Budgeting

4.1 References4.2 About the Author4.3 Photo Credits


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Payback Period

Payback period is perhaps the most simple method of capital budgeting. The basic premise of this method is todetermine the amount of time that is required to recoup the funds spent on the capital project or equipmentexpenditure. The payback period is calculated by dividing the total expenditure amount by a desired time framefor investment recovery. This method is not a recommended means of capital budgeting due to its simplisticconcept.

Net Present Value

Net present value is a widely used method of capital budgeting that determines if a capital project shouldproceed based upon analysis of the benefits versus the costs. Firms should always ensure that their rate of returnof their investment is always higher than their cost of capital and the premium that they place on the risk of theinvestment. This concept is known as the hurdle rate. Net present value is calculated by subtracting the presentvalue of the costs from the present value of the benefits of the capital project.

Internal Rate of Return

Internal rate of return is a complex capital budgeting method. The internal rate of return is the discount orinterest rate that makes the income stream of an investment sum to zero. The income stream of an investment iscalculated by adding the total cash flows of the project. The initial cash outflow begins as a negative, with theinterest, or benefits, received each year listed as a positive. When the project is completed, the value of theinvestment is also added to the negative initial investment figure and the yearly interest amount. Internal rate of return is the discount percent that makes these figures total to zero, and it is helpful when comparing alternativeinvestments or capital projects.

Spreadsheets in Capital Budgeting

The mathematical equations that arise when attempting to calculate net present value and internal rate of returncan be formidable to the untrained analyst. Spreadsheet programs have made the task of capital budgeting mucheasier and user friendly. Analysts can find spreadsheet-based capital budgeting templates online. This decreasesthe amount of time spent during the capital budgeting process, while producing a more consistent, accurateresult. Analysts and accountants can take courses to better equip them to use spreadsheet applications toproduce capital budgeting documents from groups such as a state Certified Public Accountant trade group.

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References

Murray State University: Capital Budgeting Techniques;Murray State University: The Hurdle RateUniversity of South Carolina, Arnold School of Public Health: The Internal Rate of Return

The Ohio Society of CPA's: Excel Budgeting and Forecasting Techniques

About the Author

Based in Somerset, Ohio, Justin Johnson has been writing since 1998. He was a finalist for the 1998 MuskingumCounty (Ohio) Bar Association Law Day Essay Contest and has also written academic papers on business,finance and political topics. He has a Bachelor of Science in business management from Pensacola ChristianCollege.

Photo Credits

Comstock Images/Comstock/Getty Images

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