Question

what are the keys to purchasing a large investment such as your home?

Answer 1

Keys for purchasing large investment (capital budgeting) are as follows:

1. Payback period- It simply means that how long it will take by such investment to pay us back what we have invested in such project i.e. period of return back of investment amount.It is mostly used when mutually exclusive projects are compared,the shortest payback period should be selected.It is best to use it while dealing in simple projects

Formula- total cost of project / expected cash inflow each year

2. Net Present Value(NPV)- It is a decision making tools with more effective process for evaluating projects.Perform a net present value calculation essentially requires calculating the difference between the project cost (cash outflows) and cash flows generated by that project (cash inflows) i.e. Present Value of Cash Outflow(Initial Investment)- Present Value of Cash Inflow.The term "present value" in NPV refers to the fact that cash flows earned in the future are not worth as much as cash flows today. Discounting those future cash flows back to the present creates an apples to apples comparison between the cash flows. The difference provides you with the net present value.Present Value shall be calculated by discounting Cash flows with discount rate to compensate for the uncertainty of those future cash flows.

Project having higher NPV shall be considered over other projects

3.Internal Rate of Return(IRR)- The internal rate of return is a discount rate that is commonly used to determine minimum rate of return an investor can expect to realize from a particular project or it can be said that minimum rate of return that at which Project is at break even i.e. NPV = 0.It helps in decision making as to choose only such project where the IRR is higher than the cost of financing.

The IRR decision rule is straightforward when it comes to independent projects; however, the IRR rule in mutually-exclusive projects can be tricky. It's possible that two mutually exclusive projects can have conflicting IRRs and NPVs, meaning that one project has lower IRR but higher NPV than another project. These issues can arise when initial investments between two projects are not equal. Despite the issues with IRR, it is still a very useful metric utilized by businesses.

To overcome such issue of mutual - exclusive projects we shall use Annnual Caiptal Charge/Equivalent Annual Cost(EAC)which is calculated as follows:

= Present value of all Cash outflow / Present value annuity factor (cost of capital for N number of years)

Present value annuity factor is calculated by cumlative calculation = Rate / (1+Rate)^n