You need to give a brief
introduction of Capital Budgeting and different way of evaluating
the same.
Capital Budgeting decision is a long
term decision and irreversible decision. It involves investment of
capital hence its returns should be measured to justify the
investment. The golden rule is higher the return on investment is
it good .
Now the question how to measure the
ROI of Capital investment. Below are the ways of measuring it
- Net present
value : Net present value is a method of measuring
return on investment where the Annual cash inflows are discounted
to its present value based on the cost of capital . The reason why
cash inflows are discounted is it is receivable for future period
and hence should be measured in present value. The cost of
investment is then deducted from the present value of cash inflows.
If the present value is positive it means NPV is positive and
thereby investment can be made since returns are higher than cost
of capital. If the present value is negative it means NPV is
negative and there by investment should be avoided
- Benefit Cost
Ratio : Benefit Cost Ratio is modified version of
Net present value where it is measured in terms of ratio . The
ratio is calculated dividing Present value of cash inflows by Cash
outflows. If the ratio is 1 , it means the returns from project are
positive and investment can be made. If the ratio is less than 1 ,
it means the returns are negative from the project
- Internal Rate of Return
: Internal Rate of Return is also a modified
version of Net present value. it calculates the rate at which
present value of cash inflows is equal to present value of cash
outflows. If the rate is higher than cost of capital the project is
accepted and if rate is lower than cost of capital project is
rejected
Given below table to summarize all 3
measures