Being in the financial industry will teach you more than you know in the entire business-related course you took up in college. Among these is knowing what, how, and when to do capital budgeting.
This term is simply investment appraisal or the process of planning the use of the company’s money in long-term investments.
These investments include purchasing new machineries to add in the company’s current equipment or as replacement to the old ones or other equipment.
Investing on new research development projects are also included in the list where capital budgeting is necessary. And so does with the manufacturer of new products and everything that is required in the process.
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There are so many ways you can use or apply capital budgeting. The most prevalent ones are:
1. Accounting rate of return. The accounting rate of return in capital budgeting is also known as the average rate of return (ARR) of something that a company puts its funds on. This can be calculated by dividing the average profit expected out of the new investment to the average investment that the company will put out.
The average investment in this clause is equal to the book value at the beginning of the year and the book value at the end of the year divided into 2. The ARR of this equation is in percent term. The greater the value of the ARR, the better it would be for the company who is doing a capital budgeting.
2. Payback period. Another way to know if an investment is worth investing at is by identifying its payback period. The actual value of the money between and on the period it is paid by the profit it generates is immaterial in calculating the payback period of the investment.
As a rule of thumb, the shorter payback period an investment will require, the better it will be for the company. Capital budgeting is therefore necessary for this reason.
3. Net present value. When capital budgeting, the net present value or NPV of the cash involved in the process is known as the present values or PVs of both the incoming and outgoing cash flows.
The NPV of a company’s fund or capital is important in calculating the time value of money used by a company in a long-time investment or project. This is also known as the net present worth or NPW of the cash in capital budgeting.
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4. Profitability index. The Profitability index or PI in capital budgeting is the ratio of payoff to an investment of a proposed company project. The PI of an investment is calculated by dividing the PV of future cash flow of the company to its initial investment.
It is important to know the PI of an investment because it allows the company to quantify its expected profit from an invested and thus, be able to identify which project should come first using the result. PI is also interchangeably termed as profit investment ratio (PIR) or value investment ratio (VIR) of a company investment.
These are just some of the things you need to know about capital budgeting.