Capital Budgeting

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Capital budgeting techniques

Mei Po thinks about her long-term investment—expanding her store's square footage.

Net Present Value = \ \frac{C_t}{(1+r)^{t}} - {C_0}. Where t = the time of the cash flow, n = the total time of the project, r = the discount rate, Ct = the net cash flow (the amount of cash) at time t. C0 = the capital outlay at the beginning of the investment time ( t = 0 )

Capital budgeting is the process of identifying the potential return on a given investment to determine whether the investment makes sense, and to compare alternative investment options. If many different departments are competing to have projects funded, you may be asked to justify your proposals using capital budgeting techniques:

  1. Prepare a schedule of estimated cash flows that identifies outlays, the timing of those outlays, and the expected cost savings or revenue that will result from the investment. For substantial investments, consider annual cash flows over a period of several years. If an expense will be capitalized, the full outlay is recorded for the year that it is incurred. Also record the expected tax savings that will result in subsequent years as capitalized items are depreciated.
  2. Calculate the net present value (NPV) of the cash flows using appropriate interest rates.
  3. Net present value is the current value of future cash flows—calculated by dividing each future cash flow by the compounded interest rate, and then adding up all of the discounted cash flows. You can create a spreadsheet (for situations where cash flows or the interest rates used are different from year to year) or use a financial calculator (if the cash flow and interest rate is constant throughout the period).

    The formula is:

    where each CF is a future cash flow, "n" is the number of years over which the cash flow is expected to occur, and "i" is the interest rate.

    Some experts suggest that the interest rate should be based on the company's cost of capital, while others recommend using a risk-adjusted rate that reflects the uncertainty of the future cash flows.

  4. A positive net present value indicates that the investment will potentially benefit the company, while a negative net present value indicates a losing proposition.

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