Capital Budgeting Essay

690 WordsJan 4, 20153 Pages
Capital Budgeting Student’s Name Grade Course Tutor’s Name 14, 10, 2014 Outline 1. Introduction 2. Capital budgeting techniques 3. References Introduction “Capital budgeting is a planning process used to determine whether an organization's long term investment projects are worth the funding of cash through the firm's capitalization structure (debt, equity or retained earnings)” (Gervais, Heaton & Odean, 2011, p. 1737). Resources are naturally scarce. Therefore, proper allocation should be done. The main aim of capital budgeting is to make the company more valuable to the shareholders. In most cases, the cash inflow of a project is compared to its cash outflow. The comparison helps to determine whether the cash generated in the project meets the requirement of the company. The requirement in this case is whether the project will yield returns. There are various capital budgeting techniques employed in determining whether a project will yield good returns to the company. Commonly used capital budgeting techniques include Net Present value (NPV), Payback period, Profitability Index (PI), and Internal Rate of Return (IRR) (Zimmerman & Yahya-Zadeh, 2011). Capital budgeting techniques Payback period (PBP) “This method gauges the viability of a venture by taking the inflows and outflows over time to ascertain how soon a venture can pay back, and for this reason PBP (or payout period or payoff) is that period of time or duration it will take an investment venture to generate sufficient cash inflows to pay back the cost of such investment” (Zimmerman & Yahya-Zadeh, 2011, p. 258). Its calculation involves dividing capital investment by net annual cash flow. There are cases where the net annual cash flow is not the same. This method is advantageous where the company is planning to operate for a certain time, i.e. it has a specific

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