CSS Solved Business Administration Past Papers | Discuss the three common capital budgeting decision techniques with examples and formulas.
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Topic Breakdown
The three capital budgeting techniques are payback period, net present value and Internal rate of return. The concept and formulas of capital budgeting must be clear to students as it is often given in CSS exams.
Topic: Capital Budgeting
Subject: Financial Management
Introduction:
Capital budgeting is one part of financial management. It is very crucial for investors. Before investing in the project, stakeholders need a clear view of the viability of the project. The three capital budgeting techniques are Payback Period, Net Present Value and Internal Rate of Return. All three combined give an illusive overview of the viability of the project.
Data for Calculating Payback Period, NPV and IRR:
| Year | Cash flow | Amount |
| 0 | Initial Cash flow | (100000) |
| 1 | Cash flow 1 | 35000 |
| 2 | Cash flow 2 | 38000 |
| 3 | Cash flow 3 | 41000 |
| 4 | Cash flow 4 | 39000 |
Three Capital Budgeting Techniques:
1) Pay Back Period:
It is the simplest way to determine the viability of a new asset investment. This method determines the time period in which the asset cost will be recovered from its operational benefits. The quicker the payback period more viable the project is.
- Formula:
2) Net Present Value:
The second Technique of capital budgeting is the net present value. The worth of money does not remain the same over a period of time. This method uses discounted cash flows to account for inflation and other factors. This technique gives us a summary if the project will be profitable in future or not. However, one big drawback is that it is totally based on the assumption
To calculate NPV for the above cash flows, lets assume a required rate of return to be 14%
- Formula:
3) Internal Rate of Return:
The most complex and reliable of the three techniques is the internal rate of return. In this method, the rate of return on asset is compared to the financing cost. If the rate of return is more than the cost, then the project is viable.
- Formula:
Hence, if the cost of the project is above IRR, then the project is not profitable.
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