Unit 4 PDF
Unit 4 PDF
Unit 4 PDF
Example:
An enterprise plans to invest $100,000 to enhance its
manufacturing process. It has two mutually independent options
in front: Product A and Product B. Product A exhibits a
contribution of $25 and Product B of $15. The expansion plan is
projected to increase the output by 500 units for Product A and
1,000 units for Product B.
the incremental cash flow will be calculated as:
(25*500) = 12,500 for Product A
(15*1000) = 15,000 for Product B
The Payback Period for Product A is calculated as:
The Payback Period for Product A & B is calculated as:
Product A = 100,000 / 12,500 = 8 years
This brings the enterprise to conclude that Product B has a shorter payback
period and therefore, it will invest in Product B.
Capital Budgeting
Net Present Value Method
Evaluating capital investment projects is what the NPV method helps the
companies with. There may be inconsistencies in the cash flows created over
time. The cost of capital is used to discount it. An evaluation is done based
on the investment made. Whether a project is accepted or rejected depends
on the value of inflows over current outflows.
𝑁𝑒𝑡 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤
𝑁𝑃𝑉 =
𝑟𝑛
Where : n is no. of years; r : discount rate
Example:
Assuming the values given in the table, we shall calculate
the profitability index for a discount rate of 10%.
So, Profitability Index with 10% discount = $15,807/$10,000 = 1.5807
As per the rule of the method, the profitability index is positive for the 10%
discount rate, and therefore, it will be selected
Capital Budgeting
Internal Rate of Return:
Internal rate of return (IRR) is the discount rate that makes Present value
(PV) of cash outflows equal to PV of cash inflows of an investment project.
The term 'Internal Rate of Return' is used in three senses. It is the rate of
growth of an investment, secondly, it is the highest rate of interest that an
investor could pay for borrowed funds to finance the investment. The third
interpretation is that the rate of discount (interest) that equates Net Present
Value of cash inflows with present value of outflows. Internal Rate of
Return= Discount rate that makes NPV=0;
implies discounted cash inflows are equal to discounted cash outflows.