Introduction to Capital Budgeting

Capital budgeting is a process to determine and select profitable projects/investments that will add value to the company including:

• Replacement of equipment
• Develop new products
• Market expansion
• Mandatory investments

Several main analyses are used for the capital budgeting process:

Payback period (PBP) is the # of years it takes to recover the initial cost of an investment. Cumulative Net Cash Flow (NCF) is the running total of the cash flows at the end of each period.

PBP = Full years until recovery + (unrecovered cost at the beginning of the last year/cash flow during the last year)

Example:

Compute the payback period using the cash flows below

PBP = 2 + 50 = 2.25 years

                200

Year Project  NCF

0 -$500  -$500

1 200  -300

2 250  -50

3 200  150

Discounted Payback Period. Discounted PBP discounts the project’s cash flows by the project’s discount rate. Cumulative Discounted Net Cash Flow (DNCF) is the running total of the present value cash flows at the end of each period. It is the # of years it takes to return its initial investment in present value terms.

Example:

Given a 10% discount rate, compute the payback period using the cash flows below.

DPBP = 2 + 112 = 2.75 yrs

                    150

Year Project  DNCF  Cum DNCF

0 -$500  -$500  -$500

1 200  182  -318

2 250  207  -111

3 200  150  38