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Capital_Budgeting_Assignment

Capital budgeting is the process of evaluating major investments to determine their potential returns. Key techniques include Net Present Value (NPV), Internal Rate of Return (IRR), Trial and Error, Interpolation, and Payback Period, each providing different insights into the profitability and feasibility of projects. These methods are essential for businesses to allocate resources effectively and maximize financial benefits.

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Mohsin Khan
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14 views

Capital_Budgeting_Assignment

Capital budgeting is the process of evaluating major investments to determine their potential returns. Key techniques include Net Present Value (NPV), Internal Rate of Return (IRR), Trial and Error, Interpolation, and Payback Period, each providing different insights into the profitability and feasibility of projects. These methods are essential for businesses to allocate resources effectively and maximize financial benefits.

Uploaded by

Mohsin Khan
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Assignment: Capital Budgeting and Its Types

Name: [Your Name]

Subject: Financial Management

Submitted to: [Instructor's Name]

Date: [Date]

What is Capital Budgeting?

Capital Budgeting is the process through which a business evaluates potential major investments or expenditures.

These decisions typically involve projects such as purchasing new machinery, expanding operations, or launching new

products. Capital budgeting helps in determining whether such investments will yield desired returns in the long run.

1. Net Present Value (NPV)

Definition:

NPV is the difference between the present value of cash inflows and the initial investment. It helps determine whether a

project is profitable.

Formula:

NPV = Sum (Rt / (1 + r)^t ) - C0

Where:

Rt = Cash inflow at time t

r = Discount rate

t = Time period

C0 = Initial investment
Assignment: Capital Budgeting and Its Types

Example:

A project requires an initial investment of Rs. 12,000. It is expected to generate Rs. 5,000 annually for 3 years. The

discount rate is 10%.

NPV = 5000/(1+0.10)^1 + 5000/(1+0.10)^2 + 5000/(1+0.10)^3 - 12000

= 4545.45 + 4132.23 + 3756.57 - 12000 = Rs. 434.25

Conclusion: Since NPV > 0, the project is acceptable.

2. Internal Rate of Return (IRR)

Definition:

IRR is the discount rate at which the NPV becomes zero. It indicates the expected rate of return of the project.

Formula:

0 = Sum (Rt / (1 + IRR)^t ) - C0

Example:

Investment = Rs. 10,000

Annual cash inflow = Rs. 4,000 for 3 years

Try different discount rates to find when NPV approximately 0:

- At 14%: NPV approximately +Rs. 72

- At 16%: NPV approximately -Rs. 55

3. Trial and Error Method


Assignment: Capital Budgeting and Its Types

Definition:

Trial and error is used to estimate IRR by testing various discount rates until the NPV is close to zero.

Example:

Using the IRR example:

At 14%:

NPV = 4000/1.14 + 4000/1.14^2 + 4000/1.14^3 - 10000 approximately 72

At 16%: NPV approximately -55

4. Interpolation Method

Definition:

Interpolation is used to calculate the IRR more accurately when NPV is positive at one rate and negative at another.

Formula:

IRR = r1 + [(NPV1 / (NPV1 - NPV2)) * (r2 - r1)]

Example:

r1 = 14%, NPV1 = 72

r2 = 16%, NPV2 = -55

IRR = 14 + [72 / (72 - (-55)) * (16 - 14)] = 14 + 1.13 = 15.13%

5. Payback Period

Definition:
Assignment: Capital Budgeting and Its Types

The payback period is the time taken to recover the initial investment from project cash inflows.

Formula:

Payback Period = Initial Investment / Annual Cash Inflow

Example:

Initial Investment = Rs. 15,000

Annual Cash Inflow = Rs. 5,000

Payback Period = 15000 / 5000 = 3 years

Conclusion

Capital budgeting techniques such as NPV, IRR, Payback Period, Trial and Error, and Interpolation play a vital role in

assessing investment decisions. They help ensure a business allocates resources to the most financially beneficial

projects.

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