Capital budget

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In a recession, regardless of where they work in your organization, and understanding of financial concepts to help you do your job better and contribute to the community's efforts to stay in business and continue to reap the profits. And the concentration of companies are now more than ever, the numbers of those who are trying to stay afloat, and you can become financially faster read and write and begin to contribute to the talks on the bottom line, the faster will be able to help the team.

Funding is the science of money management. Areas of public finance, corporate finance and personal finance (financing from the private sector), and public finance. This includes financing and save money and often include borrowing money. The field of financial transactions with the concepts of time and money, risk, and how they were connected. It also looks at how to spend the money and the budget.

One of the aspects of funding through individuals and businesses, that money is deposited in the bank. Then the bank lends money to other individuals or companies for the purpose of consumption or investment and interest costs on loans.

Loans have become increasingly packaged for resale, which means that the investor purchases the loan (debt) from a bank or directly from the company. Bonds and debt instruments sold to investors for organizations such as governments, companies or charities. The investor can then press on the debt and collect interest or sell the debt on the secondary market. The main banks and brokers for financing through the provision of credit, although private equity, investment funds, hedge funds, and other organizations are the importance of investing in various forms of religion. Managed financial assets, known as investments, with a focus on financial risk management to control financial risks. Financial instruments are traded that allows many forms of asset-backed securities in the securities markets, and stock exchanges, including debt such as bonds and shares in listed companies.

Central banks, such as banks, Federal Reserve System of the United States and the Bank of England in the United Kingdom, are strong players in the field of public finances, the lender of last resort, as well as the strong influence of monetary and credit conditions in the economy.

Capital budget

And capital expenditure is spending money for the project which is expected to produce cash flow for a period exceeding one year. Examples of projects include investments in property, plant and equipment, research and development, and large advertising campaigns, or any other project requires capital expenditure and generates a stream of future cash flows.

Because the capital expenditures could be quite large and have a significant impact on the financial performance of the company, given great importance to the selection of projects. This process is called capital budgeting.

Criteria for capital budgeting decisions

Potentially, a wide range of criteria for the selection of projects. Some shareholders may be the company to identify projects that demonstrate peaks immediate cash flow, and others may want to emphasize the long-term growth with little importance on performance in the short term. Viewed in this way, it would be very difficult to meet the diverse interests of all shareholders. Fortunately, there is a solution.

The company's goal is to maximize current shareholder value. This goal requires that the projects should be undertaken that lead to positive net present value, ie the present value of expected cash flows, and net present value of capital spending required. Using the net present value (NPV) as a measure of the capital budget involves identifying projects that increase the value of the company, because they have a positive net present value. The timing and rate of growth of cash flows from the important only to the extent of their impact on the net present value.

Using the net present value as the standard by which to identify projects presumed efficiency of capital markets so that the company has access to all that is required capital projects to follow up positive net present value. In cases where this is not the case, there may be capital rationing and capital budgeting process becomes more complicated.

Note that it is the responsibility of the company to decide whether to please a certain group of shareholders who prefer more or less long-term results. Once the company had chosen these projects to maximize the net present value, and it is up to individual shareholders to use capital markets to borrow or lend in order to move the exact date of the cash flows of the forward or backward. This basic idea in principal agent relationship exists between shareholders and managers. Despite all the choices may be individual, and the common goal is to maximize the present value of the company.

Alternative rules for the capital budget

While the net present value is the rule that maximizes value for shareholders, always, and some companies use other criteria to decide on the capital budget, such as:

  • internal rate of return on self)
  • Profitability indicator
  • Payback period
  • Back to Book Value

In some cases, investment decisions arising from the internal rate of return and profitability index methods agree with those of the net present value. Decisions taken by the recovery period and return on book value methods are usually not optimal from the standpoint of the value of shares to the maximum extent.

Pay period

What is the size

How long does it take to recover the funds invested in the project.

Why is it important

On a straight line method, recovery period is the easiest way to determine the potential of investment in a large project. The management expressed in a timely manner, and will take several months or years to recover the initial cost of the project cash consideration is always vital, particularly for managers to evaluate projects at one time.

This assessment becomes even more important if you include the consideration of what the present value of revenues in the future will be. How does it work in practice

Amortization period is the correct formula is as follows:

Payback period = cost of the project's annual cash receipts ÷

Thus, if a project costs $ 100,000 and would generate $ 28,000 per year, the payback period is:

100000 ÷ 28000 = 3.57 years

If the expected revenues generated by the project to vary from year to year, as well as the projected income for each year up to an additional total cost of the project.

For example, say that the expected revenues generated by the project is $ 100,000



















Thus, the project will be fully paid for in 4 years, because in that year that the total income reaches the initial cost of $ 100,000.

Complicated the picture when you enter the time value of money principle in the calculations. Some experts insist this is necessary to determine the recovery period more accurately. Accordingly, should be used in the present value tables, or the computer (now the norm), and should be discounted annual income in the rate of interest applied, and 10% in this example. In this way, give results significantly different:



Present value






















This method indicates that the recovery will not occur until after five years.

Tricks of the trade

  • Obviously, a major flaw of the straight line recovery period is that it ignores the principle of time value of money, which, in turn, can result in unrealistic expectations.
  • The second drawback is that it ignores the benefits produced after a period of consumption and, consequently, a project which has a million U.S. dollars will come back after, say, six years and can be classified as less of a project with the recovery of three years which returns only 100 thousand dollars at a later time.
  • Another alternative to calculate the amortization period is the status of internal rate of return.
  • In most of the experiments and projects with shorter recovery times superior to those with more of the profits, even if that promise higher returns. Can be affected by factors such as the repayment periods of market changes, changes in interest rates, and economic transformations. Cash dividend shorter also enable companies to recover the initial investment and put to work elsewhere.
  • In general, the recovery period for a period of three years or less desirable, if the period of recovery of the project is less than a year, and some believe that it should be considered to be essential.

Internal rate of return

Internal rate of return (IRR) is a joint evaluation metric used by financial analysts to calculate and assess the financial attractiveness / feasibility projects or capital-intensive investments.

The internal rate of return is usually easier to understand the result of the discounted cash flow analysis (ie, the net present value or net present value) for managers of non-financial, is often used to explain and justify investment decisions; Although the modeler good financial know that the internal rate of return is after all an estimated, especially when calculated in Excel, and should be used in combination with other financial parameters such as net present value and valuation multiples compared to when the issue of providing employment or investment.

What exactly is the internal rate of return? The internal rate of return is the interest rate that makes net present value of all cash flows equal to zero. In terms of financial analysis, and could be called the internal rate of return discount rate at which the current value of a series of investment equals the present value of investments.

All projects or investments with an internal rate of return that is calculated in the process of financial modeling to be superior to the weighted average cost of capital should be (or WACC) is a financially viable and technically acceptable.

When choosing between projects or investments where the benefits or services are completely independent of each other in the modeler good financial should be considered in the project or investment, according to the highest internal rate of return is calculated to be financially attractive, as long as we continue to keep in mind that it is not must be of the value of internal rate of return greater than WACC.

Net present value

I plan to write the net present value of a little 'After discussing how to calculate the discounted cash flows and net present value to calculate the value of this site. Not since I wrote about the financial at the moment, I thought that there may be a good change of pace.

When we calculate the discounted cash flows, in essence what we are trying to do is calculate the value of all future cash flows at a certain time, often more at this time. As mentioned above, in order to do this, you need to know or expected future cash flows in each period, as happened in the mind discount rate that reflects the seriousness of this project or the events that led to cash flow.

One way to determine if the project is approved or not is to look at the net present value (NPV). High-level discounted cash flow net present value are very similar. Based on net present value to compare the present value of cash flows to cash flows, and calculate every person can become complex depending on how the company is (or borrowing unleveraged), to make a decision on what to include or exclude, and can interact with the tax to get the lyrics. Therefore, to simplify this discussion on the internal rate of return, and I use the experiences in the financial accounts net present value of the evidence.


Present value refers to today's value of a future amount.

Present Value Formula:

S P = ------------ (1+rt)

Instead of beginning with the principal which is invested, you could start from what you want to accumulate in the future, and then work backward to see the amount that you must invest to reach the required amount.


For example, if you wish to retire within a certain number of years you can begin working in reverse to determine what amount must be invested today to accumulate the desired amount at the time of your retirement in the future.


Assume you need $20,000 in three years for a down payment on a house. If the simple interest rate is 5%, how much would you have to invest today to accumulate the $20,000 in three years?

In this example:

S= $20,000 (amount of maturity value)

t = 3 years

r = 0.05

The calculation for principal is:


P = ----------



P = -------------

[1 + (0.05)3]


P = -------------


P = $17,391.30

Therefore, if you invest $17,391.30 today at 5% simple interest, you will have $20,000 in three years.

Let's check it out:

nterest per year = $17,391.30 x 0.05 = $869.57

Interest for three years = $869.57 x 3 = $2,608.70

Therefore, the amount available for down payment at the end of three years is $17.391.30 + $2,608.70 = $20,000

Instead of 5% simple interest, consider 5% compound interest payable semiannually:

Formula to be used:

P = S(1+i)^-n

S = 20,000

i = 0.05 / 2 = 0.025

n = 2 x 3 = 6

P = $ 20,000(1+0.025)^-6

= $ 20,000(1.025)^-6

= $ 20,000 x 1



= $ 20,000 / 1.16

= $ 17,241.38

Let's check it out using the compound interest formula:

S = P(1 + i)^n

= $ 17,241.38(1 + 0.025)^6

= $ 17,241.38(1.025)^6

= $ 17,241.38 x 1.16

= $ 20,000