Capital Budgeting Techniques
There are a number of capital budgeting techniques available to an analyst. For our purposes, we will only review net present value and internal rate of return.
Net Present Value
The Net Present Value technique involves discounting net cash flows for a project, then subtracting net investment from the discounted net cash flows. The result is called the Net Present Value(NPV). If the net present value is positive, adopting the project would add to the value of the company. Whether the company chooses to do that will depend on their selection strategies. If they pick all projects that add to the value of the company, they would choose all projects with positive net present values even if that value is just $1. On the other hand, if they have limited resources, they will rank the projects and pick those with the highest NPV's.
The discount rate used most frequently is the company's cost of capital.
What would the net present value for a project with a net investment of $40,000 and the following net cash flows be if the company's cost of capital is 5%? NCFs for year one is $25,000, for year two is $36,000 and for year three is $5000.
|Total Discounted Cash Flows Discounted at 5%||$60,772|
|Less: Net Investment||− $40,000|
|Net Present Value||$20,772|
As discussed in the Time Value of Money Overview, different techniques can be used to determine present value. For this example, we'll use the Present Value Factors Table.