Capital Budgeting

Christian Collor

QRB/501

December 8, 2013
Mr. Rene Cintron

CAPITAL BUDGETING

There are many different methods business owners use to efficiently analyze business investment. One of these effective methods is the calculation of the net present value. The second most effective method would be the calculation of the internal rate of return. There are also other useful methods as well, for example, the payback rule and the profitability index. Many business owners use the above procedures to help them in their decision making of acquiring other businesses.

The Net Present Value is important to a project because if the cost of the investment is going to be, or is more than the revenue from that project, then it may be more cost effective to shut down the project all together rather than lose more money. If multiple projects are available, then it is wise to first calculate the Net Present Value for each project, choose those that have a positive Net Present Value, and reject the ones that have zero or negative Net Present Values. Furthermore, the Internal Rate of Return method can be used, and generally, they should provide the same ranking of the projects because the projects with high Net Present Value also tend to have high Internal Rate of Return.

There are many reasons the Internal Rate of Return is important to a company. If the rate of return is insufficient, it means additional cash is outflowing from the company than is inflowing into the company. According to (Sharon, 1983). This could lead to negative working capital. The Internal Rate of Return is important for a company to understand, so if necessary, they can afford to finance more activity or if necessary, they then can invest additional money.

The formula used to calculate the PV is future value times (1/((1+i)^n)) = present value. This