Capital Budgeting

Answer

1. Traditional Techniques of capital budgeting
   
   1. Average rate of return: The accounting rate of return (ARR) equals the average annual after tax accounting profit generated by the investment divided by the average investment, ie.
      ARR=(average annual profit from investment)/((I+S)/2)
   2. Pay back period method: The payback period is the length of time it takes to recover the initial investment on a project.
2. Discounted cash-flow Techniques of capital budgeting
   
   1. Net Present value Method(NPV)
      The present value rule states that an investment should be adopted only if the present value of the cash flow it generates in the future exceeds its cost, that is, if it has a positie net present value (NPV). The net present value of a assets equals
      NPV=present value of future cash flows - Initial cost
      =cf1/1+K + cf2/(1+K)² + ------ cf2ⁿ/(1+K)ⁿ
      Where cf₁= cash flow in period 1
      ----------------------------------
      Where cf_n= cash flow in period n
      k= cost of capital
      I= Initial cost
      
   2. Profitability Index: A measure of the profitability of an investment computed by deviding the net present value by the initial cost of the investment. The profitability index (PI) can be found with help of the formula
      PI=Present value of cash in flows/Initial investment
      
   3. Internal rate of return (IRR):
      An internal rate of return (IRR) is the rate we expect to earn on an investment project. The IRR is the rate which discount a projects cash flow to an NPV of zero. Lettering r signify the IRR, an investments IRR is that rate r which satisfy the flowing relationship
      0=cf1/1+r + cf2/(1+r)² + ------ cf2^r/(1+r)ⁿ - I
      =cf1(P/E,r,1) + cf2(P/E,r,2) + -------------------------cfn(P/E,r,n) - I
      If the cash flow returns are a level annuity, that is, if cf1=cf2=..........................=cfn=cf then (1) becomes
      0=cf/1+r + cf/(1+r)² + ------ cf^r/(1+r)ⁿ - I
      =cf(P/A, r, n) - I