Capital Budgeting
Capital Budgeting: Net Present Value vs Internal Rate of Return
(Relevant to AAT Examination Paper 4 – Business Economics and Financial Mathematics)
Y O Lam
Capital budgeting assists decision makers in a company evaluate multiple investments of the company’s capital. Capital budgeting is used to plan for the acquisitions of other companies, for the development of new product lines of business, for the expansion of the existing production plants or for the replacement worn-out equipment, and in planning decisions on whether or not to enter a new market line, whether to buy or rent production facilities, and any other investment project resulting in costs and revenues that are spread over a number of years.
Capital budgeting is the method used to assess a major investment or to see whether one option is better than another. There are several capital budgeting methods, each with advantages and disadvantages. In this article, we discuss the basic principle and the advantages and disadvantages of using the net present value technique and the internal rate of return technique.
Net present value (NPV) method
When using the net present value method of capital budgeting, one of most important factors is the estimation of net cash flows from an investment. The net cash flow is the difference between cash outflows and cash inflows over the life of the investment. First, cash flows should be calculated on an incremental basis, and include changes in operating cash flows and changes in investment cash flows. Second, cash flows must be measured on an after-tax basis. Third, non-cash expenses are also considered; for example, depreciation is an expense item but not a cash flow.
Example 1
NP Ltd is considering an initial investment of $100,000 in order to open a new production line for a new product. The expected life of the production line is four years. Sales are estimated to be
$100,000 during the first year and to increase by 10% per year until the
(Relevant to AAT Examination Paper 4 – Business Economics and Financial Mathematics)
Y O Lam
Capital budgeting assists decision makers in a company evaluate multiple investments of the company’s capital. Capital budgeting is used to plan for the acquisitions of other companies, for the development of new product lines of business, for the expansion of the existing production plants or for the replacement worn-out equipment, and in planning decisions on whether or not to enter a new market line, whether to buy or rent production facilities, and any other investment project resulting in costs and revenues that are spread over a number of years.
Capital budgeting is the method used to assess a major investment or to see whether one option is better than another. There are several capital budgeting methods, each with advantages and disadvantages. In this article, we discuss the basic principle and the advantages and disadvantages of using the net present value technique and the internal rate of return technique.
Net present value (NPV) method
When using the net present value method of capital budgeting, one of most important factors is the estimation of net cash flows from an investment. The net cash flow is the difference between cash outflows and cash inflows over the life of the investment. First, cash flows should be calculated on an incremental basis, and include changes in operating cash flows and changes in investment cash flows. Second, cash flows must be measured on an after-tax basis. Third, non-cash expenses are also considered; for example, depreciation is an expense item but not a cash flow.
Example 1
NP Ltd is considering an initial investment of $100,000 in order to open a new production line for a new product. The expected life of the production line is four years. Sales are estimated to be
$100,000 during the first year and to increase by 10% per year until the