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Capital Budget Essay Example

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Capital Budget

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Regarded as the discounting rate that equate the present value of expected cash outflow to the present value of expected cash inflow such that net present values equals to zero. Internal rate of return is the minimum required rate of return from an investment; therefore it measures the efficiency of an investment. In investment appraisal for mutually exclusive project the higher the internal rate of return this reflect that the project is more profitable. The decision criterion under this method is; accept the project if IRR is greater than the company cost of capital, if the IRR is equal to the company cost of capital consider other factors and reject the project if IRR is lower than the company cost of capital (Shapiro, 2005).Average rate return refers to the ratio of total cash inflow to the total amount or initial invested; it measures the profitability of an investment. Under this technique the higher the figure the better, as it showcases higher profitability. Usually, the management set the company ARR in order to evaluate the viability of the company. If the project ARR is greater than the predetermined ARR then the company should accept the project and reject if it is below the company ARR. In addition the company should consider factors if the project ARR is equal to that of the company. The major limitation of this technique is that it fails to acknowledge the concept of time value of money (Shapiro, 2005).Profitability index, this technique is ratio of present value of all future cash inflows to the total amount invested in the project (initial investment), it quantity the amount of value produced per unit investment. In ranking mutually exclusive project the index the higher the profitability of the investment. The selection criterion under this technique is accept the project if the index is greater than one and reject if lower than one.Assuming a free market interest rates of 10% and risk premium of 4.5% (inflation rate in the country) the cost capital of Guillermo Furniture will be 14.5% (Madura, 2009) and the life of the investment to be infinite( perpetuity), we will calculate the present values of cash inflow as follows,The firm should switch from the current production plan to high tech production since this option has the highest net present value. This implies, adoption of high-tech production will increase the profitability of the company.In the above analysis the computation of net present value the economic

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Works Cited

Madura, J. (2009). International Financial Management. Mason, Ohio : Cengage Learning.

Shapiro, A. (2005). Capital budgeting and investment analysis. Upper Saddle River, New Jersey: Pearson/Prentice Hall.

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