How to Calculate Capital Budgeting

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As the financial manager of a firm you are expected to find and implement investments that produce high cash flows and rates of return. Financial managers often sort through the good and bad investments by calculating the capital budget. Cash flow, payback, discounted payback, net present value and profitability index are all used to calculate a capital budget.

Estimate the investment cash flows. Start with years zero through five. Decide how much the investment will cost up front and how much return it will give in the following five years.

Calculate the payback. This will determine when you will get back your original cash investment. Take the balance of cash you used to get into the investment, then subtract that from the cash flow for each year until you reach a positive number.

Configure the discounted payback by discounting the cash flows. Reduce the future payments to the investment by the cost of capital.

Calculate the net present value by adding up all of the discounted cash flows. You will end up with the final running total number that will tell you to either invest (positive number) or not invest (negative number).

Find the profitability index by dividing the net present value by the total investment.

Analyze each of these factors and decide if the investment is worth taking advantage of depending on the number of positive outcomes.