CAPITAL BUDGETING

Capital Budgeting

Alsoknown as "investment appraisal." The process in which a business determines whether projects such as building a new plant orinvesting in a long-term venture are worth pursuing.  Often times,a prospective project's lifetime cash inflows and outflows are assessed inorder to determine whether the returns generated meet asufficient target benchmark.  Popularmethods of capital budgeting include net present value (NPV), internal rate ofreturn (IRR),discounted cash flow (DCF) and payback period.

Annuity

A financial product sold by financial institutions that is designed to acceptand grow funds from anindividual and then, upon annuitization, pay out a stream of payments to theindividual at a laterpoint in time. Annuities are primarily used as a means of securing a steadycash flow for an individualduring their retirement years.  Annuitiescan be structured to provide fixed periodic paymentsto the annuitant or variable payments.  Variable annuities is to allow the annuitant to receivegreater payments if investments of the annuity fund do well and smallerpayments if its investmentsdo poorly.

Average Annual Net Income

Net incomerepresents the amount of money remaining after all operating expenses, interest, taxesand preferredstock dividends (but not commonstock dividends) have been deductedfrom a company's total revenue.   Net incomeis also referred to as the bottom line, net profit or net earnings. The formula for net incomeis as follows:

Total Revenue � TotalExpenses = Net Income

AVERAGEANNUAL NET  INCOME =     TOTAL INCOME___

                                                                          NUMBER OF YEARS

Discounting

Theprocess of determining the present value of a payment or a stream of paymentsthat is to be received in the future. Given the time value of money, a dollaris worth more today than it would beworth tomorrow given its capacity to earn interest. Discounting is the methodused to figure outhow much these future payments are worth today. Discounting is one of the core principals of finance and is the primary factor used inpricing a stream of cash flows, such as those found ina traditional bond or annuity. For example, the succession of coupon paymentsfound in a regularbond is discounted by a certain interest rate and summed together with thediscounted par valueto determine the bond's current value.

Internal rate of return

Sometimesreferred to as "economic rate of return (ERR)," is the discount rateoften used in capitalbudgeting that makes the net present value of all cash flows from a particularproject equalto zero. Generally speaking, the higher a project's internal rate of return,the more desirable itis to undertake the project. As such, IRR can be used to rank severalprospective projects a firmis considering. Assuming all other factors are equal among the variousprojects, the project withthe highest IRR would probably be considered the best and undertaken first IRRscan be compared against prevailing rates of return in the securities market. Ifa firm can't findany projects with IRRs greater than the returns that can be generated in thefinancial markets,it may simply choose to invest its retained earnings into the market.

Payback period

Thelength of time required to recover the cost of an investment. The paybackperiod of a given investment or project is an important determinantof whether to undertake the position or project,as longer payback periods are typically not desirable for investment positions.

Present value/discounted value

Thecurrent worth of a future sum of money or stream of cash flows given aspecified rate of return.Future cash flows are discounted at the discount rate, and the higher thediscount rate, the lowerthe present value of the future cash flows. Determining the appropriatediscount rate is the keyto properly valuing future cash flows, whether they be earnings or obligations.  Thebasis is that receiving $1,000 now is worth more than $1,000 five years fromnow, because ifyou got the money now, you could invest it and receive an additional returnover the five years.

Return on average investment

A performance measure used toevaluate the efficiency of an investment or to compare the efficiency of anumber of different investments. To calculate ROI, the benefit (return) of aninvestment is divided by the cost of the investment; the result is expressed asa percentage or a ratio.  The return on investment formula:
In the above formula "gainsfrom investment", refers to the proceeds obtained from selling theinvestment of interest. Return on investment is a very popular metric becauseof its versatility and simplicity. That is, if an investment does not have apositive ROI, or if there are other opportunities with a higher ROI, then theinvestment should be not be undertaken.