Capital budgeting is the process a business undertakes to evaluate potential major projects or investments. Construction of a new plant or a big investment in an outside venture are examples of projects that would require capital budgeting before they are approved or rejected. As part of capital budgeting, a company might assess a prospective project's lifetime cash inflows and outflows to determine whether the potential returns that would be generated meet a sufficient target benchmark.
The capital budgeting process is also known as investment appraisal. Ideally, businesses would pursue any and all projects and opportunities that enhance shareholder value and profit. However, because the amount of capital or money any business has available for new projects is limited, management uses capital budgeting techniques to determine which projects will yield the best return over an applicable period.
Although there are numerous capital budgeting methods , below are a few that companies can use to determine which projects to pursue. Discounted cash flow DCF analysis looks at the initial cash outflow needed to fund a project, the mix of cash inflows in the form of revenue , and other future outflows in the form of maintenance and other costs.
These cash flows, except for the initial outflow, are discounted back to the present date. The cash flows are discounted since present value states that an amount of money today is worth more than the same amount in the future.
With any project decision, there is an opportunity cost , meaning the return that is foregone as a result of pursuing the project. In other words, the cash inflows or revenue from the project needs to be enough to account for the costs, both initial and ongoing, but also needs to exceed any opportunity costs. With present value , the future cash flows are discounted by the risk-free rate such as the rate on a U.
Treasury bond, which is guaranteed by the U. The future cash flows are discounted by the risk-free rate or discount rate because the project needs to at least earn that amount; otherwise, it wouldn't be worth pursuing. Also, a company might borrow money to finance a project and as a result, must at least earn enough revenue to cover the cost of financing it or the cost of capital. Publicly-traded companies might use a combination of debt—such as bonds or a bank credit facility —and equity —or stock shares.
The cost of capital is usually a weighted average of both equity and debt. The goal is to calculate the hurdle rate or the minimum amount that the project needs to earn from its cash inflows to cover the costs. A rate of return above the hurdle rate creates value for the company while a project that has a return that's less than the hurdle rate would not be chosen.
Project managers can use the DCF model to help choose which project is more profitable or worth pursuing. Projects with the highest NPV should rank over others unless one or more are mutually exclusive. However, project managers must also consider any risks of pursuing the project. Payback analysis is the simplest form of capital budgeting analysis, but it's also the least accurate.
It's still widely used because it's quick and can give managers a "back of the envelope" understanding of the real value of a proposed project. Payback analysis calculates how long it will take to recoup the costs of an investment.
The payback period is identified by dividing the initial investment in the project by the average yearly cash inflow that the project will generate. The primary advantage of implementing the internal rate of return as a decision-making tool is that it provides a benchmark figure for every project that can be assessed in reference to a company's capital structure. The IRR will usually produce the same types of decisions as net present value models and allows firms to compare projects on the basis of returns on invested capital.
Despite that the IRR is easy to compute with either a financial calculator or software packages, there are some downfalls to using this metric. Similar to the PB method, the IRR does not give a true sense of the value that a project will add to a firm—it simply provides a benchmark figure for what projects should be accepted based on the firm's cost of capital.
The internal rate of return does not allow for an appropriate comparison of mutually exclusive projects; therefore managers might be able to determine that project A and project B are both beneficial to the firm, but they would not be able to decide which one is better if only one may be accepted.
Another error arising with the use of IRR analysis presents itself when the cash flow streams from a project are unconventional, meaning that there are additional cash outflows following the initial investment. Unconventional cash flows are common in capital budgeting since many projects require future capital outlays for maintenance and repairs. In such a scenario, an IRR might not exist, or there might be multiple internal rates of return.
In the example below two IRRs exist— The IRR is a useful valuation measure when analyzing individual capital budgeting projects, not those which are mutually exclusive.
It provides a better valuation alternative to the PB method, yet falls short on several key requirements. The net present value approach is the most intuitive and accurate valuation approach to capital budgeting problems.
Discounting the after-tax cash flows by the weighted average cost of capital allows managers to determine whether a project will be profitable or not.
The NPV rule states that all projects with a positive net present value should be accepted while those that are negative should be rejected. If funds are limited and all positive NPV projects cannot be initiated, those with the high discounted value should be accepted. Some of the major advantages of the NPV approach include its overall usefulness and that the NPV provides a direct measure of added profitability.
It allows one to compare multiple mutually exclusive projects simultaneously, and even though the discount rate is subject to change, a sensitivity analysis of the NPV can typically signal any overwhelming potential future concerns. Although the NPV approach is subject to fair criticisms that the value-added figure does not factor in the overall magnitude of the project, the profitability index PI , a metric derived from discounted cash flow calculations can easily fix this concern.
The profitability index is calculated by dividing the present value of future cash flows by the initial investment. Weighted average cost of capital WACC may be hard to calculate, but it's a solid way to measure investment quality.
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I Accept Show Purposes. Your Money. Personal Finance. Your Practice. Popular Courses. Table of Contents Expand. What Is Capital Budgeting? Understanding Capital Budgeting. A simple method of capital budgeting is the Payback Period.
The number of years required to recoup the investment is six years. The Payback Period analysis provides insight into the liquidity of the investment length of time until the investment funds are recovered. However, the analysis does not take this into account and the Payback Period is still six years. Three capital projects are outlined in Table 1.
Project C has the shortest Payback Period of two years. Project B has the next shortest Payback almost three years and Project A has the longest four years. Thus, the Payback Period method is most useful for comparing projects with nearly equal lives. The Payback Period analysis does not take into account the time value of money. The discount rate for a company may represent its cost of capital or the potential rate of return from an alternative investment.
For example, it takes 3. It takes an additional 1. The present value of the initial investment is its full face value because the investment is made at the beginning of the time period. From a different perspective, a positive negative Net Present Value means that the rate of return on the capital investment is greater less than the discount rate used in the analysis.
The discount rate is an integral part of the analysis. The discount rate can represent several different approaches for the company. It may represent the rate of return needed to attract outside investment for the capital project.
Or it may represent the rate of return the company can receive from an alternative investment. The Threshold Rate of Return may represent an acceptable rate of return above the cost of capital to entice the company to make the investment.
Choosing the proper discount rate is important for an accurate Net Present Value analysis.
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