What is Capital Budgeting?

Capital budgeting, also known as investment appraisal ,can simply be defined as the process of planning, used to determine whether an organization’s long term investments in items like replacement of machinery, new machinery, new products, new plants and other R & D projects are worth pursuing. So, it is simply the budgeting for investment, major capital, or expenditures.

There are many formal methods that are used in the technique of capital budgeting, such as-

Net present value
Accounting rate of return
Profitability index
Modified internal rate of return
Internal rate of return
Equivalent annuity

Some hybrid and simplified methods are also used, like discounted payback period and payback period.

Net present value
This method of valuation requires estimating the timing and size of all of the cash flows (incremental) from the project. These future cash flows are then discounted in order to determine their actual present value. Finally, these present values will be summed up in order to get the Net Present Value i.e. NPV. On the basis of this NPV value, financial managers take decision about an investment project. The decision rule of the NPV method is simply to accept all those projects that are having positive NPV value in an unconstrained environment; in other words, if the projects are mutually exclusive, then we will accept the one that is having the highest NPV.

The NPV is highly dependent upon the discount rate, so selecting the most appropriate rate— sometimes known as the hurdle rate–is very critical for making the right decision by the NPV method. The hurdle rate can be defined as the minimum acceptable return on an investment. The hurdle rate should always reflect the riskiness of an investment, which will be typically measured by the volatility of various cash flows, and it should also take into account the financing mix.
Managers usually use models like APT or CAPM in order to estimate the discount rate which is suitable for each particular project, and they may use the weighted average cost of capital (WACC) for reflecting the financing mix selected. One of the most common practices in choosing a suitable discount rate for a project is simply to implement a WACC that applies to the entire firm, but it has been observed that a higher discount rate is usually more appropriate when the risk involved in the project is higher than the risk of the whole firm.

Internal rate of return
The internal rate of return i.e. IRR can simply be defined as the discount rate which simply produces a NPV (net present value) of zero. It is the most commonly used measure of finding the investment efficiency.

The IRR method will also facilitate the same kind of decisions as taken in the NPV method for projects (non-mutually exclusive) in an unconstrained environment, also in the usual cases where, at the start of the project, a negative cash flow occurs but is followed by all positive cash flows. It can be postulated that in most realistic cases, those projects that are having IRR higher than the hurdle rate should always be accepted. But, for the mutually exclusive projects, we should select a project that is having a lower value of NPV.

Written by Lucas Beaumont

Generalist. Wikipedia contributor. Elementary school teacher from Saskatchewan, Canada.

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