Capital Budgeting also known as investment appraisal is a process in which a company/business determines whether a particular project such as building a new plant or investing in a long term venture is worth pursuing.
Nov 27 2013 11:03 PM
Popular methods of capital budgeting include-
1.Net present value (NPV)- The difference between the present value of cash inflows and the present value of cash outflows.
NPV is used in capital budgeting to analyze the profitability of an investment or project.
NPV analysis is sensitive to the reliability of future cash inflows that an investment or project will yield.
NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account. If the NPV of a prospective project is positive, it should be accepted. However, if NPV is negative, the project should probably be rejected because cash flows will also be negative.
2.Internal rate of return (IRR)- The discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero. Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project. As such, IRR can be used to rank several prospective projects a firm is considering. Assuming all other factors are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first.
3.Discounted cash flow (DCF) - A valuation method used to estimate the attractiveness of an investment opportunity. Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one.
4.Payback Period - The length of time required to recover the cost of an investment. The payback period of a given investment or project is an important determinant of whether to undertake the position or project, as longer payback periods are typically not desirable for investment positions.
Payback Period = Cost of Project / Annual Cash Inflows
All other things being equal, the better investment is the one with the shorter payback period. For example, if a project costs $100,000 and is expected to return $20,000 annually, the payback period will be $100,000/$20,000, or five years. There are two main problems with the payback period method:
1. It ignores any benefits that occur after the payback period and, therefore, does not measure profitability.
2. It ignores the time value of money.
Because of these reasons, other methods of capital budgeting, like net present value, internal rate of return or discounted cash flow, are generally preferred.