In this paper, I have discussed at length the concept of capital budgeting, its advantages and use. Capital budgeting projects typically includes potentially long-term investments, are predicted to yield cash flows over several years. The choice to accept or reject a Capital Budgeting project relies on an analysis of the cash flows created by the project and its cost. There are more hybrid and simplified methods such as payback period and discounted payback period. Many formal methods are used in capital budgeting, including the techniques such as accounting rate of return, net present value, and profitability index, internal rate of return, modified internal rate of return, equivalent annuity and real option analysis.
Capital budgeting also known as investment appraisal refers to the planning process which is a helpful tool in determining the worth of organization’s long term investments such as new machinery, new plants, products, and research development. It is budget for major capital, or investment, expenditures. (Sullivan, 2003)
Capital budgeting projects usually involves potentially long-term investments, are projected to produce cash flows over several years. The choice to accept or reject a Capital Budgeting project hinges on an analysis of the cash flows created by the project and its cost.
The capital budgeting must meet certain criteria. These methods entail Pay Back Period, Net Present value, and Internal Rate of return. They use the incremental cash flows from each potential investment, or project. Techniques based on accounting earnings and accounting rules are sometimes used - though economists consider this to be improper - such as the accounting rate of return, and "return on investment." Simplified and hybrid methods are used as well, such as payback period and discounted payback period.
Through net present value method, it is necessary that each potential project’s value be estimated with the help of discounted cash flow (DCF) valuation aimed to achieve its net present value. This method would require the organization to take into account the size and timing of all the incremental cash flows of the project. In the next phase, the future cash flows are discounted to ascertain their present value later to be summed and get the NPV.
The internal rate of return is described as a discount rate that provides a net present value (NPV) of zero. It is a generally used as a measure of investment effectiveness. The IRR method will end in the same decision as the NPV method for (non-mutually exclusive) projects in an unimpeded environment, in the usual cases where a negative cash flow takes place at the start of the project, followed by all positive cash flows.
In most practical cases, all autonomous projects that have an IRR higher than the hurdle rate must be accepted. However, for mutually special projects, the decision rule of taking the project with the highest IRR - which is often used – can select a project with a lower NPV.In spite of the strong academic preference for NPV; surveys reveal that executives fall for IRR over NPV, even if they are supposed to be used in agreement.
The equivalent annuity method brings forth the NPV as an annualized cash flow by dividing it by the present value of the annuity factor. It is so often than not used during the assessment process of the particular projects that have the same cash inflows. In this form it is known as the equivalent annual cost (EAC) method and is the cost per year of owning and operating an asset over its entire lifespan.
It is often used when comparing investment projects of unequal lifespans. For example if project A has an expected lifetime of 7 years, and project B has an expected lifetime of 11 years it would be improper to simply compare the net present values (NPVs) of the two projects, unless the projects could not be repeated. The use of the EAC method implies that the project will be replaced by an identical project. Real options analysis has also gained enormous significance especially after the sophistication of option pricing models.
Sullivan, arthur; Steven M. Sheffrin (2003). Economics: Principles in action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. pp. 375.