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Capital budgeting, which is also called investment appraisal, is a planning process in which a company makes long-term investment decisions of how they will make major capital expenditures.
The purpose of budgeting is to form a forecast of revenues and expenditures and build a model of how the business might perform financially. Capital budgeting is most involved in ranking projects and raising funds when long-term investment is taken into account. It is important because large sums of money are involved and long-term investments, once made, cannot be reversed.
The first step involves tracking the projected inflows and outflows of cash. These cash flows represent payments and returns, internally or externally, as a byproduct of operations over time. Cash flow analysis on potential projects and investments is the most critical aspect of capital budgeting. It determines profitability, the cost of capital, and the future rate of return.
Cash flows come from the three fundamental business activities.
Once the cash flow analysis is complete, the capital budgeting process calls for ranking of investment proposals. It is very rare that the company has so much cash that it can take on all the investment opportunities it has before them. Most often, they need to be ranked for eligibility. There are several methods to do this.
Methods of Evaluation | Description |
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Net Present Value Method |
Each project's value is calculated using discounted cash flows for expenditures and expected revenues. It is important that the company choose the correct discount rate (sometimes called a hurdle rate) when establishing this net present value, or NPV.
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Internal Rate of Return (IRR) | The IRR is the rate that makes the net present value of the cash flows, both inflows and outflows, equal to zero. Assuming all projects require the same upfront investment, the project with the highest internal rate of return would be considered the best. The IRR is a very popular method because, generally, businesses love percentage rates. |
Profitability Index | This method allows you to rank projects based on a unit of investment that is calculated by the present value of the cash flows divided by the initial investment. As the profitability index increases, the project becomes more attractive. The rule for selection would be if the profitability index is more than 1, then the project should be considered for acceptance. |
Payback | The payback period measures how long something takes to pay itself back. It is the amount of time that it takes to generate revenues that offset the initial investment. Shorter payback periods are preferable to longer payback periods. This method is very broadly used even though it has one big disadvantage: it completely disregards the time value of money. In addition to its simplicity, it also has an advantage as an indicator of liquidity generation, or how quickly a firm can recover its investment. |
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