Capital budgeting, which is
also called "investment appraisal," is the planning process used to
determine which of an organization's long term investments such as new
machinery, replacement machinery, new plants, new products, and research
development projects are worth pursuing. It is to budget for major capital
investments or expenditures.
Major
Methods
Many formal methods are used in capital
budgeting, including the techniques as followed:
- Net present value
- Internal rate of return
- Payback period
- Profitability index
- Real options analysis
Net Present Value
Net present value (NPV) is used to
estimate each potential project's value by using a discounted cash flow (DCF)
valuation. This valuation requires estimating the size and timing of all the
incremental cash flows from the project. The NPV is greatly affected by the
discount rate, so selecting the proper rate–sometimes called the hurdle rate–is
critical to making the right decision.
This should reflect the riskiness of the
investment, typically measured by the volatility of cash flows, and must take
into account the financing mix. Managers may use models, such as the CAPM or
the APT, to estimate a discount rate appropriate for each particular project,
and use the weighted average cost of capital(WACC) to reflect the financing mix
selected. A common practice in choosing a discount rate for a project is to
apply a WACC that applies to the entire firm, but a higher discount rate may be
more appropriate when a project's risk is higher than the risk of the firm as a
whole.
Internal Rate of Return
The internal rate of return (IRR) is
defined as the discount rate that gives a net present value (NPV) of zero. It
is a commonly used measure of investment efficiency.
The IRR method will result in the same
decision as the NPV method for non-mutually exclusive projects in an
unconstrained environment, in the usual cases where a negative cash flow occurs
at the start of the project, followed by all positive cash flows. Nevertheless,
for mutually exclusive projects, the decision rule of taking the project with
the highest IRR, which is often used, may select a project with a lower NPV.
One shortcoming of the IRR method is
that it is commonly misunderstood to convey the actual annual profitability of
an investment. Accordingly, a measure called "Modified Internal Rate of
Return (MIRR)" is often used.
Payback Period
Payback period in capital budgeting
refers to the period of time required for the return on an investment to
"repay" the sum of the original investment. Payback period
intuitively measures how long something takes to "pay for itself."
All else being equal, shorter payback periods are preferable to longer payback
periods.
The payback period is considered a
method of analysis with serious limitations and qualifications for its use,
because it does not account for the time value of money, risk, financing, or
other important considerations, such as the opportunity cost.
Profitability Index
Profitability index (PI), also known as
profit investment ratio (PIR) and value investment ratio (VIR), is the ratio of
payoff to investment of a proposed project. It is a useful tool for ranking
projects, because it allows you to quantify the amount of value created per
unit of investment.
Real Options Analysis
The discounted cash flow methods
essentially value projects as if they were risky bonds, with the promised cash
flows known. But managers will have many choices of how to increase future cash
inflows or to decrease future cash outflows. In other words, managers get to
manage the projects, not simply accept or reject them. Real options analysis
try to value the choices–the option value–that the managers will have in the
future and adds these values to the NPV.
These methods use the incremental cash
flows from each potential investment or project. Techniques based on accounting
earnings and accounting rules are sometimes used. Simplified and hybrid methods
are used as well, such as payback period and discounted payback period.
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