Capital Budgeting: Techniques And Importance

What is capital budgeting and its role?

• What is the capital budgeting, and what role does it play in long-term investment decisions?

• What are the basic capital budgeting models, and which ones are considered the most reliable and why?

• What is net present value (NPV), how is it calculated, and what is the basic premise of its decision rule?

• What is the internal rate of return (IRR), how is it calculated, and what is the basic premise of its decision rule?

• What is the modified internal rate of return (MIRR), how is it calculated, and what is the basic premise of its decision rule?

• How is the weighted average cost of capital (WACC) employed in capital budgeting decisions, and should it be used for all project regardless of the riskiness of a project?

1. Capital budgeting, also known as investment appraisal is the process of planning that is utilized for deciding whether the long term investments of the organization are worth funding by cash through the capitalization structure by. Capitalization structure means equity, debt or retained earnings. It is the technique of allocating resources for important capital expenditure. The main aim of capital budgeting is actually increasing the value of the business firm to the shareholders. The main techniques  used in capital budgeting includes accounting rate of return, payback period, net present value, internal rate of return, profitability index. These are the major techniques used in this process. (Bekaert & Hodrick 2014)

The method of capital budgeting helps to take major long term investment decisions. Certain investment decisions are so critical that a lot of analysis is required to decide whether those investments are worth considering. Capital budgeting helps to analyze those investments by comparing their return with the investment in terms of present value of money. Money has a time value. The value of money changes with time. So comparing investment with it’s rate of return in terms of present value of money . This is done through the use of discounting rate, and this process is called discounting. The choice a proper discounting rate depends on a variety of factors.

2. There are many capital budgeting techniques, but some of them are the most reliable and mostly used . These are as follows:

Payback Period: This is the easiest tool for making investment decisions. With this method, one is determining the amount of time that would be required to pay back the initial investment. This method is most suitable in case of small and simple investment projects (Goel 2013).

Basic capital budgeting models

Net Present Value: This is much more effective in reality than other methods of capital budgeting. It essentially involves calculating the difference between cash flows generated by the projects and the project cost. This method is effective because it considers time value of money.

Internal Rate of Return: This is a type of discounting rate that is popularly used to calculate the amount of return that can be expected by an investor from a particular project. IRR is actually the is the rate of discount that occurs in the break even state of the project. Break even state means when NPV=0.

There are basically many other capital budgeting techniques that are used by financial managers. But these three are the most effective ones.

3. Net present value is a decision method that is commonly used in the capital budgeting method. This method is effective as it uses cash flow analysis after it is discounted. This compensates for the uncertain future cash flows. Here, present value means cash flows earned in the future are not as much of worth as cash flows of today. Those cash flows after being discounted of future back to present value creates proper comparison between those cash flows. The main rule of NPV is that a particular project is that the project would be accepted when there is a positive NPV, and rejected in case of negative NPV. The project which has the highest NPV is to be accepted in case of mutually exclusive projects (Kalyebara & Islam 2015)

4. This is  a measure which is used in capital budgeting which calculates the profitability of probable investments. IRR is actually a rate of discount which makes the NPV of all cash flows from a particular project equal to zero. NPV and IRR rely on the same calculatiopns as NPV.

In general term, higher the internal rate of return of a project, it is more desirable to accept that project for investment. To calculate this Internal Rate of Return, NPV is to be set equal to zero and then the discount rate r is to be solved , which is here the IRR. But it is to be remembered that IRR cannot be calculated in analytical terms. It is to be calculated either through computer software or through human trail and error. Sometimes, IRR is referred to as economic rate of return or ERR.

Theoritically, any project which has an IRR greater than its cost of capital would be profitable.

5. Modified Internal Rate of Return is actually financially measures the attractiveness of an investment. MIRR targets to solve some of the problems of IRR and is a type of modification of the IRR. This rate of return is not applicable to rank projects of different sizes. This is because more large is the project with a smaller MIRR, it may possess a higher Net Present Value.

6. Weighted Average Cost of Capital is the return rate that an organization is expected to pay on all its security holder’s average. Security holder means those who finance its assets. The WACC actually is the mininmum return that an organization should earn on existing base of assets in order to satisfy its creditors, providers of capital and owners. WACC is not dictated by the management, but dictated by the external market (Corelli 2012)

References

Bekaert, Geert, & Robert J Hodrick. International Financial Management. Print.

Corelli, Angelo. Understanding Financial Risk Management. Hoboken: Taylor and Francis, 2014. Print.

Goel, Sandeep. Capital Budgeting. Print.

Grabowski, Roger J, & James P Harrington. 2015 International Valuation Handbook. Print.

Kalyebara, Baliira, & Sardar M. N Islam. Corporate Governance, Capital Markets, And Capital Budgeting. Dordrecht: Physica-Verlag, 2014. Print.

Pratt, Shannon P, & Roger J Grabowski. Cost Of Capital. Hoboken, New Jersey: Wiley, 2014. Print.