The analysis stipulates a decision rule for:
The attractiveness of a capital investment should consider the time value of money, the future cash flows expected from the investment, the uncertainty related to those cash flows and the performance metric used to select a project.
The most commonly used methods for capital budgeting are the payback period, the net present value and an evaluation of the internal rate of return.
Payback Period The payback period method is popular because it's easy to calculate. Quite simply, the payback period is a calculation of how long it takes to get your original investment back. It depends on your criteria for a required payback period.
The payback method has a flaw in that it does not consider the time value of money. Suppose you're considering two projects and both have the same payback period of three years. However, Project A returns most of your investment in the first one and one-half years whereas Project B returns most of its cash flow return in years two and three.
They both have the same payback period of three years, so which one would you choose? You would select Project A, because you would get most of your money back in the early years, as opposed to Project B, which has returns concentrated in the later years.
Note that the payback method only considers the time required to return the original investment. Now, which project would you choose? Net Present Value Unlike the payback method, the net present value approach does consider the time value of money for as long as the projects generate cash flow.
The net present value method uses the investor's required rate of return to calculate the present value of future cash flow from the project. The rate of return used in these calculations depends on how much it cost for the investor to borrow money or the return that the investor wants for his own money.
The evaluation of projects depends on whatever return the investor says it has to be. If the present value of discounted future cash flows exceeds the initial investment, then the project is acceptable.
If the present value of future cash flows is less than the initial outlay, the project is rejected. The net present value method considers the differences in the timing of future cash flows over the years. Getting your money back in the early years is preferable to receiving it 20 years from now.
Inflation makes money worth less in future years than it is worth today. Internal Rate of Return The internal rate of return method is a simpler variation of the net present value method.
The internal rate of return method uses a discount rate that makes the present value of future cash flows equal to zero. This approach gives a method of comparing the attractiveness of several projects. The project with the highest rate of return wins the contest.
However, the rate of return of the winning project must also be higher than the investor's required rate of return. If the investor says he wants to receive a 12 percent return on his money, and the winning project only has a return of 9 percent, then the project would be rejected.
The investor's cost of capital is the minimum return acceptable, when using the internal rate of return method. As you can see, none of these methods are completely reliable by themselves.
They all have their flaws for making an intelligent analysis, when evaluating the worth of several projects. A project that has the highest internal rate of return may not have the best net present value of future cash flows. Another project could have a short payback period, but it continues to produce cash flows after the payback period ends.
This means that all these methods of analysis should be used, and investment decisions made with good business judgement.Capital Budgeting Analysis Project MBA The General Capital Budgeting Process and how it is implemented within Organizations The general capital budgeting process is the tool by which an organization determines its choice of investments through analyzing and evaluating its .
Aug 01, · Capital budgeting techniques are essential tools used by small business owners to evaluate the worth of investments. The methods use to evaluate projects could be as simple as the payback model or.
The capital budgeting decisions for a project requires analysis of: • its future cash flows, • the degree of uncertainty associated with these future cash flows, and. Once projects have been identified, management then begins the financial process of determining whether or not the project should be pursued.
The three common capital budgeting decision tools are. Free Essay: Capital Budgeting Methods for Corporate Project Selection In a Graham and Harvey survey of chief financial officers (CFOs) asked “how. Capital budgeting is the process in which a business determines and evaluates potential large expenses or investments.
These expenditures and investments include projects such as building a new.