Capital Budgeting Procedure

Capital Budgeting Procedure

Introduction

Capital budgeting involves selecting projects that increase the value of an organization. It is a process by which a business adapts to assess possible investments. Advancement of another property or a big project in a venture is cases of undertakings that would need the process capital budgeting before being endorsed or unaccepted. Organizations are ordinarily supposed to take projects which will boost profit and subsequently increase investors’ wealth.

The three primary methods used in capital budgeting are net present value, payback period and internal rate of return.

Payback Period

Payback period determines the duration of time required by a company to get enough income to repay the initial investment. Giving an example, if a project requires an original investment of $2,000,000, the payback period measures how long the project is needed for the inflows of cash to be the same as the $2,000,000 outlay. A shorter payback duration is preferable to a more extended payback period because it shows that the investment would pay itself within a shorter time.

A benefit of using the payback period is the fact that it is straight forward in determining. The method has some disadvantages such as it does not account for the opportunity cost and money time value.

Internal Rate of Return

This refers to a rate of discount that would give a net present value equal to zero. Choose the investment with the highest internal rate. The return rate of the chosen investment must also be higher than the return rate of the investor. When the IRR is higher than the capital cost, accept the scheme and when it is lower, reject the project.

An advantage of using the method is that it is easy to compute. The technique has the disadvantage that it does not consider the project size, future expenses, and duration of the project.

Net Present Value

The NPV method determines the present value of future cash flows from the project using the rate of return of the investor. It is usually the subtraction of today’s value of expected cash flows from today’s value of invested cash flows over a given time duration. The method analyzes how profitable a project would be. The formula for NPV is given by:-

Where:-

St = the net difference between cash inflows and outflows during a duration of time t

d = the rate of discount

t = the length of time

If the present worth of future cash flows discounted exceeds the initial outlay, accept the project. If the current value of discounted future cash flows is lower than the actual investment, take the project.

The method of NPV is advantageous since it reveals how profitable a given project is.

Conclusion

The NPV method is the most effective approach in capital budgeting procedures due to its profitability valuation factor. However, none of the methods can be relied on by themselves since they all have one or two negative factors.