Capital Budgeting – definition of the term

Capital Budgeting – definition of the term

The process of capital budgeting is used by business organizations for determining the investment projects that can be taken over and the ones that will be rejected. It is associated with the purchase of any new assets or undertaking any new business projects. For instance, the purchase of a piece of land or construction of a new production unit in a particular site requires performing capital budgeting so that it can be ascertained if such projects can be approved or not. This process helps in reflecting a quantitative analysis for all the identified projects in a portfolio and gives a rational base to different companies in making judgments for the acceptance of various projects. In this process, any company can identify cash inflows along with cash outflows of the potential projects. For this, the process is also known as investment appraisal. Moreover, with this project, each of the projects in a portfolio is ranked according to the probable returns from them, which helps the management in choosing the plan that can be taken over first. Capital budgeting uses several methods to determine the profitable investments for companies, which include net present value, discounted cash flow, internal rate of return, and payback period (Mao, 1970).

The rationale for the NPV approach

The concept of net present value or NPV is primarily associated with identifying the most profitable and valuable investment option. It is for any business by comparing it with others in a project portfolio through the present values of their cash outflows received in the future. Its rationale says about the focus of NPV in maximizing the profit or wealth of the business owners through identifying the most profitable investment options depending on the nature of business (Ross, 1995). The concept allows the professionals to know if the cash flow values of a project will generate more revenue than the cost of initiating the specific project under consideration. It enables the managers to make more informed decisions as they approach provides them with an overall outlook of the project – whether the organization to undertake it or not.

One of the prime advantages of the NPV approach is that the value of the dollar is assumed to be low in comparison to the dollar value in present times. It implies that the cash flows of each period are discounted over the capital cost of another period. Further, it provides valuable insights into the values of an investment and the expected return that it would fetch. Also, the process considers the inherent risks of the project to make more accurate predictions.

IRR approach ascertaining the desirability of a project

The IRR approach is often used to determine project desirability in organizations (Lohmann, 1988). Let us consider an example where an organization needs to decide on purchasing new tools that would incur $500,000 expense. The new asset is estimated to live for four years with expectations of bringing an additional $160,000 of profit annually. Further, the organization also has another option of investment that can fetch a 10% return – 2% more than the present hurdle rate of the organization. The company now needs to decide on the best option for its investment and use the IRR tool to calculate the same.

NPV = 0

IRR = 13%

The IRR of 13% has been calculated using Excel and the =IRR() function. When considered from the financial context, purchasing the tools is the right option for the organization as the IRR is not only more than the organization’s hurdle rate but also the IRR of the other investment option.

Reference

Lohmann, J. R. (1988). The IRR, NPV, and the fallacy of the reinvestment rate assumptions. The Engineering Economist, 33(4), 303-330.

Mao, J. C. (1970). Survey of capital budgeting: Theory and practice. The Journal of Finance, 25(2), 349-360.

Ross, S. A. (1995). Uses, abuses, and alternatives to the net-present-value rule. Financial management, 24(3), 96-102.