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What is Capital Budgeting

What is Capital Budgeting

Capital budgeting is the planning process used to determine which of an organization's long term investments are worth pursuing.

  1. fig. 1
    Capital Budgeting
    Investment in real estate needs capital budgeting in advance.

Key Points

  • Capital budgeting, which is also called investment appraisal, is the planning process used to determine whether an organization's long term investments, major capital, or expenditures are worth pursuing.
  • Major methods for capital budgeting include Net present value, Internal rate of return, Payback period, Profitability index, Equivalent annuity and Real options analysis.
  • The IRR method will result in the same decision as the NPV method for non-mutually exclusive projects in an unconstrained environment; Nevertheless, for mutually exclusive projects, the decision rule of taking the project with the highest IRR may select a project with a lower NPV.

Terms

  • Modified Internal Rate of Return
    The modified internal rate of return (MIRR) is a financial measure of an investment's attractiveness. It is used in capital budgeting to rank alternative investments of equal size. As the name implies, MIRR is a modification of the internal rate of return (IRR) and, as such, aims to resolve some problems with the IRR.
  • APT
    In finance, arbitrage pricing theory (APT) is a general theory of asset pricing that holds, which holds that the expected return of a financial asset can be modeled as a linear function of various macro-economic factors or theoretical market indices, where sensitivity to changes in each factor is represented by a factor-specific beta coefficient.

Examples

  • Payback period: For example, a $1000 investment which returned $500 per year would have a two year payback period. The time value of money is not taken into account.

Capital Budgeting

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. Figure 1

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
  • Equivalent annuity
  • 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.
Equivalent Annuity
The equivalent annuity method expresses the NPV as an annualized cash flow by dividing it by the present value of the annuity factor. It is often used when comparing investment projects of unequal lifespans. For example, if project A has an expected lifetime of seven years, and project B has an expected lifetime of 11 years, it would be improper to simply compare the net present values (NPVs) of the two projects, unless the projects could not be repeated.
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.
Cost of Capital:
The rate of return that capital could be expected to earn in an alternative investment of equivalent risk.
APPEARS IN THESE RELATED CONCEPTS:
  • Cost of Capital Considerations
  • Evaluating Interest Rates
Discounted cash flow:
In finance, discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money.
APPEARS IN THIS RELATED CONCEPT:
  • Ranking Investment Proposals
Modified Internal Rate of Return:
The modified internal rate of return (MIRR) is a financial measure of an investment's attractiveness. It is used in capital budgeting to rank alternative investments of equal size. As the name implies, MIRR is a modification of the internal rate of return (IRR) and, as such, aims to resolve some problems with the IRR.
APPEARS IN THESE RELATED CONCEPTS:
Present Value:
Also known as present discounted value, is the value on a given date of a payment or series of payments made at other times. If the payments are in the future, they are discounted to reflect the time value of money and other factors such as investment risk. If they are in the past, their value is correspondingly enhanced to reflect that those payments have been (or could have been) earning interest in the intervening time. Present value calculations are widely used in business and economics to provide a means to compare cash flows at different times on a meaningful "like to like" basis.
APPEARS IN THIS RELATED CONCEPT:
  • Calculating Values for Different Durations of Compounding Periods
Present value:
Present value, also known as present discounted value, is the value on a given date of a payment or series of payments made at other times.
APPEARS IN THIS RELATED CONCEPT:
  • Capital Leases versus Operating Leases
Time value of money:
The time value of money is the value of money, figuring in a given amount of interest earned over a given amount of time.
APPEARS IN THIS RELATED CONCEPT:
  • Ranking Investment Proposals
Weighted average cost of capital:
The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets.
APPEARS IN THIS RELATED CONCEPT:
  • Reinvestment Assumptions
analysis:
A process of dismantling or separating into constituent elements in order to study the nature, function, or meaning.
APPEARS IN THIS RELATED CONCEPT:
  • Scenario Analysis
annuity:
A specified income payable at stated intervals for a fixed or a contingent period, often for the recipient’s life, in consideration of a stipulated premium paid either in prior installment payments or in a single payment. For example, a retirement annuity paid to a public officer following his or her retirement.
APPEARS IN THESE RELATED CONCEPTS:
  • Impact of Payment Frequency on Bond Prices
  • Future Value, Multiple Flows
capital:
Money and wealth; the means to acquire goods and services, especially in a non-barter system.
APPEARS IN THESE RELATED CONCEPTS:
  • Defining the Cost of Capital
  • Differences Between Required Return and the Cost of Capital
  • Role in Capital Allocation
  • Types of Financial Markets
  • The Financial Manager: An Overview of the Role
capital budgeting:
The budgeting process in which a company plans its capital expenditure (the spending on assets of long-term value).
APPEARS IN THESE RELATED CONCEPTS:
  • Advantages of the IRR Method
  • Replacement Projects
cash flow:
The sum of cash revenues and expenditures over a period of time.
APPEARS IN THESE RELATED CONCEPTS:
  • Defining the Cash Flow Cycle
  • Interpreting the NPV
  • Interpreting Overall Cash Flow
  • Calculating the NPV
  • Future Value, Multiple Flows
cost of capital:
The rate of return that capital could be expected to earn in an alternative investment of equivalent risk. If a project is of similar risk to a company's average business activities, it is reasonable to use the company's average cost of capital as a basis for the evaluation. A company's securities typically include both debt and equity. One must, therefore, calculate both the cost of debt and the cost of equity to determine a company's cost of capital.
APPEARS IN THESE RELATED CONCEPTS:
  • Advantages of the IRR Method
  • Modified IRR
  • Calculating the IRR
  • Disadvantages of the Payback Method
  • Funding the International Business
  • Defining the Payback Method
discount:
To find the value of a sum of money at some earlier point in time. To find the present value.
APPEARS IN THIS RELATED CONCEPT:
  • Present Value, Multiple Flows
discount rate:
The interest rate used to discount future cash flows of a financial instrument; the annual interest rate used to decrease the amounts of future cash flow to yield their present value.
APPEARS IN THESE RELATED CONCEPTS:
  • The Discount Rate
  • Calculating the Yield to Maturity using the Bond Price
  • Present Value of Payments
  • Calculating the NPV
  • NPV Profiles
  • Discounted Cash Flow Approach
discounted cash flow:
In finance, discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money. All future cash flows are estimated and discounted to give their present values (PVs)–the sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value or price of the cash flows in question.
APPEARS IN THESE RELATED CONCEPTS:
  • Valuing the Target and Setting the Price
  • Valuing the Corporation
discounted payback period:
The discounted payback period is the amount of time that it takes to cover the cost of a project, by adding positive discounted cash flow coming from the profits of the project.
APPEARS IN THIS RELATED CONCEPT:
  • Calculating the Payback Period
financing:
A transaction that provides funds for a business.
APPEARS IN THESE RELATED CONCEPTS:
  • Cash Flow from Financing
  • Types of Financial Decisions: Investment and Financing
internal rate of return:
IRR. The rate of return on an investment which causes the net present value of all future cash flows to be zero.
APPEARS IN THESE RELATED CONCEPTS:
  • Yield to Maturity
  • The Cost of Debt
  • Percentage Returns
  • NPV Profiles
investment:
A placement of capital in expectation of deriving income or profit from its use.
APPEARS IN THESE RELATED CONCEPTS:
  • Defining Finance
  • Functions of Corporate Finance
mutually exclusive:
Describing multiple events or states of being such that the occurrence of any one implies the non-occurrence of all the others.
APPEARS IN THESE RELATED CONCEPTS:
  • Multiple IRRs
  • Disadvantages of the IRR Method
net present value:
The present value of a project or an investment decision determined by summing the discounted incoming and outgoing future cash flows resulting from the decision.
APPEARS IN THIS RELATED CONCEPT:
  • Other Considerations in Capital Budgeting
opportunity cost:
The cost of an opportunity forgone (and the loss of the benefits that could be received from that opportunity); the most valuable forgone alternative.
APPEARS IN THESE RELATED CONCEPTS:
  • Disadvantages of the NPV method
  • Replacement Projects
  • Differences Between Required Return and the Cost of Capital
  • Understanding the Cost of Money
  • Disadvantages of the Payback Method
  • Defining the Payback Method
period:
The length of time during which interest accrues.
APPEARS IN THESE RELATED CONCEPTS:
  • Single-Period Investment
  • Annuities
  • Number of Periods
ratio:
A number representing a comparison between two things.
APPEARS IN THESE RELATED CONCEPTS:
  • Benchmarking
  • Classification
return:
Gain or loss from an investment.
APPEARS IN THESE RELATED CONCEPTS:
  • Dollar Returns
  • Finance, Economics, and Accounting: Differences and Commonalities
  • Disadvantages of the Payback Method
risk:
The potential (conventionally negative) impact of an event, determined by combining the likelihood of the event occurring with the impact, should it occur.
APPEARS IN THESE RELATED CONCEPTS:
  • The Cost of Debt
  • Portfolio Risk
time value of money:
The value of money, figuring in a given amount of interest, earned over a given amount of time.
APPEARS IN THESE RELATED CONCEPTS:
  • Coupon Interest Rate
  • Price/Earnings Ratio
  • Discounted Cash Flow Approach
  • Defining the Payback Method
valuation:
The process of estimating the market value of a financial asset or liability.
APPEARS IN THESE RELATED CONCEPTS:
  • Evaluating Financial Statements
  • Industry Comparisons
  • Limitations of Financial Statement Analysis
  • Valuation
value:
A value is extremely absolute or relative ethical value, the assumption of which can be the basis for ethical action.
APPEARS IN THIS RELATED CONCEPT:
  • Personal Values and Ethics
values:
A collection of guiding principles; what one deems to be correct and desirable in life, especially regarding personal conduct.
APPEARS IN THIS RELATED CONCEPT:
  • Definition of Ethics
volatility:
A quantification of the degree of uncertainty about the future price of a commodity, share, or other financial product.
APPEARS IN THIS RELATED CONCEPT:
  • Historical Returns: Market Variability and Volatility
weighted average:
An arithmetic mean of values biased according to agreed weightings.
APPEARS IN THIS RELATED CONCEPT:
  • Market Reporting
weighted average cost of capital:
The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. The WACC is the minimum return that a company must earn on an existing asset base to satisfy its creditors, owners, and other providers of capital, or they will invest elsewhere.
APPEARS IN THIS RELATED CONCEPT:
  • Discounted Payback

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