Capital Budgeting
Capital Budgeting
Introduction
Capital budgeting decisions are the most important investment decisions made by management. The objective of these decisions is to select investments in real assets that will increase the value of the firm. (Kidwell and Parrino, 2009)
Project Classification Types * Replacement projects are expenditures necessary to replace worn-out or damaged equipment. * Cost reduction projects include expenditures to replace serviceable but obsolete plant and equipment. * Safety and environmental projects are mandatory investments that may not produce revenues. * Expansion projects increase the availability of existing products and services
Steps in Capital Budgeting 1. Sequence of Project Valuation * Project cost must be determined. * Management must estimate the expected cash flows. * Risk of projected cash flows must be estimated. * Given the risk of projected cash flows, the firm must determine an appropriate discount rate. * Expected cash flows must be converted to present-values. * Compare present-value of expected cash inflows with the required outlay. 2. Cash Flow Estimation * Expected cash inflows and outflows must be estimated within a consistent and unbiased framework
Capital budgeting techniques help management systematically analyze potential business opportunities in order to decide which are worth undertaking. (Kidwell and Parrino, 2009) There are many techniques used in the process of capital budgeting. The most common methods are payback, discounted payback period, net present value (NPV), internal rate of return (IRR), accounting rate of return (ARR) and modified internal rate of return (MIRR).
Payback Period
The payback period is defined as the number of years that it will take a project to recover the initial investment of a company. This period can be easily calculated by adding the years before cost recovery to the remaining cost to recover divided by the
Introduction
Capital budgeting decisions are the most important investment decisions made by management. The objective of these decisions is to select investments in real assets that will increase the value of the firm. (Kidwell and Parrino, 2009)
Project Classification Types * Replacement projects are expenditures necessary to replace worn-out or damaged equipment. * Cost reduction projects include expenditures to replace serviceable but obsolete plant and equipment. * Safety and environmental projects are mandatory investments that may not produce revenues. * Expansion projects increase the availability of existing products and services
Steps in Capital Budgeting 1. Sequence of Project Valuation * Project cost must be determined. * Management must estimate the expected cash flows. * Risk of projected cash flows must be estimated. * Given the risk of projected cash flows, the firm must determine an appropriate discount rate. * Expected cash flows must be converted to present-values. * Compare present-value of expected cash inflows with the required outlay. 2. Cash Flow Estimation * Expected cash inflows and outflows must be estimated within a consistent and unbiased framework
Capital budgeting techniques help management systematically analyze potential business opportunities in order to decide which are worth undertaking. (Kidwell and Parrino, 2009) There are many techniques used in the process of capital budgeting. The most common methods are payback, discounted payback period, net present value (NPV), internal rate of return (IRR), accounting rate of return (ARR) and modified internal rate of return (MIRR).
Payback Period
The payback period is defined as the number of years that it will take a project to recover the initial investment of a company. This period can be easily calculated by adding the years before cost recovery to the remaining cost to recover divided by the
References: Kidwell, D. & Parrino, R. (2009). Fundamentals of Corporate Finance. New Jersey: Walsworth Publishing Company. Glann, N. (2009). Pros and Cons of Different Capital Budgeting Techniques.Yahoo! Contributor Network (2010). Capital Budgeting. Wikipedia, Free Online Encyclopedia. Retrieved on April 6, 2011 from http://en.wikipedia.org/wiki/Capital_budgeting Anonymous. (2009). Advantages and Disadvantages of Capital Budgeting. Retrieved On April 6, 2011 from http://www.finweb.com/financial-planning/advantages-and-disadvantages-of-capital-budgeting.html Gitman, L. (2009). Principles of Managerial Finance (12th ed.). Pearson Prentice Hall: Boston, MA Peterson-Drake, P. (2008). Advantages and Disadvantages of the Different Capital Budgeting Techniques