Capital Budgeting Can Be Defined

Finance Essay
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Capital budgeting can be defined as the process of analyzing, evaluating, and deciding
whether resources should be allocated to a project or not. Capital budgeting addresses
the issue of where funds should be disbursed over a long period of time. The process of
capital budgeting ensures the optimal
placement of funds and resources. It also helps management work toward the goal of
maximizing shareholder wealth. The method used by most large companies to evaluate
investment projects is called the net present value (NPV). It is a standard method for the
monetary worth of long-term projects. It measures the surplus or deficit of cash flows, in
present value (PV) terms, once financing charges are met. The NPV is used for
budgeting and is widely used throughout economics. The way NPV works is simple.
When firms make investments, they are spending money they have obtained from
investors. Investors expect a return on the money that they give to firms, so a firm
should accept an investment only if the present value of the cash flow is greater than the
cost of making the investment. However, decision-makers must somehow verify that
any decisions made based on the NPV can be flexible. This flexibility is in place in the
event that factors affecting the decision later change. NPV compares the value of a dollar
today to the value of that same dollar in the future, taking inflation and returns into
account. If the NPV of a prospective project is positive, it should be accepted.
However, if the NPV is negative, the project should probably be rejected because cash
flows will also be negative.

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Internal rate of return (IRR) is the expected rate of return that can be earned on a
capital project. The IRR is a calculated interest rate based on the cash flows of a project
or investment. The calculation estimates what the future rate of return is but translates
it into present cash value. IRR is typically a calculation for businesses to use in

determining the NPV of its money when considering income and initial costs for starting
a business. IRR is typically an estimate and will often differ from the actual execution of
a project. However, stronger growth would still be expected from a project with a
greater IRR.
Like the NPV calculation, the IRR evaluation also determines if a company should
accept or reject a project proposal. A project should be accepted when the IRR is greater
than the rate of return and should be rejected if the IRR is less than the rate of return.
When evaluating mutually exclusive project, the projects with the greatest IRR should
be accepted .The project with the greatest IRR would be assumed to provide the most
cash flow growth. An IRR calculation for a project can also be compared against
prevailing rates of return for alternate investments such as an investment in the
securities market. If a company cannot generate project alternatives with IRRs greater
than the returns that can be generated from alternate investments, it may invest its
retained earnings in the market or alternative investments to internal projects.
Many advantages accompany the use of IRR. One would be that it is considered to be
straight forward and easy to understand. It also recognizes the time value of money. IRR
also uses cash flows. One disadvantage of internal rate of return is it often gives
unrealistic rates of return and unless the calculated IRR gives a reasonable rate of
reinvestment of future cash flows, it should not be used as a reason to accept or reject a
project. Another disadvantage to the use of IRR is that there may not be one singular
rate. Depending on the cash flow structure, if there are different cash flow signs in
different years (positive and negative), then the math will not add up. In essence it
entails more problems than a practitioner may think. Another disadvantage is that the
IRR could be quite misleading if there is no large initial cash outflow.
The profitability index for a project proposal is compared to the present value of future
inflows with the initial outflow, in ratio terms. To calculate the profitability index take
the present value of all future cash flows and divide that by the initial cash investment.
Calculating the profitability index only requires the initial investment figure and the
present value of cash flows figures. The decision to undertake or reject a project relies on
whether the profitability index is greater than or less than 1. Any profitability index
value less than 1 would mean that the project's present value is less than the initial
investment and the relationship between costs and benefits is not positive. A project
should be accepted when the PI is greater than 1 and should be rejected if the PI is less

than 1. When evaluating a mutually exclusive project the project with the greatest PI
should be accepted as the project with the greatest PI would be assumed to provide the
greatest financial benefit. The profitability index is easily understood by people with
minimal background knowledge in finance-because it uses a simple formula of division.
A major disadvantage of the profitability index is that it may lead to incorrect decisions
when comparing mutually exclusive projects. These are a set of projects for which at
most one will be accepted the most profitable one. Decisions made from the profitability
index do not show which of the mutually exclusive projects has a shorter return
duration. This leads to choosing a project with longer a return duration. The profitability
index requires an investor to estimate the cost of capital in order to calculate it.
Estimates may be biased and therefore inaccurate. Because there is no systematic
procedure for determining cost of capital of a project this may lead to inconsistent
decision making when the assumptions do not hold in the future.

The payback period is the time it takes to recover the initial investment in a project
while it is operating. The payback period is used to assess projects and to calculate the
return per year from the beginning of the project until the investment is said to have
been paid back. That is usually when the accumulated returns are equal to the cost of the
investment. The payback method is computed as follows: Payback Period= Initial
Investment Cash Inflow per Period. The payback decision rule states that acceptable
projects must have less than some maximum payback period designated by
management. Payback is said to emphasize the management's concern with liquidity
and the need to minimize risk through a rapid recovery of the initial investment. It is
often used for small expenditures that have obvious benefits, and projects which the use
of more sophisticated capital budgeting methods is not required or justified. Some
advantages of the payback period are that it is widely used and easily understood and it
favors capital projects that return large early cash flows. There are also safe-guards
against risk and uncertainty in this area. The payback method also allows a financial
manager to deal with the risk by investigating how long it will take to get back the initial
investment, although it does not treat risk directly. It addresses capital control issues
easily.

The payback method remains a major supplementary tool prevalent in the investment
process.
Along with advantages, there are also disadvantages associated with the payback
method. One disadvantage is that it ignores any benefits that occur after the payback
period, thus it does not measure total revenue. Another disadvantage of the payback
period is its disregard of money's varying value. Inflation and deflation change the value
of money over time. The payback method over-emphasizes short run profitability.