Capital Budgeting .December 26, 2020
Capital budgeting, and investment appraisal, is the planning process used to determine whether an organization’s long term investments such as new machinery, replacement of machinery, new plants, new products, and research development projects are worth the funding of cash through the firm’s capitalization structure (debt, equity or retained earnings). It is the process of allocating resources for major capital, or investment, expenditures. One of the primary goals of capital budgeting investments is to increase the value of the firm to the shareholders.
Net present value :
Main article: Corporate finance § Investment and project valuation
Cash flows are discounted at the cost of capital to give the net present value (NPV) added to the firm. Unless capital is constrained, or there are dependencies between projects, in order to maximize the value added to the firm, the firm would accept all projects with positive NPV. This method accounts for the time value of money. For the mechanics of the valuation here, see Valuation using discounted cash flows.
Mutually exclusive projects are a set of projects from which at most one will be accepted, for example, a set of projects which accomplish the same task. Thus when choosing between mutually exclusive projects, more than one of the projects may satisfy the capital budgeting criterion, but only one project can be accepted; see below #Ranked projects.
Internal rate of return :
Main article: Internal rate of return
The internal rate of return (IRR) is the discount rate that gives a net present value (NPV) of zero. It is a widely used measure of investment efficiency. To maximize return, sort projects in order of IRR.
External links and references :
- ^ O’Sullivan, Arthur; Sheffrin, Steven M. (2003). Economics: Principles in Action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. pp. 375. ISBN 0-13-063085-3.
- ^ Varshney, R.L.; K.L. Maheshwari (2010). Managerial Economics. 23 Daryaganj, New Delhi 110002: Sultan Chand & Sons. p. 881. ISBN 978-81-8054-784-3.