What is Capital Budgeting?
Capital budgeting refers to a process, which a business entity determines the kind of projects to pursue. Such projects may include putting up new buildings, acquisition of equipment or a long-term investment venture. During this evaluation process, it is important for a company to weigh the cash inflows against cash outflows in order to determine if the venture is feasible and the returns agree with the target benchmark.
Importantly, the basis of this type of budgeting is to establish the merits of the project before pumping in resource as no one wants to invest in loss making undertaking. Thus, you need to do this analysis step-wise in order to allow or decline investment projects as part of the business strategy of expansion. Once a company establishes the project’s rate of return, it becomes easy to make an informed decision on appropriate ideas to pursue. Noteworthy, other factors that are specific to the organization and the nature of the project come into play when considering a venture as acceptable on unacceptable.
How to do capital budgeting
In capital budgeting there are varied reasons that business owners use to select feasible projects. In some cases, shares may go for projects that show immediate surges in cash inflow while others may focus on the long-term benefits of the venture without a thought on instant benefits. On this basis, it would be almost impossible to settle on a project that has the backing of every shareholder in the company. However, there is a solution to this stalemate.
At the heart of every business is to ensure that the present shareholder value is at its optimum. This objective means that every project, which the company agrees to advance, must lead to a positive net value. This implies the current value of the likely cash inflow below the present value of the firm’s necessary capital expenditures. When using Net Present Value (NPV), the process involves choosing projects, which raise the company’s value since they have a positive NPV. When using this approach efficient capital markets are assumed to allow the firm access required capital to pursue the projects.
Other Rules for Capital Budgeting
In the absence of this measure, capital budgeting and capital rationing can be complex. Another measure of feasible project is by use of the Internal Rate of Return (IRR). This refers to the rate of return stemming from capital investment. Stated differently, is the discount rate, which makes NPV equal to zero. Another measure of the acceptability of a capital venture is Profitability Index (PI).PI is obtained by dividing the present value of cash inflows by the present value of the cash outflow of the investment project. If PI is greater than one, then the capital investment is feasible. The project is unacceptable if the value if less than one.
Another simplest method is Payback Period. This refers to the time needed for the investment to generate cash flows to settle the original cost of the project.
Pros and Cons of Capital Budgeting
In most cases, this approach of determining the acceptability of an investment project is applied in long-term ventures, usually more than one year. In addition, such investments are likely to generate returns for several subsequent years. Importantly, it allows accountability and measurability. A company that does not weigh between the risks and returns of an investment project is simply irresponsible. In addition, it becomes hard for a business that does not do capital budgeting to survive in a competitive market place.
Another advantage is the ability to determine the profitability of the project. Since the main goal of a commercial business entity is to make profit, determining this investment acceptability of a project is crucial.
On the other hand, subjecting investment projects to this kind of evaluation has a number of demerits. For example, the formula works for long-term projects. This means a company that is pursuing short-term investments might not find it applicable. Moreover, this method is anchored on assumptions and predictions since the future is always uncertain. Thus, it does not give accurate results on the acceptability of a potential capital investment. Lastly, a wrong decision approved because of capital budgeting will affect the lifespan of the company. Therefore, it requires a judicious and professional attention.
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