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. 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.
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