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Capital budgeting or investment decision techniques refers to tools used by businesses and individuals to assess the viability of short-term and long-term investments. The quality of an investment decision hinges on the investment appraisal rule applied under the situation. Therefore, capital budgeting methods are vital in circumstances that require business management to evaluate project life, cash flows and cost of capital. The effectiveness of capital budget analysis depends on how well these three elements have been estimated. The information collected should satisfy estimator’s objectives of capital budgeting.
What is Capital Budgeting?
Capital budgeting is the procedure that entities or people use to make decisions concerning capital projects. This practice is paramount in corporations because it enables management to assess the effects of certain projects on business value. Any capital project implemented should have positive impacts on business and shareholders’ value. Capital budget analysis is therefore a vital finance area that finance students and financial analysts should focus on for many reasons.
Types of Project Appraisal
Several project appraisal techniques can be used to check the viability of various projects. These techniques help in assessing the situation on the ground against the required project benefits. The methods include, but are not limited to
This type of project appraisal methodology helps investors to determine whether pre-requisites that would result in project success have been considered. Some of the benchmarks that need to be addressed consist of the size required, machine quality, location proximity and process efficiency.
This appraisal technique opens investors’ minds and makes them cognizant of the fact that all projects are exposed to undue threats. As such, this approach yields solutions that make project paybacks sustainable.
In essence, all projects are supposed to produce economic benefits; for example, improve the distribution of wealth. This appraisal methodology is taught in class to enable learners to understand the connection between projects and factors such as social cost-benefits, savings benefits, and employment.
Here, individuals are required to evaluate anything relating to project financing. Which mechanisms will be used to finance the project? Such a question should be dealt with upfront. The principles that should be applied in this type of appraisal should help people achieve revenue and obligations goals.
Negative climate change is defined as a menace to the environment. People should therefore learn how to test the project’s impact on the quality of vegetation, air, life, and water. Investors are required to evaluate the cost implication of potential climate damages and the expenses of restoring the effects.
Steps of Project Appraisal
The project appraisal process has five key stages. It starts with initial project assessment. This phase seeks to assess whether the purpose of a particular project will be achieved in accordance with the set standards. It is followed by problem definition. Project leaders should comprehend what opportunities and challenges they will be facing. After doing this, the next step relates to developing options. When individuals are studying project appraisal, they are taught about valuation techniques for project appraisal, which include the internal rate of return and profitability index among others.
After getting a clear picture of the value of each option, a comparison ought to be made so that the best project is selected. Thus, the comparison of options is a fundamental step in project appraisal. The last stage of analysis involves selecting the most competitive and viable project. Overall, the project appraisal process commences the moment an idea is received or conceptualized.
Although some project appraisal aspects are easy to understand, it is advisable to find someone who can help you deal with complex appraisal assignments. Getting finance homework help does not lower your self-esteem in any way. Instead, it helps you understand things better.
Methods of Project Appraisal
There are numerous capital budgeting techniques that people can use. Some of the techniques are listed and explained below:
- Net Present Value
- Payback Period
- Accounting Rate of Return
- Discounted Payback Period
- Profitability Index
- Internal Rate of Return
Net Present Value (NPV)
The net present value is one of the time-adjusted techniques. This method assumes that cash flows creeks at dissimilar periods, and they fluctuate in value. In this view, this method enables individuals to assess the relationship between present and future cash flows. This approach is beneficial because it recognizes the influences of cost of capital and risks associated with budget estimations. Nonetheless, it is considered inferior since it cannot predict opportunity cost and the required rate of return (RRR).
Payback Period (PB)
PB is a traditional budgeting method that measures the number of years or the time it takes for cash flows from an investment to match the initial capital used. The decision rule for this process is that the project with the shortest PB ought to be selected. People use PB because it recognizes uncertainties, liquidity and it is easy to undertake. On the other hand, it faces backlash because of its inability to factor in profitability and return on investment, which is important during capital budgeting analysis.
Discounted Payback Period
Just like the simple PBP, this investment decision technique calculates the investment recovery time in a more effective manner. The main advantage is that it considers the impact of cash flows, which means it actively reflects the effects of the time value of money and actual threats facing the investment. Some companies hesitate using this method because it fails to determine what effects the investment will have on the business value.
Accounting Rate of Return (ARR)
The relief that people get when they use the accounting rate of return is great. ARR as a capital budgeting criteria calculates the return on capital employed (ROCE) because it includes dividing after-tax operating profit by the cost of investment. This fact has intensified the importance of capital budgeting in financial management field. This appraisal tool is highly referred by users because it considers profitability and time value of money.
Profitability Index (PI)
The PI approach is used to measure the present value (PV) of earnings per dollar investment. It should be noted that PI can evaluate numerous investments requiring different initial costs at the same time. It identifies the time value of money as one of the dynamics that should be used in capital budgeting evaluation. Since it addresses cash flows, it can be argued that PI runs consistently with shareholders’ value maximization. Using this technique, you cannot determine the opportunity cost or the required rate of return.
Internal Rate of Return (IRR)
IRR is one of the capital budgeting tools that are easy to interpret. This approach evaluates the productivity of investment since it considers factor such as time value of money, which are core in discounting cash flow trends or streams. Individuals would want to use this technique because it aids in making accept or reject decisions. This tool is consistent with the investment goal of increasing shareholder wealth. It measures profitability, opportunity cost and the time value of money. Some people will disregard this method because it demands lengthy and intricate calculations.
Modified Internal Rate of Return (IRR)
As the name suggest, MIRR is an improved version of Internal rate of return. MIRR was developed to counter the IRR assumption that all the positive cash flows during a project’s life are supposed to be re-invested at the same rate of IRR until the end of the period of investment. To read more on modified rate of return click here.
Advantages and Disadvantages of Capital Budgeting
Investment decisions are integral in every day’s financial management practices because it helps people in understanding investment risks and their effects. With this knowledge, individuals can then make sound decisions about seizing investment opportunities. It also plays a fundamental role in assisting corporations to control expenditure and avoid over or under-investing.
On the negative side, capital budgeting tools are complex to use. In many organizations, there are a few skilled professionals who can tackle capital investment appraisal tasks. Equally, when one makes a decision based on wrong budgeting data, their investment stands to suffer losses considering that most of capital budgeting decisions are long-term and irreversible.
The importance of capital budgeting cannot be discounted in the investment field. One is likely to encounter investment opportunities on a daily basis. As such, you should ensure that you are equipped with the necessary skills that will help you use various budgeting methods featured above to make sound decisions. You can also get finance assignment help online without much stress so that you can build your knowledge and skills. There are numerous online platforms that provide quality such quality services.