Capital Budgeting



Capital Budgeting

Capital Budgeting is a process in which a company or an institution evaluates its investment decision, whether is it financially feasible to go for the project or not. It includes various methods and tools to find out whether the investment is feasible or not. These tools have several advantages and disadvantages. These tools include NPV, IRR and Payback Period. We will discuss each one of them individually.

Net Present Value

The Net Present Value (NPV) is the most popular method used, when evaluating investment projects in the long term. The net present value is used to determine whether an investment complies with the basic financial objective or not that is to maximize investment. The Net Present Value determines if the investment may increase or decrease the value of Stock Holder Wealth. This change in the estimated value may be positive, negative, or remain the same. If it is positive it means that the value of the firm will have an increase equal to the amount of Net Present Value. If it is negative, than it means that the firm will reduce its wealth in the value PN. If the result is zero NPV, the company will not change the amount of its value. It is important to note that the value of net present value depends on Initial Investment/Prior Investment, Discount Rate and life of the project.

Initial Investment

It corresponds to the amount or value of the payout that the company made at the time of acquiring the investment. This amount can be found: the value of fixed assets, deferred investment and working capital.

Fixed assets are those tangible assets necessary for the transformation of raw materials (buildings, land, machinery, equipment) or that can support the process. These assets make the investment capacity of which depend on production capacity and marketing capacity.

Deferred investment is one that does not enter the production process and it is necessary to fine tune the project: construction, installation and assembly of a plant, the paperwork that is required in developing the project such as, the costs of organizing, patents and legal documents needed to initiate activities, are examples of deferred investment.

Discount Rate

The discount rate is the required rate of return on an investment. The discount rate reflects the lost opportunity to spend or invest in this so it is also known as opportunity cost or rate. Its operation is applied in a manner contrary the concept of composite rate. That is, if future interest rates compound the amount of interest capitalized of this investment, the discount rate reverses this operation. In other words, this rate is responsible for deducting the capitalized amount of total interest income in the future.

Example:

Investment: $ 1,000 off regular rate: 15%. Years to capitalize: 2

Future value at end of period 2 = 1.000 x (1.15) 2 = 1322.50

Present value of 1322.50 at a discount rate of 15% for 2 years = 1,000

1322.50 ÷ (1.15) 2 = 1,000

In evaluating projects an investor can have difficulty determining the discount ...