Capital Budgeting

Investment Appraisal or Capital Budgeting is the planning process used to determine a company's long-term investments, including such things as new plants, new machinery, new products, replacement machinery, and research and development projects. Capital expenditures range from medium to very large and also have a significant impact on the company's financial performance as, more often than not, a high level of importance is placed on the project selection. This process is referred to as capital budgeting within the industry.

In Capital Budgeting, many formal methods are used, including such techniques as:

Profitability index

Net present value

Internal Rate of return

Equivalent annuity

Modified Internal Rate of Return

All these above methods use incremental cash flow from projects or from each potential investment.

Criteria for capital Budgeting Decisions

Selecting projects is one of the criteria necessary in every capital budgeting decision. Sometimes shareholders of the company may want the company to select projects that will quickly surge in money inflows, while others may want to give little importance to short-term performance and instead place the emphasis on long-term growth. It would be difficult for the company to satisfy its shareholders with differing interests, but there is a solution-Net Present Value.

Using Net Present Value (NPV) as criteria to select projects assumes proficient capital markets. In other words, in order to work the company has to have access to whatever budget is needed to continue the positive Net Present Value projects. Sometimes there may also be capital ration and the concept of capital budgeting process becomes more and more complex.

Alternative Rules for Capital Budgeting

While NPV is the rule which maximizes value of shareholders, some companies use other strategies for their capital budgeting decisions. Common alternative strategies include:

Profitability Index

Internal Rate of Return (IPR)

Payback Period

Return on Book Value

Investment decisions made from the Profitability index and Internal Rate of Return methods agree with those of Net Present Value. Decisions made using the return on book value and payback period method usually are suboptimal from the point-of-view of increasing shareholders value.