Capital Budgeting is the process of planning whether the Company’s long term investments like machinery, plants, buildings etc. are worth the funding out of the company’s capital structure i.e. equity, debt or retained earnings or not. The basic focus of the capital budgeting is to lower the cost to the firm and increase the value of the firm. It is a wise way of planning to invest the company’s resources into major projects. Thus Capital Budgeting is a vital and sensitive element of business. It is also known as Investment Appraisal. This is linked with only the investment decisions.
There are several methods to study the Capital budgeting process and to evaluate as if which asset is appropriate to be taken and how it is to be funded. The following methods are adopted for the study:
All these methods help in the proper evaluation of projects and to choose the best suited project for the business which helps in minimizing the cost and maximizing the value of the business. These methods usually study the capital budgeting process using the analysis of cash flows from the project.
The most widely used methods among these are Internal Rate of Return (IRR) and Net Present Value (NPV).
Internal Rate of Return: Internal Rate of Return is based on the discount rate which brings down the present value of cash flows of all the projects to zero. Thus, the higher the IRR the higher will be the returns. The basic aim of the project is to increase the rate f return as much as possible beyond the hurdle rate i.e. expected rate of return.
Net Present Value: NPV is the difference between the present value of the inflows to the present value of the cash flows. This method is purely based on the time value of money and the discounting factor taken for bringing the inflows and outflows to present value. This method is highly recommended and appropriate of its reliability and also helps in maximizing the value of the firm.
The other methods in consideration are:
Payback Period: Payback period is the period required for the return on investment to repay the original amount. It is the time required by the investment to repay its own original amount. The lesser the payback period for an investment is, the more preferable it is.
Real Option Analysis: The managers are not supposed to accept or reject the plans only. Instead they manage the projects along with the inflows and outflows. Thus this method gives the business the options along with other features by which they can choose the appropriate method of evaluating the project.
1. Selection of Project: The Capital budgeting process helps in the selection of an appropriate project which will earn the maximum benefit to the business. The project decision needs to be correct because it is a vital element in the business.
2. Long term Decision: The decision is taken for the long term investments. These long term investments involve huge amounts and allocations of these amounts need to be taken track of and utilized efficiently.
3. Ranking of Projects: Choosing one project from a lot is a challenging task. Thus capital budgeting makes the task simpler by ranking the projects according to their cash flows and their feasibility.
1. Time Value of Money: The Capital Budgeting process gives due consideration to time value of money. It tells about the investment earnings in the present value by using discounting. This makes the data more reliable and user friendly. The future investments can be analyzed properly in present time and ranked accordingly.
2. Maximizes value of the company: The capital budgeting process helps in the maximization of its value. The aim of the business is to earn maximum return to the shareholders and this is done by using the projects that can maximize the value of the firm and earn good returns to the business.
Thus, we see how the capital budgeting process is of great importance for the proper planning in the business and maintaining its assets efficiently. NPV Model is better than IRR in terms of its reliability and correctness.
Thus a business’s functioning is highly reliable on the Capital Budgeting Process. The calculation and analysis of different plans available with the business for the investments in the assets can be a complicated task as it includes analyzing various fields and dimensions. But we are here to help you at assignmenthelp.net where you can contact us at anytime and we will help you with your queries and helping you out with your assignments. We respect that you can’t lose on marks and that is why we are here to provide you with the best facilities and qualitative results. You can also take online classes from the best tutors. We believe in providing the best services for your satisfaction. We serve our clients with good and satisfying work and with complete dedication.
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