At its core, capital budgeting refers to the process undertaken by a business or organization to evaluate, rather determine projects or investments options that could be advantageous. In other words, the process of capital budgeting entails choosing projects that add value to an organization (Malenko, 2019). Examples of projects or investments that would require capital budgeting include the establishment of a new plant, purchasing of new equipment or even venturing into new markets. Through capital budgeting the projects are either approved or rejected depending on the value they add to the organization.
The process of capital budgeting has five steps. They include identification and evaluation of investment opportunities, estimation of costs of operation and implementation, estimation of cash flow or benefit, assessment of risk, and implementation (Abor, 2017). Capital budgeting begins with the exploration of opportunities available. In most cases, organizations have a variety of projects and investments options from which to choose. Therefore each option is evaluated to determine the most financially and logistically feasible. In the second step, the organization estimates the costs of bringing the project to fruition. Depending on the organization and project, this step could involve both internal and external research. After which the company should cut down costs of implementation.
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In the third step of capital budgeting, the organization estimates the cash flow the project should generate. For projects that do not directly generate cash flows but increase efficiency, an organization can conduct a cost-benefit analysis to determine if it is logic. The fourth step involves assessing risk associated with the project (Abor, 2017). Risk is in terms of the extent of money the company is willing to loose in case the project or investment does not generate cash as anticipated. After a degree of risk is established the organization can then determine whether it is feasible to proceed to the next step. The final step in capital budgeting process involves implementation. Following the analysis made in the previous steps, the organization then decides to move forward with the project. At this stage, an implementation plan that includes the projects’ milestones and deadlines is developed.
Net Present Value (NPV) is difference between present value of cash inflows and present value of cash outflows that result from implementing a project. The NPV of a project is determined by adding present values of all cash inflows and outflows (Bornholt, 2017). Examples of cash inflows of a project include coupon repayments or even repayment of a principal bond. Cash outflows on the other hand refers to money used in the underlying activities of implementing a project. For instance, buying of an equipment. Cash inflows have positive sign while cash outflows have negative sign. The accuracy of NPV in a project is dependent on knowledge of each cash flow as well as the time it will take place.
Used in capital budgeting, Net Present Value is a technique used to evaluate potential physical assets that a company might want to invest in, taking into consideration the time value of money. A discounted cash flow valuation is used and requires estimation of size and timing of the cash flows to the project (Bornholt, 2017). Notably, the NPV is greatly influenced by the discounted rate. Choosing the right discounted rate is critical for the right decision for the organization. When the NPV turns out to be positive, it is an indication that the organization will profit from the investment. On the other hand, a project or investment with a negative NPV reveals a net loss. Through the NPV, a company can accept or reject the available projects and investment options.
References
Abor, J. Y. (2017). Evaluating Capital Investment Decisions: Capital Budgeting. In Entrepreneurial Finance for MSMEs (pp. 293-320). Palgrave Macmillan, Cham.
Bornholt, G. (2017). What is an investment project's implied rate of return?. Abacus , 53 (4), 513-526.
Malenko, A. (2019). Optimal dynamic capital budgeting. The Review of Economic Studies , 86 (4), 1747-1778.
