At its core, capital budgeting entails a firm’s choice of projects that add value to it. Depending on an organization, projects can range from opening a new plant, acquiring equipment, and purchasing fixed assets among others. Typically, organizations are supposed to undertake projects that will increase margins and sequentially the wealth of its shareholders. The process of capital budgeting is important for an organization because it creates not only a measure of anticipated returns but also accountability. Except for non-profit organizations, the process of capital budgeting creates a measurable way through which a firm can determine or rather gauge long-term economic profitability of projects it undertakes (Almazan, Chen & Titman, 2017). When a capital budgeting decision is presented to a firm, three major method are used to determine whether it is viable or not. These include the payback period, internet rate of return, and net present value. Each valuation method has its cons and pros and best used in different organizations.
Payback period calculates the length of time a business takes to break even. For instance, if a business initially invested $100 million dollars and anticipates a margin of $30 million per year, the payback period determines the length of time to get back the original amount. A major benefit of the payback method is that it is easy to calculate. Drawbacks for this method on capital budgeting are numerous. First, the method does not take into account the time value of money which automatically violates fundamental principles of finance (Goyat & Nain, 2016). Another drawback stems from the fact that discounted payback periods ignore cash periods that take place when a project’s life cycle is almost coming to an end. As such, the method is not considered a direct measure for a company’s profitability.
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On the other hand, the internal rate of return is a simpler value of the net present value method whose result is zero. The method utilizes a discounted rate to translate the present value of future cash flows to zero. The major benefit of the method is that it is easy to compute. Just as the payback method, this method does not indicate a true sense of the value of a project to a fir. Simply put, it merely provides a benchmark figure for acceptance of projects based on cost capital of a firm (Almazan, Chen & Titman, 2017). In addition, it does not enable the comparison among mutually exclusive projects that a firm might be considering to undertake.
Net present value is regarded as the most accurate and intuitive method for the capital budgeting process. A major rule for NPV is the acceptance of all projects with a positive net present value and the vice versa. Also, projects that have a high discounted value should be given first priority. A major advantage of the NPV approach in capital budgeting is that it provides a direct measure of profitability and value of a project to an organization (Almazan, Chen & Titman, 2017). One major disadvantage of NPV is that the firm’s cost of capital is not accurate but requires some guesswork. As such the company may fall for suboptimal investments or even leave out some. Another drawback is that there is no guaranteed return which makes it difficult to determine the cashflows from particular projects.
The three valuation methods are used for different decisions and organizations, both profit and non-profit. The payback period is best used in projects that require the use of liquidity as an important criterion in the choice of project. Often it is best used in non-profit organizations. The internal rate of return is most useful when making decisions for long-term projects. The method is best applied in for-profit organizations. The NPV method is best used in profit organizations to make decisions on the viability of a project in the long-term.
In conclusion, the above three valuation methods are critical in the process of capital budgeting. In the health care industry, for instance, inflation has affected trends in terms of Price Index and even personal consumption (Warburton, 2019). Since health care inflation has been steadily increasing over the years, capital budgeting is critical for organizations to figure their long-term profitability in the industry. While health care teams have diligently worked to meet the extensive capital needs, the growing demand for modern equipment, increase safety, and improved patient outcomes requires capital budgeting to ensure profitability at the same time.
References
Almazan, A., Chen, Z., & Titman, S. (2017). Firm Investment and Stakeholder Choices: A Top‐Down Theory of Capital Budgeting. The Journal of Finance , 72 (5), 2179-2228.
Goyat, S., & Nain, A. (2016). Methods of Evaluating Investment Proposals. International Journal of Engineering and Management Research (IJEMR) , 6 (5), 278-280.
Warburton, L. (2019). Managing the rising costs of healthcare provision. TAXtalk , 2019 (76), 30-32.
