Capital budgeting is a crucial business process that aims at determining the level of the worthiness of a project or investment. There are several major steps in the capital budgeting process that cannot be ignored. First, it is necessary to identify all available potential opportunities. As a rule, people involved in capital budgeting face several projects and methods, and they should decide which business strategies can be realistic. Second, the participants should estimate all operating costs to make a beneficial project.
The next step is the estimation of cash flow that is required for the implementation of the project. Then, the assessment of risks should occur to comprehend how much money may be sacrificed or lost in a budgeting process. Finally, the implementation step should be taken when a plan is offered, finances make sense, and feedback can be given to prove the importance or failure of the capital budgeting process.
Each step in a capital budgeting process has to be taken thoroughly and according to certain decision rules, and different aspects of the work have to be evaluated in order to make sure that all cash flows are considered. Payback Period, Net Present Value, and Internal Rate of Return are three main rules that are used in capital budgeting. The Payback Period Rule states that there is a certain number of years till the moment when a capital budgeting process can recover its initial cost. In other words, it is the period when invested capital is at risk, and cash flows may be discounted and calculated during this period.
The Net Present Value (NPV) aims at indicating the expected impact the project may have on the company’s value. To calculate NPV, it is necessary to find out the difference between the present value of the incremental benefits and costs. The rule sounds like an independent project may take positive NPVs and reject all negative NPVs or take the feasible combination and obtain the highest combined NPV. Finally, there is the Internal Rate of Return (IRR) in a capital budgeting project. This rule states that an independent project has to be accepted in case its IRR is greater than the existing market-based discount rate. It may happen that an NPV can equal zero. To promote the effectiveness of the rule, it is possible to compare the IRR and a market rate.
Capital budgeting is characterized by a number of rules and approaches with the help of which it is possible to evaluate a project. The NPV, like any other capital budgeting procedure, has its advantages and disadvantages. However, in many cases, the NPV remains to be the best procedure conceptually. There are several reasons for such judgments. First, the NPV method is based on the idea that cash flows can be reinvested at the current cost of capital.
In comparison to the IRR method, the NPV turns out to be a realistic and appropriate to many organizations approach. Besides, the NPV is the method with the help of which the evaluation of mutually exclusive projects can be easier and better in terms of reinvestment rate assumptions, profitability, and shareholder wealth. Finally, the work with non-normal or not known cash flows can be facilitated for the developers who use the NPV. The NPV method provides the users with the possibility to work with the time value. Cash flows may be used any time till the project is defined as ongoing.