Capital budgeting (or investment appraisal) is the planning process used to determine whether an organization's long term investments

such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is budget for major capital, or investment, expenditures.[1] Many formal methods are used in capital budgeting, including the techniques such as

Accounting rate of return Payback period Net present value Profitability index Internal rate of return Modified internal rate of return Equivalent annuity Real options valuation

These methods use the incremental cash flows from each potential investment, or project. Techniques based on accounting earnings and accounting rules are sometimes used - though economists consider this to be improper - such as the accounting rate of return, and "return on investment." Simplified and hybrid methods are used as well, such as payback period and discounted payback period. Capital Budgeting Definition acoording to two Economist Khizar Hayyat And Saqlain Shah: capital budgeting is a long term economics decision making it is called capital budgeting Each potential project's value should be estimated using a discounted cash flow (DCF) valuation, to find its net present value (NPV). (First applied to Corporate Finance by Joel Dean in 1951; see alsoFisher separation theorem, John Burr Williams: Theory.) This valuation requires estimating the size and timing of all the incremental cash flows from the project. (These future cash highest NPV(GE).) The NPV is greatly affected by the discount rate, so selecting the proper rate sometimes called the hurdle rate - is critical to making the right decision. The hurdle rate is the Minimum acceptable rate of return on an investment. This should reflect the riskiness of the investment, typically measured by the volatility of cash flows, and must take into account the financing mix. Managers may use models such as the CAPM or the APT to estimate a discount rate appropriate for each particular project, and use the weighted average cost of capital (WACC) to reflect the financing mix selected. A common practice in choosing a discount rate for a project is to apply a WACC that applies to the entire firm, but a higher discount rate may be more appropriate when a project's risk is higher than the risk of the firm as a whole. [edit]Internal rate of return Main article: Internal rate of return The internal rate of return (IRR) is defined as the discount rate that gives a net present value (NPV) of zero. It is a commonly used measure of investment efficiency.

The IRR method will result in the same decision as the NPV method for (non-mutually exclusive) projects in an unconstrained environment, in the usual cases where a negative cash flow occurs at the start of the project, followed by all positive cash flows. In most realistic cases, all independent projects that have an IRR higher than the hurdle rate should be accepted. Nevertheless, for mutually exclusive projects, the decision rule of taking the project with the highest IRR - which is often used - may select a project with a lower NPV. In some cases, several zero NPV discount rates may exist, so there is no unique IRR. The IRR exists and is unique if one or more years of net investment (negative cash flow) are followed by years of net revenues. But if the signs of the cash flows change more than once, there may be several IRRs. The IRR equation generally cannot be solved analytically but only via iterations. One shortcoming of the IRR method is that it is commonly misunderstood to convey the actual annual profitability of an investment. However, this is not the case because intermediate cash flows are almost never reinvested at the project's IRR; and, therefore, the actual rate of return is almost certainly going to be lower. Accordingly, a measure called Modified Internal Rate of Return (MIRR) is often used. Despite a strong academic preference for NPV, surveys indicate that executives prefer IRR over NPV[citation needed], although they should be used in concert. In a budget-constrained environment, efficiency measures should be used to maximize the overall NPV of the firm. Some managers find it intuitively more appealing to evaluate investments in terms of percentage rates of return than dollars of NPV. [edit]Equivalent annuity method Main article: Equivalent annual cost The equivalent annuity method expresses the NPV as an annualized cash flow by dividing it by the present value of the annuity factor. It is often used when assessing only the costs of specific projects that have the same cash inflows. In this form it is known as the equivalent annual cost (EAC) method and is the cost per year of owning and operating an asset over its entire lifespan. It is often used when comparing investment projects of unequal lifespans. For example if project A has an expected lifetime of 7 years, and project B has an expected lifetime of 11 years it would be improper to simply compare the net present values (NPVs) of the two projects, unless the projects could not be repeated. The use of the EAC method implies that the project will be replaced by an identical project. Alternatively the chain method can be used with the NPV method under the assumption that the projects will be replaced with the same cash flows each time. To compare projects of unequal length, say 3 years and 4 years, the projects are chained together, i.e. four repetitions of the 3 year project are compare to three repetitions of the 4 year project. The chain method and the EAC method give mathematically equivalent answers. The assumption of the same cash flows for each link in the chain is essentially an assumption of zero inflation, so a real interest rate rather than anominal interest rate is commonly used in the calculations.Y

[edit]Real options Main article: Real options analysis Real options analysis has become important since the 1970s as option pricing models have gotten more sophisticated. The discounted cash flow methods essentially value projects as if they were risky bonds, with the promised cash flows known. But managers will have many choices of how to increase future cash inflows, or to decrease future cash outflows. In other words, managers get to manage the projects - not simply accept or reject them. Real options analysis try to value the choices - the option value - that the managers will have in the future and adds these values to theNPV. [edit]Ranked Projects The real value of capital budgeting is to rank projects. Most organizations have many projects that could potentially be financially rewarding. Once it has been determined that a particular project has exceeded its hurdle, then it should be ranked against peer projects (e.g. highest Profitability index to lowest Profitability index). The highest ranking projects should be implemented until the budgeted capital has been expended. [edit]Funding Sources When a corporation determines its capital budget, it must acquire said funds. Three methods are ge stock have no financial risk but dividends, including all in arrears, must be paid to the preferred stockholders before any cash disbursements can be made to common stockholders; they generally have interest rates higher than those of corporate bonds. Finally, common stocks entail no financial risk but are the most expensive way to finance capital projects.The Internal Rate of Return is very important. [edit]Need For Capital Budgeting 1. As large sum of money is involved which influences the profitability of the firm making capital budgeting an important task. 2. Long term investment once made can not be reversed without significance loss of invested capital. The investment becomes sunk and mistakes, rather than being readily rectified,must often be born until the firm can be withdrawn through depreciation charges or liquidation. It influences the whole conduct of the business for the years to come. 3. Investment decision are the base on which the profit will be earned and probably measured through the return on the capital. A proper mix of capital investment is quite important to ensure adequate rate of return on investment, calling for the need of capital budgeting. 4. The implication of long term investment decisions are more extensive than those of short run decisions because of time factor involved, capital budgeting decisions are subject to the higher degree of risk and uncertainty than short run decision.[2] .

Introduction The three capital budgeting techniques widely used today are the payback, net present value (NPV), and internal rate of return (IRR) methods. Each one of them has their own individual pros and cons. In addition, each method can be used to derive a decision as to whether a business should conclude to accept or reject a project. Payback Method The payback method is useful because of its simplicity. You simply take the expected cash inflows per year expected after the initial investment and find the breakeven point in where the cash inflows equals the initial investment. Whenever that breakeven point occurs on your timeline, that is your payback period. Let us suppose an initial investment for a project is $1.3 million, the expected cash inflows for the first two years totals $850,000, and the third year is expected to be $475,000. $850,000 subtracted from $1.3 million equals $450,000 left, which needs to be taken out of the $475,000 to derive at the breakeven point. 450 divided by 475 is 0.95. When this is taken and added it to the first two years, it is easy to see that the payback period is 2.95 years. (Gitman, 2009, p. 426) The payback method is a one-sidedly derived number which tells a small amount about a project's beginning phase, but it tells one close to nothing about the full lifetime of the project. The effortlessness of calculating payback can possibly promote carelessness, especially in the failure to incorporate all the costs linked with investing in a project, such as training and maintenance. The payback method does not account for the time value of money either, and is therefore considered an unsophisticated capital budgeting technique. Even though the payback method has these cons associated with it, the simplicity of the method can allow it to be used as a filter for those projects which should go on to a more in-depth method, such as those explained below. If a project is not recommended based on the payback method, then chances are pretty high the project should not even be considered for the other methods. (p. 427) NPV Method The NPV method does take into consideration the time value of money, so it is referred to as a sophisticated capital budgeting technique. Therefore, everything is calculated based of today's dollars. For example, if $300,000 is expected to be earned in year 5, then its worth is $155,811 in today's dollars. This method is easier to calculate by hand than the IRR method. In addition, the NPV method gives a more realistic solution due to the fact that it takes into consideration that the firm reinvests intermediate cash flows at the company's cost of capital rate, rather than the high rate specified by the IRR method. The NPV method is the theoretically preferred method of capital budgeting techniques. (p. 429-430)

The NPV is considered less insightful because it does not measure the interest rates, profitability, and other benefits relative to the amount invested. This means that NPV gives one a measure of the expected dollar amount of money made from the proposed project. Most often, financial managers want to see results measured in annual rate of return, such as with the IRR method. (p. 439-441) IRR Method The IRR method is another sophisticated capital budgeting technique and is the most widely used. It is, however, more complicated to calculate by hand, and a scientific calculator or spreadsheet application may need to be used. Businesspeople typically would rather see calculation results in the form of annual rates of return instead of actual dollar returns. This allows them to really compare two or more projects for ranking purposes to see which project is going to provide more bang for the buck. The IRR method gives the rate of return result. This is especially important in our current economic climate, where businesses are trying to cut costs and only invest in those projects which will yield a higher rate of return. (p. 439) As stated the IRR method is difficult to calculate by hand. Therefore, the IRR method is more time consuming. It is, however, the preferred practical application of capital budgeting techniques due to its intuitive appeal. There are some complications which can arise out of utilizing the IRR method when there is a nonconventional cash flow pattern. The financial analysts will just need to ensure they spend the extra time identifying and resolving the problems with the IRR prior to the managers utilizing the data to make a decision. (p. 439) Accept or Reject Project In seeing, in our example, that if a five year payback period is required and that the calculated payback period is 2.95, it is recommended that this project be filtered on through to the next steps of looking at the NPV and IRR methods. When using the NPV method, the basis for accepting or rejecting a project lies in whether the NPV is greater than or less than $0. If the NPV is calculated out to be greater than $0, then it is recommended that the project be accepted based on the NPV method. Before moving forward, however, we need to look at the IRR method. Under the IRR method rules, the criteria for deciding to accept or reject a project is based on whether the IRR is greater than or less than the cost of capital. If the IRR is greater than the cost of capital, then the final recommendation would be to move forward with the project. (p. 425, 430, 432) Conclusion

Even though the NPV and IRR methods yield better decision-making data based off them being sophisticated capital budgeting techniques, the payback method is not without a purpose. The payback method is a quick and easy way to filter a project to see if the time should be spent to further analyze whether the project should move forward. In the example, the payback period was almost half of what the maximum payback period was, so it was definitely a good candidate for further scrutiny. The NPV and IRR methods both give very good accept-reject results. However, IRR is the preferred method by most since its results are portrayed in rates of return, which most financial managers see as representative across the board.