Capital budgeting

Capital budgeting, or investment appraisal, is the planning process used to determine whether an organization's long term investments such as new machinery, replacement of machinery, new plants, new products, and research development projects are worth the funding of cash through the firm's capitalization structure (debt, equity or retained earnings). It is the process of allocating resources for major capital, or investment, expenditures. One of the primary goals of capital budgeting investments is to increase the value of the firm to the shareholders.

Many formal methods are used in capital budgeting, including the techniques such as

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.

'Net Present value:'

Project classifications

Capital budgeting projects are classified as either Independent Projects or Mutually Exclusive Projects. An Independent Project is a project whose cash flows are not affected by the accept/reject decision for other projects. Thus, all Independent Projects which meet the Capital Budgeting criterion should be accepted.

Mutually exclusive projects are a set of projects from which at most one will be accepted. For example, a set of projects which are to accomplish the same task. Thus, when choosing between "mutually exclusive projects", more than one project may satisfy the capital budgeting criterion. However, only one, i.e., the best, project can be accepted.

Of these three, only the net present value and internal rate of return decision rules consider all of the project's cash flows and the time value of money. As we shall see, only the net present value decision rule will always lead to the correct decision when choosing among mutually exclusive projects. This is because the net present value and internal rate of return decision rules differ with respect to their reinvestment rate assumptions. The net present value decision rule implicitly assumes that the project's cash flows can be reinvested at the firm's cost of capital, whereas the internal rate of return decision rule implicitly assumes that the cash flows can be reinvested at the project's IRR. Since each project is likely to have a different IRR, the assumption underlying the net present value decision rule is more reasonable.

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