Capital budgeting , and investment assessment , is the planning process used to determine whether an organization's long-term investments such as new machines, replacement machines, new plants, new products, and research development projects worth of cash funding through the company's capital structure (debt, equity or retained earnings). This is the process of allocating resources for major capital, or investment, spending. One of the main objectives of capital budgeting investment is to increase the value of the company to shareholders.
Many formal methods are used in capital budgeting, including such techniques
- Accounting rate of return
- Average recalculation
- Return period
- Net present value
- Profitability Index
- Internal rate of return
- Modified internal rate of return
- The equivalent annual fee
- Real option assessment
This method uses additional cash flows from each potential investment, or the project . Techniques based on accounting earnings and accounting rules are sometimes used - although economists consider this to be inappropriate - such as accounting returns, and "return on investment." Simple and hybrid methods are also used, such as payback period and discount refund period .
Video Capital budgeting
Net present value
' Nilai Net Present:'
Project classification: - As the name suggests, this method - recognizes the time value of money that is critical to the implementation of long-term capital projects. this is a discounted cash flow approach for capital budgeting where all cash flows are discounted to the present value.
Capital budgeting projects are classified as Mandiri Projects or Joint Exclusive Projects. Independent Project is a project whose cash flow is not affected by acceptance/rejection decisions for other projects. Thus, all Independent Projects meeting Capital Adjustment criteria should be accepted.
A mutually exclusive project is the most widely accepted project set. For example, a set of projects must accomplish the same task. Thus, when choosing between "mutually exclusive projects", more than one project can meet capital budgeting criteria. However, only one, that is, the best project, is acceptable.
Of the three, only the net present value and the internal rate of return decision decision consider all the project's cash flows and the time value of money. As we will see, only net value decision rules will now always lead to the right decision when choosing among mutually exclusive projects. This is because the net present value and internal rate of return decision decision differ with respect to the assumption of their reinvestment rate. The current net value decision rule implicitly assumes that the project's cash flows can be reinvested at the firm's capital costs, while the internal rate of return decision decision implicitly assumes that cash flows can be reinvested in the IRR of the project. Since each project tends to have a different IRR, the assumptions underlying the net value decision rule now make more sense.
Maps Capital budgeting
Internal rate of return
internal rate of return (IRR) is defined as the discount rate that gives the current net value (NPV) zero. This is a commonly used measure of investment efficiency.
The IRR method will yield the same decision as the NPV method for (non-exclusive) projects in an unlimited environment, in ordinary cases where negative cash flows occur 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 level of obstacles should be accepted. However, for mutually exclusive projects, the decision rule of taking projects with the highest IRR - often used - can choose projects with lower NPVs.
In some cases, some zero discount rates of NPV may exist, so there is no unique IRR. IRR exists and is unique if one or more years of net investment (negative cash flows) is followed by years of net income. But if the signs of cash flow change more than once, there may be several IRRs. The IRR equation generally can not be solved analytically but only through iteration.
One disadvantage of the IRR method is that it is often misinterpreted to indicate the actual annual profits of an investment. However, this is not the case because medium cash flows are almost never reinvested in the IRR of the project; and, therefore, the actual rate of return will almost certainly be lower. Thus, a measure called Internal Modified Rate (MIRR) is often used.
Despite strong academic preferences for NPV, surveys show that executives prefer IRRs rather than NPVs, although they should be used simultaneously. In a budget-limited environment, efficiency measures should be used to maximize the overall NPV of the enterprise. Some managers find it intuitively more appealing to evaluate investment in terms of percentage of return than NPV dollars.
Equal annuity method
The equivalent annuity method states the NPV as the annual cash flow by dividing it by the current value of the annuity factor. This is often used when assessing only certain project costs that have the same cash inflows. This form is known as the method of annual cost equivalent (EAC) and is the annual cost to own and operate the asset for the entire life of its life.
This is often used when comparing investment projects from different lifespan. For example, if project A has a life expectancy of 7 years, and project B has an age of 11 it is inappropriate to compare only the current net value (NPVs) of two projects, unless the project can 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 assuming that the project will be replaced with the same cash flows each time. To compare projects that are not the same length, say 3 years and 4 years, the projects are chained together, ie four repetitions of a 3-year project compared to three repetitions of a 4-year project. EAC chain and method methods provide equivalent mathematical answers.
The same cash flow assumption for each link in the chain is essentially a zero inflation assumption, so the real interest rate rather than the nominal interest rate is usually used in the calculations.
Real options
Analysis of real options is important since the 1970s because the option pricing model is becoming more sophisticated. The discounted cash flow method basically assesses the project as if they are a risky bond, with the promised cash flow known. But managers will have many choices about how to increase future cash inflows, or to reduce future cash outflows. In other words, managers can manage projects - not just accept or reject them. Analysis of real options tries to assess the options - the options value - that managers will have in the future and add these values ​​to the NPV.
Increase project rank
The real value of capital budgeting is to rank the project. Most organizations have many projects that have the potential to provide financial rewards. Once it is determined that a particular project has exceeded its obstacles, it should be ranked against peer projects (eg - the highest Profitability Index to the lowest Profitability index). The highest-ranking project should be implemented until the budgeted capital has been spent.
Funding source
Investment and capital budgeting projects should be funded through the excess cash provided through increased debt capital, equity capital, or retained earnings. Debt capital is borrowed in cash, usually in the form of bank loans, or bonds issued to creditors. Equity capital is an investment made by shareholders, who buy shares in the company's stock. Retained earnings are the surplus cash advantages of current and past corporate earnings.
Need
- A large amount of money is involved which affects the profitability of a company making the capital budget an important task.
- Long-term investments, once created, can not be canceled without significant loss of invested capital. Investments are sinking, and mistakes, rather than being repaired, should often be borne until the company can be withdrawn through depreciation or liquidation charges. This affects all business behavior for years to come.
- The investment decision is the basis from which the profits will be earned and may be measured by payback. A proper mix of capital investments is essential to ensure an adequate return on investment, which demands the need for capital budgeting.
- The implications of long-term investment decisions are broader than short-term decisions because of the time factor involved, capital budgeting decisions are subject to higher levels of risk and uncertainty than short-term decisions.
See also
- Operations budget
External links and references
- International Good Practices: Guide to Assessing Projects Using Discounted Cash Flow , International Federation of Accountants, June 2008, ISBN 978-1-934779-39-2
- Prospective Analysis: Guidelines Forecasting Financial Statements, Ignacio Velez-Pareja, Joseph Tham, 2008
- To Connect or Not to Connect, That's the Question: No Plugs, No Distribution: A Better Way to Predict Financial Statements, Ignacio Velez-Pareja, 2008
- Step-by-Step Guide to Building a No-Plug and Non-Circular Financial Model for Rating Interests, Ignacio Velez-Pareja, 2008
- Estimated Long-Term Financial Statement: Reinvesting Retained Earnings, Sergei Cheremushkin, 2008
Source of the article : Wikipedia
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