Companies generally don't have unlimited money, so they must be strategic in how they spend the resources they do have. Capital budgeting is a process by which companies decide which projects or purchases are worth the cost involved. Companies use capital budgeting to determine whether they should expand their operations, invest in new equipment, or pursue other projects with the potential to bring in additional profits.
There are various capital budgeting methods companies can employ to aid in the decision-making process. The most common methods are outlined below.
The payback period method of capital budgeting allows companies to calculate how long it will take to recoup the outlay for an investment. The payback period is calculated by taking the total cost of a project and dividing it by its anticipated annual revenue. If a company needs to spend $50,000 on new equipment but anticipates that it will generate additional revenue of $25,000 per year as a result, then the payback period would be two years.
Net present value
The net present value method of capital budgeting shows companies the difference between the cost of a project and the cash flow it is expected to bring in. It works by taking the initial investment amount and comparing it to the present value of the future cash flow generated by moving forward with that investment.
Net present value is based on the idea that future cash is not worth as much as present cash: Because cash in hand can be used for revenue-generating purposes, the sooner cash is received, the more it's actually worth. For this reason, in a net present value calculation, future cash flow is assigned a discounted or reduced rate to make up for its lower value. This method of capital budgeting is similar to the payback period method in that it requires a company to estimate the revenue a given project will bring in from year to year. Once that's determined, the value of that anticipated revenue must be discounted to see whether the investment is worthwhile or not.
Internal rate of return
The internal rate of return method of capital budgeting is a way of measuring the rate at which an investment breaks even. It works by setting the net present value of all cash flows to zero and taking external factors such as inflation out of the equation. The goal of this method is to identify projects whose internal rate of return is higher than the cost of implementation: Theoretically, a project whose internal rate of return is higher than its cost will be profitable. The higher the internal rate of return, the more profitable a project is likely to be.
Also known as the profit investment ratio or value investment ratio, the profitability index method of capital budgeting works by examining the relationship between the costs of pursuing a project and its anticipated benefits. It is calculated by taking the present value of future cash flows and dividing it by the initial investment cost. A profitability index that's lower than 1.0 indicates that a project's present value of future revenue is lower than the cost of the initial investment, which means it's not worth pursuing. On the other hand, a profitability index that's greater than 1.0 means that a project may be worthwhile from a financial perspective, and the higher the profitability index, the more financially attractive the project will be.
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