Capital Budgeting

Capital Budgeting Practices

MGMT 640 Section 9040

Professor J.Jain

Executive Summary

This essay discusses the importance of capital budgeting and analyzes the most common techniques. The most frequently used methods are the net present value (NPV) and internal rate of return (IRR). These are both tools that analyze the present value of the cost of a project as well as the present value of that projects future cash flows. An essential part of these methods is that they both account for discounted cash flow (DCF), meaning that they both reflect the time value of money. When analyzing independent projects with conventional cash flows, both the NPV and IRR will provide projections along the same lines. However when those two conditions are not met, the IRR method will become misleading. Therefore I argue that the NPV should take precedence over the IRR when only one method can be chosen. However, financial managers should be wary when using the NPV as it does not account for certain factors such as the value of waiting and cash flows that occur on a non-yearly basis.

There are direct correlations between the size of a firm and the capital budgeting method most utilized. Small businesses frequently overlook the two most popular methods and opt to analyze projects with the “payback period”, which evaluates the time it will take in order to recuperate cash flows invested in a given project. The variation of this method is known as the discounted payback period, which also accounts for the time value of money. The payback period methods were also found to be most prevalent among non-American firms.

Based on my research, I conclude that companies attempting to create the most value for stockholders should utilize a combination of the NPV and IRR methods (MIRR if reinvestment of capital is called for), while still remaining conscious of each approach’s shortcomings. This strategy will provide the best opportunity for success.

One of the most important decisions made within a company are those pertaining to capital budgeting. This is the process of “choosing real assets in which the [company] will invest” (Parrino & Kidwell, 2009). This process will have momentous impact on the company’s overall financial performance and cannot be taken lightly. In order for a company to have success in this department, management will have to make highly educated decisions regarding which types of investments to make and determine whether each of these investments will be worth more in the future than they initially cost (i.e. create value). These investments will vary from company to company, however some examples of projects include: investments in property, research and development projects, plant expansion or replacement,