# What is Capital Budgeting

## Capital budgeting is the planning process used to determine which of an organization's long term investments are worth pursuing.

#### Key Points

• Capital budgeting, which is also called investment appraisal, is the planning process used to determine whether an organization's long term investments, major capital, or expenditures are worth pursuing.

• Major methods for capital budgeting include Net present value, Internal rate of return, Payback period, Profitability index, Equivalent annuity and Real options analysis.

• The IRR method will result in the same decision as the NPV method for non-mutually exclusive projects in an unconstrained environment; Nevertheless, for mutually exclusive projects, the decision rule of taking the project with the highest IRR may select a project with a lower NPV.

#### Terms

• In finance, arbitrage pricing theory (APT) is a general theory of asset pricing that holds, which holds that the expected return of a financial asset can be modeled as a linear function of various macro-economic factors or theoretical market indices, where sensitivity to changes in each factor is represented by a factor-specific beta coefficient.

• The modified internal rate of return (MIRR) is a financial measure of an investment's attractiveness. It is used in capital budgeting to rank alternative investments of equal size. As the name implies, MIRR is a modification of the internal rate of return (IRR) and, as such, aims to resolve some problems with the IRR.

#### Examples

• Payback period: For example, a $1000 investment which returned$500 per year would have a two year payback period. The time value of money is not taken into account.

#### Figures

1. ##### Capital Budgeting

Investment in real estate needs capital budgeting in advance.

### Capital Budgeting

Capital budgeting, which is also called "investment appraisal," is the planning process used to determine which of 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 to budget for major capital investments or expenditures.

### Major Methods

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

Net Present Value

Net present value (NPV) is used to estimate each potential project's value by using a discounted cash flow (DCF) valuation. This valuation requires estimating the size and timing of all the incremental cash flows from the project. 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.

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.

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. 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.

One shortcoming of the IRR method is that it is commonly misunderstood to convey the actual annual profitability of an investment. Accordingly, a measure called "Modified Internal Rate of Return (MIRR)" is often used.

Payback Period

Payback period in capital budgeting refers to the period of time required for the return on an investment to "repay" the sum of the original investment. Payback period intuitively measures how long something takes to "pay for itself." All else being equal, shorter payback periods are preferable to longer payback periods.

The payback period is considered a method of analysis with serious limitations and qualifications for its use, because it does not account for the time value of money, risk, financing, or other important considerations, such as the opportunity cost.

Profitability Index

Profitability index (PI), also known as profit investment ratio (PIR) and value investment ratio (VIR), is the ratio of payoff to investment of a proposed project. It is a useful tool for ranking projects, because it allows you to quantify the amount of value created per unit of investment.

Equivalent Annuity

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 comparing investment projects of unequal lifespans. For example, if project A has an expected lifetime of seven 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.

Real Options Analysis

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 the NPV.

These methods use the incremental cash flows from each potential investment or project. Techniques based on accounting earnings and accounting rules are sometimes used. Simplified and hybrid methods are used as well, such as payback period and discounted payback period.

#### Key Term Glossary

analysis
A process of dismantling or separating into constituent elements in order to study the nature, function, or meaning.
##### Appears in these related concepts:
annuity
A specified income payable at stated intervals for a fixed or a contingent period, often for the recipient’s life, in consideration of a stipulated premium paid either in prior installment payments or in a single payment. For example, a retirement annuity paid to a public officer following his or her retirement.
##### Appears in these related concepts:
APT
In finance, arbitrage pricing theory (APT) is a general theory of asset pricing that holds, which holds that the expected return of a financial asset can be modeled as a linear function of various macro-economic factors or theoretical market indices, where sensitivity to changes in each factor is represented by a factor-specific beta coefficient.
##### Appears in these related concepts:
bond
A documentary obligation to pay a sum or to perform a contract; a debenture.
##### Appears in these related concepts:
Bond
A bond is an instrument of indebtness of the bond issuers toward the bond holders.
##### Appears in these related concepts:
capital
Money and wealth; the means to acquire goods and services, especially in a non-barter system.
##### Appears in these related concepts:
capital budgeting
The budgeting process in which a company plans its capital expenditure (the spending on assets of long-term value).
##### Appears in these related concepts:
Capital Budgeting
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.
##### Appears in these related concepts:
CAPM
In finance, the capital asset pricing model (CAPM) is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk.
##### Appears in these related concepts:
cash flow
The sum of cash revenues and expenditures over a period of time.
##### Appears in these related concepts:
cash inflow
Cash that is received by the investor. For example, dividends paid on a stock owned by the investor is a cash inflow.
##### Appears in these related concepts:
cash outflow
Any cash that is spent or invested by the investor.
##### Appears in these related concepts:
cost of capital
the rate of return that capital could be expected to earn in an alternative investment of equivalent risk
##### Appears in these related concepts:
Cost of Capital
The rate of return that capital could be expected to earn in an alternative investment of equivalent risk.
##### Appears in these related concepts:
discount
To find the value of a sum of money at some earlier point in time. To find the present value.
##### Appears in these related concepts:
discounted cash flow
In finance, discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money. All future cash flows are estimated and discounted to give their present values (PVs)–the sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value or price of the cash flows in question.
##### Appears in these related concepts:
Discounted cash flow
In finance, discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money.
##### Appears in these related concepts:
discounted payback period
The discounted payback period is the amount of time that it takes to cover the cost of a project, by adding positive discounted cash flow coming from the profits of the project.
##### Appears in these related concepts:
discount rate
The interest rate used to discount future cash flows of a financial instrument; the annual interest rate used to decrease the amounts of future cash flow to yield their present value.
##### Appears in these related concepts:
financing
A transaction that provides funds for a business.
##### Appears in these related concepts:
hurdle rate
Minimum acceptable rate of return on an investment
##### Appears in these related concepts:
incremental cash flows
the additional money flowing in or out of a business due to a project
##### Appears in these related concepts:
investment
A placement of capital in expectation of deriving income or profit from its use.
##### Appears in these related concepts:
mutually exclusive
Describing multiple events or states of being such that the occurrence of any one implies the non-occurrence of all the others.
##### Appears in these related concepts:
net present value
the present value of a project or an investment decision determined by summing the discounted incoming and outgoing future cash flows resulting from the decision
##### Appears in these related concepts:
opportunity cost
The cost of an opportunity forgone (and the loss of the benefits that could be received from that opportunity); the most valuable forgone alternative.
##### Appears in these related concepts:
Option
In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price (the strike).
##### Appears in these related concepts:
payback period
the amount of time required for the return on an investment to return the sum of the original investment
##### Appears in these related concepts:
period
The length of time during which interest accrues.
##### Appears in these related concepts:
Present value
Present value, also known as present discounted value, is the value on a given date of a payment or series of payments made at other times.
##### Appears in these related concepts:
Present Value
Also known as present discounted value, is the value on a given date of a payment or series of payments made at other times. If the payments are in the future, they are discounted to reflect the time value of money and other factors such as investment risk. If they are in the past, their value is correspondingly enhanced to reflect that those payments have been (or could have been) earning interest in the intervening time. Present value calculations are widely used in business and economics to provide a means to compare cash flows at different times on a meaningful "like to like" basis.
##### Appears in these related concepts:
ratio
A number representing a comparison between two things.
##### Appears in these related concepts:
replacement
A person or thing that takes the place of another; a substitute.
##### Appears in these related concepts:
return
Gain or loss from an investment.
##### Appears in these related concepts:
risk
The potential (conventionally negative) impact of an event, determined by combining the likelihood of the event occurring with the impact, should it occur.
##### Appears in these related concepts:
Risk
The potential that a chosen action or activity (including the choice of inaction) will lead to a loss (an undesirable outcome).
##### Appears in these related concepts:
valuation
The process of estimating the market value of a financial asset or liability.
##### Appears in these related concepts:
volatility
A quantification of the degree of uncertainty about the future price of a commodity, share, or other financial product.
##### Appears in these related concepts:
WACC
The WACC is the minimum return that a company must earn on an existing asset base to satisfy its creditors, owners, and other providers of capital, or they will invest elsewhere.
##### Appears in these related concepts:
weighted average
An arithmetic mean of values biased according to agreed weightings.
##### Appears in these related concepts:
Weighted Average
In statistics, a weighted average is an average that takes each object and calculates the product of its weight and its figure and sums all of these products to produce one average. It is implied that all the individual weights add to 1.