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

Differentiate between the different capital budget methods
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 nonmutually 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

Modified Internal Rate of Return
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.

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 macroeconomic factors or theoretical market indices, where sensitivity to changes in each factor is represented by a factorspecific beta coefficient.
Example
 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.
Full Text
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
 Internal rate of return
 Payback period
 Profitability index
 Equivalent annuity
 Real options analysis
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 nonmutually 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 Reference
 Opportunity cost
 Appears in these related concepts: Differences Between Required Return and the Cost of Capital, The Importance of Motivation, and Defining Comparative Advantage
 analysis
 Appears in these related concepts: The Impact of External and Internal Factors on Strategy, Scenario Analysis, and Writing in Different Academic Disciplines
 annuity
 Appears in these related concepts: Future Value, Multiple Flows, Impact of Payment Frequency on Bond Prices, and Applications of Geometric Series
 bond
 Appears in these related concepts: Factors Affecting the Price of a Bond, Current Maturities of LongTerm Debt, and Preferred Stock
 capital
 Appears in these related concepts: Temple Architecture in the Greek Orientalizing Period, Minoan Architecture, and The Acropolis
 capital budgeting
 Appears in these related concepts: Advantages of the IRR Method, Defining the IRR, and Replacement Projects
 cash flow
 Appears in these related concepts: Calculating the NPV, Interpreting the NPV, and Defining the Cash Flow Cycle
 cash inflow
 Appears in these related concepts: Defining NPV, Calculating the Payback Period, and The Financial Statements
 cash outflow
 Appears in these related concepts: Managing Disbursements, Advantages of the NPV method, and Selected Financial Ratios and Analyses
 discount
 Appears in these related concepts: The Discount Rate, Par Value at Maturity, and Present Value, Multiple Flows
 discount rate
 Appears in these related concepts: Discounted Cash Flow Approach, The Discount Rate, and The Federal Reserve and the Financial Crisis of 2008
 discounted cash flow
 Appears in these related concepts: Valuing the Target and Setting the Price, Valuing the Corporation, and Ranking Investment Proposals
 discounted payback period
 Appears in this related concept: Discounted Payback
 financing
 Appears in these related concepts: Reporting Financing Activities, Cash Flow from Financing, and Deficit Spending, the Public Debt, and Policy Making
 incremental cash flows
 investment
 Appears in these related concepts: Functions of Corporate Finance, The Role of the Financial System, and GDP Equation in Depth (C+I+G+X)
 mutually exclusive
 Appears in these related concepts: Complementary Events, Multiple IRRs, and Solving Systems of Linear Inequalities
 net present value
 Appears in these related concepts: Other Considerations in Capital Budgeting, The Role of Financial Managers, and CostBenefit Analysis
 payback period
 Appears in these related concepts: Advantages of the Payback Method and Defining the Payback Method
 period
 Appears in these related concepts: Frequency of Sound Waves, Sine and Cosine as Functions, and Tangent as a Function
 present value
 Appears in these related concepts: Capital Leases vs. Operating Leases, Calculating Values for Different Durations of Compounding Periods, and Present Value and the Time Value of Money
 profitability
 Appears in these related concepts: Relationships Between Statements, Profitability Ratios, and The Challenge of Ethics and Governance
 ratio
 Appears in these related concepts: The Importance of Productivity, Basic Descriptive Statistics, and Schedules of Reinforcement
 return
 Appears in these related concepts: Dollar Returns, Comparing the Fields of Finance, Economics, and Accounting, and Disadvantages of the Payback Method
 risk
 Appears in these related concepts: The ExportImport Bank of the United States, Approaches to Assessing Risk, and Risks Involved in Capital Budgeting
 valuation
 Appears in these related concepts: Evaluating Financial Statements, Valuation of Intangible Assets, and Basic Components of Asset Valuation
 volatility
 Appears in these related concepts: Misleading Graphs, Historical Returns: Market Variability and Volatility, and BlackScholes Formula
 weighted average
 Appears in these related concepts: Average Cost Method, Market Reporting, and Expected Value
Sources
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