Value and Capital Budgeting

Capital Budgeting is the process by which the firm decides which long-term investments to make. Capital Budgeting projects, i.e., potential long-term investments, are expected to generate cash flows over several years. The decision to accept or reject a Capital Budgeting project depends on an analysis of the cash flows generated by the project and its cost. The following three Capital Budgeting decision rules will be presented:

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 thevolatility 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.