Capital Budgeting Techniques

Capital Budgeting Techniques
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CAPITAL BUDGETING TECHNIQUES
Capital budgeting is the process of planning which is used to determine the investments that are worth pursuing within an organization. Capital budgeting is also known as investment appraisal employs a procedure that conclude whether long term investments of a certain organization, expenditure or major capital are worth to pursue (Lasher, 2011). Most of the projects involve huge sums of money and therefore the risk involved is immense. Considering that long-term plans cannot be reversed without great losses and implications compared to the short-term projects, it is always important to make sure the money are committed in the right place. The goal for any business is the level of profit that is derived from the investment that is put into the project. Every project has the sole interest of maximizing the returns to the shareholders, which is why capital budgeting uses various techniques that evaluate the rate of return. There are always competing projects that need to be funded, but only the most viable can be commenced. As such these techniques help in reviewing the available options in terms of profitable ventures/projects and awarding the funds to the one that show the most promising returns on investment. Those that do not meet the criterion of evaluation are redefined further or shelved for later dates when they can be more profitable. Various techniques are applicable in capital budgeting even though each of them contains comparable strengths and weaknesses to the other, according to their operations.
Various formal methods are usable in capital budgeting and the techniques suitable for this function include the Net present value, the profitability index, international rate return, as well as payback period. The long-term investment assessed by these techniques may include replacement machinery, new machinery, new products, new plants, and projects of research development. The Net present value abbreviated as NPV, I usable in estimating the value of potential project through valuation of discounted cash flow. This kind of valuation needs estimating the timing and size of the entire incremental cash flows derived in the project. The Net present value is usually affected greatly by the rate of discount and thus it is important to select the proper rate occasionally called the hurdle rate. The hurdle rate defines the minimum rate of return. As such it is use to establish if the project is going to meet the minimum rate of retur...