In general, projects do not simply come into existence generating cash inflows. Capital expenditure represents the cash used to buy manufacturing tools and facilities, carry out r amp d and marketing, and do various other activities that are needed for a project to produce positive cash flows in the future. As a result of this, capital is one of the critical aspects needed by almost all firms: even dotcom firms need to buy domain names and carry out advertising. The importance of capital in the successful operation of firms means that many businesses, particularly large firms, will pay great attention to ensuring that their capital is only used on the most important projects. The process of capital budgeting will depend a lot on the preferences of the specific firm and its owners. Some shareholders will demand an immediate positive return from projects to recover their costs, whilst others want a project that produces sustained long term profits even if there is a small loss in the short term. To balance these conflicting demands, mathematical methods have been created to analyse the potential uses for the firm rsquo s capital.

One method by which firms can budget their capital is by working out the net cash flow from a project over a certain period of time. For example, if a project requires capital investments of 1 million in the first year, but provides cash flows of 400,0 per year for the next three years, then it produces a net positive cash flow of 200,0. This approach has the advantage of being very simple, particularly for projects with lots of different cash flows coming in at different times. However, it does not take account of the fact that money received in the future tends to have a lower present value than money spent today, due to the impact of the time value of money. Our professionally qualified writers are available to produce most types of academic work on the subject of finance.

From assignments and coursework to full dissertations we are bound to have a service to suit your needs: a second method is referred to as the payback period. This method aims to determine how long it will take a project to recoup all capital it has expended. For example, in the project above, the net cash flow will be 600,0 after the first cash inflow, 200,0 after the second and + 200,0 after the third. Therefore, the payback period will be three years, as the project repays all its capital to the firm after three years of operation. This approach is useful for the type of shareholders discussed above, who simply want to ensure that they get their initial investment back as soon as possible. However, it does not take account of the time value of money, and nor does it consider any cash flows which occur after payback. For example, there could be two projects with cash flows similar to the one above, but in the fourth year one of them has a net positive cash flow of 500,0 and the other one has a net negative cash flow of 500,0.

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A third method is to use the present and future value concept discussed above to produce a net present value, or npv, for a project. The npv concept is based on the premise that shareholders want any capital invested in a firm to achieve a certain percentage return. This return is referred to as the cost of capital, and is used as the interest rate, i, in calculating the present value of all future cash flows. Therefore, when using the npv approach to calculate whether a project should be undertaken, a business will project its expected future cash flows from the project and discount them to their present value according to the firm rsquo s cost of capital. The sum of all the present values, including the initial capital, gives the net present value of the project. Npv has the advantage that it takes account of the shareholders rsquo specific requirements for returns and their time value of money. However, npv can be very time consuming to calculate, particularly for projects with lots of capital inflows, and they also require firms to know their cost of capital which, in the real world where capital rates can change rapidly, is not always possible.

The final common method, which is often used to overcome some of the deficits of npv, is the internal rate of return, or irr of the project. The irr is defined as the cost of capital at which the npv of the project will be zero. It can be calculated by choosing two costs of capital, ideally one with a positive and one with a negative npv, and using the following formula: where a is the npv at discount rate a and b is the npv at discount rate b. Alternatively, microsoft excel and other spreadsheet programs can be used to calculate the irr based on a series of cash flows and dates.

The main advantage of irr is that it gives a firm a simple rule for a project: if the cost of capital is lower than the irr, the project should proceed and if it is higher the project should be rejected. This is useful in real life situations because the cost of capital available, in terms of loans and other sources of finance, can vary on a daily basis. As such, by the time an npv has been calculated the cost of capital may have changed, requiring another calculation.

In contrast, the irr is independent of the cost of capital of the project and allows a firm to make an instant decision based on available market finance. However, the main drawback of irr is that it does not provide a clear distinction between two projects at a given cost of capital, and projects requiring more than one inflow of capital may have two irr values. On top of our mba help guides we also have a range of free resources covering the topic of finance: in this chapter, both traditional capital budgeting techniques and practical capital budgeting techniques are reviewed. At the same time, the limitations of traditional capital budgeting techniques are discussed and the usage of practical capital budgeting techniques to deal with these limitations. And the practical capital budgeting techniques involve real options method and simulation method.

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Traditional capital budgeting techniques consist of discounted cash flow which involve npv and irr whereas non discounted cash flow involve payback method. Net present value is the difference between the amount invested and the present value of future cash flows alan, 2004. Charles et al 2009 reviewed that the npv method calculates the expected monetary gain or loss from a project by discounting all expected future cash inflows and outflows back to the present point in time using the required appropriate rate of return. Colin 2006 added that npv is the most straightforward way to determine whether a project yields a return in excess of the alternative equal risk investment in trade securities. Npv is the present value of the net cash inflows less the project’s initial investment outlay, if the rate of return from the project is greater than the return from an equivalent risk investment in securities traded in the financial market, the npv will be positive, vice versa, if the rate of return is lower, the npv will be negative colin, 2006.

A positive npv shows that an investment should be accepted, while a negative npv shows that the investment should be rejected colin, 2006. Kashyap 2006 added that the key inputs of the calculation of npv are the interest rate or discount rate which used to compute the present values of future cash flows. When the discount rate higher than the shareholders’ required rate of return, and the project has a positive npv at this rate, then shareholders will expect an additional profit that has a present value equal to the npv kashyap, 2006. Formula for computing npv is: ct is the cash flow at time t, r is the discount rate and co is the cash outflow at time 0 kashyap, 2006. In other words, this technique compares the value of a pound today to the value in the future by taking inflation and returns in consideration kashyap, 2006.

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Irr is another of capital budgeting technique which same as npv technique in using the time value of money but results in answer expressed in percentage form pauline, 2006. Irr represents a discount rate which leads to a net present value of zero where the present value of the cash inflows equals to the cash outflows pauline, 2006. Charles et al 2009 added that irr method calculates the discount rate at which an investment’s present value of all expected cash inflows equals to the present value of its expected cash outflows. Kashyap 2006 described the irr graphically as below: managers who make decision based on irr should carry out the investment whenever the irr is greater than the original cost of capital.

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Kashyap 2006 emphasized that when choosing investments or projects, the investment with the highest irr should be chosen and of course that the irr is greater than the cost of capital at the same time. There have two formulas for calculating irr: one is with the help from computer tools cft the cash flow at time t and the irr can be computed by using excel with its inbuilt function kashyap, 2006. The second simple formula of irr is: lower of the pair of discount rate + npv at lower rate/difference between the npvs x difference in rates payback period, this technique used to forecast the length of time period taken to recover expected net cash inflows from investment. Alan 2004 added that this method used by a lot of firms and frequently especially at the times when the interest rates are high and/or the firms are experiencing cash flow problems.

This method measures the length of time it takes to recover the original cash outlay from the stream of net cash proceeds from the investment alan, 2004. Pauline 2006 defined the payback method as the investment appraisal calculates the length of time required for the stream of cash inflows from a project to equal the original cash outlay. And the payback period is the length of time required for a stream of net cash inflows from a project to equal the original cash outlay pauline, 2006. Kashyap 2006 reviewed that the payback method is generally used as a comparison of two or more projects and has a wide acceptance as a rule of thumb. Formula for calculating payback period is: theoretically, the traditional capital budgeting techniques are the best choices for corporation to apply in evaluating its capital investment. In real business world, there have several drawbacks of traditional capital budgeting techniques which discourage the corporation apply the traditional capital budgeting techniques.

According to myers’ observations, the npv analysis ignored the time series interactions among contingent investments and this cost the delayed investments may accrue extra benefits david, 1995. The probability distribution of npv which incorporates the valuation of flexibility is not symmetrically distributed as in the certainty–equivalent npv case david, 1995. The use of simple risk adjusted rates to assess investments in which there is flexibility will undervalue the investments david, 1995. David 1995 added that the asymmetry arises because the certainty equivalent npv rules ignore flexibility which provides protection against future events turning out differently from expected at the outset. Pankaj 2009 added that npv technique does not consider the extent of management’s flexibility to respond to uncertainty over the life of the project. Todd et al 2004 reviewed that by using npv model, an increase in risk is accounted for increasing the discount rate which resulting in lower valuations.