Capital Budgeting Practices
MGMT 640 Section 9040
This essay discusses the importance of capital budgeting and analyzes the most common techniques. The most frequently used methods are the net present value (NPV) and internal rate of return (IRR). These are both tools that analyze the present value of the cost of a project as well as the present value of that projects future cash flows. An essential part of these methods is that they both account for discounted cash flow (DCF), meaning that they both reflect the time value of money. When analyzing independent projects with conventional cash flows, both the NPV and IRR will provide projections along ...view middle of the document...
One of the most important decisions made within a company are those pertaining to capital budgeting. This is the process of “choosing real assets in which the [company] will invest” (Parrino & Kidwell, 2009). This process will have momentous impact on the company’s overall financial performance and cannot be taken lightly. In order for a company to have success in this department, management will have to make highly educated decisions regarding which types of investments to make and determine whether each of these investments will be worth more in the future than they initially cost (i.e. create value). These investments will vary from company to company, however some examples of projects include: investments in property, research and development projects, plant expansion or replacement, large advertising campaigns, or any other project that requires a capital expenditure and generates a future cash flow. The importance of the capital budgeting process cannot be understated as each capital investment not only involves substantial cash outlays that are uneasily reversible, but it will also define the company’s lines of business and its inherent business risks (Parrino & Kidwell, 2009). To give a firm the ability to generate the highest possible value for stockholder’s, managers must analyze the capital budgeting methods and determine which are most suitable for their particular situation.
The capital budgeting process begins with a strategic plan. This plan will delineate a company’s strategic objectives for around the next five years. In order to complete these objectives, managers will create business plans, which are short term plans that propose quantifiable targets that each division of the company is expected to achieve. (Parrino & Kidwell, 2009). These plans will also demonstrate if there is any need for capital expenditures, routine or otherwise. When the need arises for a capital investment project, it will be classified as one of three types: independent project, mutually exclusive project, or contingent project.
Independent projects are those whose cash flow is not related to any other project, meaning that “accepting or rejecting one project does not eliminate the other projects from consideration” (Parrino & Kidwell, 2009). An example of two independent projects would be investing in an advertizing campaign and the replacement of outdated production equipment. Assuming that the company has unlimited funds it can perform both projects simultaneously without interference from one another.
Mutually exclusive projects, on the other hand, are related in that accepting one project means not accepting another. This occurs when there are two projects that are both essentially a means to the same end and therefore only one need be done. An example of this would be a company that is considering two third-party logistics providers to help ease operations. After one has been selected the other will no longer be...