Capital budgeting or investment appraisal is a planning process used by management in a firm to determine whether it’s planned long term investment in new machinery, new plants, new products, and research and development projects are worth investing in them in terms of future returns. Businesses everywhere are always seeking for ways to grow with an aim of increasing the shareholders value. This can only be done through deciding on, and choosing the best investment from a basket of competing alternatives after factoring in the firm’s resources its readiness to commit, risks associated with the proposals and whether the proposed project coincides with the firm’s long term plan (Dayananda Don, 2002).
Money changes value over time. The value of a dollar today will not be the same tomorrow. An investment appraisal on any investment decision follows this idea of time value of money. This concept of time value of money is closely related to interest rate which leads to discount factor. In capital budgeting, investors try to find the current value of capital good e.g. new machinery, against its value in future. Time value of money lays out the different factors that are important in investing, and is part of the opportunity cost that will guide the decision maker on whether to invest on a capital good or not. Techniques used in capital budgeting include: accounting rate of return, net present value, profitability index, internal rate of return, modified internal rate of return, cost-benefit analysis, real option method, equivalent annuity.
The budgeting techniques listed above assist firms in making the best allocation of resources. As said earlier, some of these models use the concept of time value of money to obtain a measure of the cost/benefit analysis trade-off of projects under consideration. The earliest methods used in capital budgeting were payback model, which determines the period the firm will take to recover its initial investment outlay. More current models attempt to include non-quantifiable factors significant in the project but ignored in the earlier models. Investment analysis decisions are important to a firm’s success for four reasons. First, investment expenditures in most cases require large outlay of funds. Second, it’s important for the firm to determine the best way to raise and repay these funds. Third, most investment decisions require long term commitment and finally, firms must keep an eye on financial markets because the cost of capital is directly related to prevailing interest rate.
As already stated, capital budgeting decisions are very important for a firm and same time complex. This is because it involves making decision after considering many seemingly good proposals without all the information in an uncertain business environment (Droms William, 1997). For instance, when a firm is considering an investment proposal in line with its long term goals, it must look into: the need to tap international markets, balance between strategic consideration v/s proposals impact on cash flow and stock price, among others. In summary, capital budgeting is a crucial part of the firm’s financial management today. After the firm analyses its proposals, it must make an investment decision, a financing decision, and a dividend decision. Investment decision will typically be made after evaluating project proposal using investment analysis techniques. Achieving the goal of corporate finance will require a firm to choose an appropriate financing source. This generally includes a mix of debt and equity financing. Company decision on whether to issue dividends and what amount is determined by its unappropriated profits and it’s earning prospects for the year coming.
Dayananda Don, 2002, Capital Budgeting: Financial Appraisal of Investment Projects, Cambridge University Press.
Droms William, 1997, Finance and Accounting for Nonfinancial Managers: All the Basics You Need to Know, Perseus Books.