Question

In 200 words or more How does one understand basic capital budgeting? How is it used? Give an example

Answer 1

Capital budgeting is the process of analysing large capital investments. An organisation may have various options as regards capital investments in different projects. However it has limited resources at hand and at times it needs to choose between different mutually exclusive projects. In that scenario it needs to use capital budgeting techniques for analysing different projects and selecting the most profitable once.

There are different methods as regards capital budgeting. The discounted payback method is used to analyse the period within which initial investment can be recovered. Similarly the internal rate of return method is used to analyse the return on investment of a project. However these methods have their own limitations and the net present value method is considered to be the most effective. As per this method the present value of future cash flows is computed and the initial cost is deducted from this amount to derive the net value that can be added by undertaking a particular investment. This allows the organisation to understand the net value added in dollar terms. If a project has positive net present value it is considered profitable else it is rejected.

For instance and investment in a new machine maybe 1 million dollars and the present value of its future cash flows maybe 1.5 million dollars. This implies that the net present value of the project is $500,000. Since this value is positive the investment in the machine will be considered profitable and will be undertaken.