Capital budgeting; importance; NPV

Capital budgeting decision

Capital budgeting is the process of planning, evaluating and selecting long-term investment projects whose benefits come over several years (such as a new plant, road or building), by comparing the cash outlay with the expected future returns.

Importance

1. Large funds are committed for a long period.
2. Decisions are irreversible; a wrong decision may cause heavy loss.
3. It decides the future growth and profit of the firm.
4. It affects the firm's risk and its cost of capital.
5. Funds are limited, so projects have to be ranked.
6. It needs a long-term forecast of demand, cost and technology.

Net present value

Net present value (NPV) is the difference between the present value of all cash inflows and the present value of all cash outflows, discounted at the required rate of return (cost of capital).

$$NPV = \sum_{t=1}^{n}\frac{CF_t}{(1+k)^t} + \frac{S}{(1+k)^n} - I_0$$

where $CF_t$ is net cash flow in year $t$, $k$ is the discount rate, $S$ is salvage value and $I_0$ is the initial investment.

• Decision rule: accept if NPV > 0; reject if NPV < 0; for mutually exclusive projects choose the highest NPV.
• Advantages: considers the time value of money, all cash flows and the size of the project; gives the gain in money terms; additive.
• Limitations: needs a correct discount rate; harder to explain; ranking can be misleading for projects of different size and life.