There are basically five steps in the capital budgeting process. They are identifying possible capital projects, estimating project costs and benefits, evaluating the proposed projects, developing the capital expenditure budget, and re-examining projects that are accepted. The completed capital budget includes all capital investment projects that were approved for the period. All of the individual projects are listed with a description of each project and the investment amount expected for that particular project.
Capital budgeting decisions are based on many different factors. Management often needs to work with a limited amount of resources for capital expenditures, and may need to prioritize among the various proposed projects. After a capital project is accepted and included in the budget, it must be followed closely. In rare cases, management may decide to end a project that is not meeting expectations.
There are several methods that are used to evaluate capital projects. There are three different discounted cash flow methods, which are internal rate of return, net present value, and profitability index. The discounted cash flow methods utilize the time value of money. Other evaluation methods include the payback method, the payback reciprocal method, and accounting rate of return. The internal rate of return is basically the interest rate that is earned on the investment. If the internal rate of return is greater than the cost of the capital, the project is viable. Net present value is the difference between the present value of the project’s inflows and outflows of cash, discounted at the cost of capital. If ever a project has a negative net present value, the project should be rejected.
The payback method determines how long it takes for the project to return the original investment. The formula to compute the payback period is original cost divided by annual cash inflows. The payback reciprocal method is an attempt to estimate the internal rate of return. The payback reciprocal is one divided by the payback period. The accounting rate of return method evaluates a project by figuring a rate of return on investment. The formula for the accounting rate of return is incremental income from the project divided by the project investment cost.
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