Capital Budgeting Process

Capital Budgeting Process Evaluation of Capital budgeting project involves six steps:

First, the cost of that particular project must be known. Second, estimates the expected cash out flows from the project, including residual value of the asset at the end of its useful life. Third, riskiness of the cash flows must be estimated. This requires information about the probability distribution of the cash outflows. Based on projects riskiness, Management find outs the cost of capital at which the cash out flows should be discounted. Next determine the present value of expected cash flows. Finally, compare the present value of expected cash flows with the required outlay. If the present value of the cash flows is greater than the cost, the project should be taken. Otherwise, it should be rejected. OR

If the expected rate of return on the project exceeds its cost of capital, that project is worth taking. Firms stock price directly depends how effective are the firms capital budgeting procedures. If the firm finds or creates an investment opportunity with a present value higher than its cost of capital, this would effect firms value positively.

Capital Budgeting Techniques Independent and Mutually Exclusive Projects Understanding of classification of capital budgeting projects plays a crucial role while analyzing viability of projects. A Project whose cash flows have no impact on the acceptance or rejection of other projects is termed asIndependent Project. Thus, all such Projects which meet this criterion should be accepted. A set of projects from which at most one will be accepted is termed as Mutually Exclusive Projects. In mutually exclusive projects, cash flows of one project can be adversely affected by the acceptance of the other project. In mutually exclusive projects, all projects are to accomplish the same task. Therefore, such projects cannot be undertaken simultaneously. Hence, while choosing among Mutually Exclusive Projects, more than one project may satisfy the Capital Budgeting criterion. However, only one project can be accepted. Which project should be accepted depends on different factors like initial investment, time period required for completion, strategic importance of the project, etc. usually the project which adds more value to the business in the long run will be selected. Capital budgeting techniques give same acceptance or rejection decisions regarding independent projects but conflict may arise in case of mutually exclusive projects. If conflicts arise while making decision regarding mutually exclusive projects, the Net Present Value method should be given priority due to its more conservative or realistic reinvestment

rate assumption. The Net Present Value and Internal Rate of Return, both methods are superior to the payback period, but Net present Value is superior to even Internal Rate of Return.