According to Danielson & Scott (2006), the corporate capital budget is the process of carefully evaluating investment projects. Accordingly, companies choose certain projects to carry out and cancel others. This is done by ignoring sunk costs from expenses that cannot be recovered and have not benefited the project or opportunity costs when companies forgo potential benefits from one project when choosing another.
Methods of Evaluating the Capital Budget:
According to Maritan and Lee (2017), this is done by analyzing the cash inflows and outflows from each of them separately. To do this, companies take some gradual steps to choose the best investment. Many methods can be used to prioritize a particular project over another. The first of these methods is analyzing the Payback Period (PB), which calculates how long it takes for a project to recover investment costs (Lefley, 1996).
PayPerioderiod = Cost of Investment ÷ Average Annual Cash Flow
An internal Rate of Return (IRR) is the expected project return upon completion (PticPatrickench, 2016).
$0 = Σ CFt ÷ (1 + IRR)t
where:
CF = net cash flow
IRR = internal rate of returnPerioderiod (from 0 to Perioderiod)
Finally, the Net Present Value (NPV) is calculated, and after-tax cash flows can be discounted by the weighted average cost of capital (Cheng, Kite & Radtke 1994).
Challenges of Evaluating the Capital Budget:
When doing the cash flow analysis, some aspects that could be useful in decision-making are neglected; for example, one of the challenges of payback (PB) analysis is that the payback period can ignore the cash flows that could come near the end of the project, one of the challenges of calculating the internal return (IRR) is that it simply gives a record of the project that can be accepted, this is without calculating the real value that the project can add to the company, as for the NPV, it does not take into account the total size of the project, (Peterson & Fabozzi, 2002).
Discounted Cash Flow and Resource Allocation:
The most prominent areas where discounted cash flow is used are investment finance and resource allocation. In the latter, DCF calculates the value of the investment based on the money that is likely to be obtained in the future. In the resource allocation process, DCF can greatly benefit decision-makers, as the capital is allocated in a way that guarantees profit to the stakeholders (Danielson & Scott, 2006).
The discounted cash flow also calculates the present value of the expected future cash flows using the discount rate, and then the potential investment is evaluated; if the estimated value is higher than the current cost of the investment, then the direction should be changed to another opportunity, as the purpose of discounted cash flow analysis is to estimate the money that the investor will receive according to the time value of money because a dollar today is worth more than a dollar tomorrow (Danielson & Scott, 2006).
Conclusion
When evaluating a company's capital budget, many factors must be considered. Chief among them are future sales growth, profit margins, and the discount rate, which is affected by the interest rate. In addition, the cost of the company's capital and the potential risks to its share prices must be considered.
References
Cheng, C. A., Kite, D., & Radtke, R. (1994). The applicability and usage of NPV and IRR capital budgeting techniques.
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Lefley, F. (1996). The payback method of investment appraisal: A review and synthesis. International Journal of Production
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Maritan, C. A., & Lee, G. K. (2017). Resource Allocation and Strategy. Journal of Management, 43(8), 2411–2420. Retrieved
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