Capital Budgeting Steps example

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Capital Budgeting Steps

Сapital budgeting is a process of analyzing potential capital investments and deciding what investments will be beneficial for the firm. Decisions in the field of investment policy are probably among the most important areas of activity of the financial manager. The key element in the process of capital budgeting is the methodology of capital budgeting, which is a set of financial and mathematical methods and tools for making investment decisions. Generally, there are five main steps in capital budgeting process (The Motley Fool). The first step is to identify all possible and available investment projects. This is very important especially for a portfolio investor, who usually has shares of companies that operate in completely different industries. Such a portfolio helps the investor to hedge possible risks of market volatility. The second step is evaluation of these potential investment proposals. This can be done in a numerous ways. For example, the most applicable are methods based on payback period, return on investment, internal rate of return, net present value, options valuation, etc. Moreover, this step implies evaluation of plausible risks and the methods of mitigating them. The third step is called selection. Based on the estimated metrics, we define the most profitable investment or that one that will bring profits sooner. The fourth step is implementing the project. Finally, the fifth step is monitoring the performance of the chosen investments. By doing so, the analyst or the investor often use so called key performance indicators as well as profitability margins. On the information, which we get from monitoring and control, we conclude what to do with the project further.

NPV (Net Present Value) is the sum of the estimated flow of payments, reduced to the current (at the present time) cost in assessing the economic efficiency of investments. The operation of bringing to the present value is called discounting. The reduction to the current value is carried out at a specified discount rate. The need to calculate NPV reflects the economic fact that the amount of money that we have at the moment has a greater real value than the equal amount that will appear in the future. This is due to several reasons, for example, influence of inflation; a decrease in the real purchasing power of money; the available amount can be invested and make a profit; risk of non-receipt of the estimated amount. Usually, payments are grouped and summed within certain periods: annually, quarterly, or monthly. Then, for a cash flow consisting of N + 1 periods (steps), we can write:

CF = CF0 + CF1 + CF2 + ... + CFN,

In other words, the total cash flow is equal to the sum of the cash flows of all periods. Then the NPV calculation formula is as follows (Juhász, 2011):

Where D is the discount rate. The value of CFN / (1 + D)N is called the discounted cash flow in step N. The positive value of the NPV indicates the advisability of making decisions about the financing and implementation …

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