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Capital budgeting is an important process for all organizations because it gives them the means to compare different investments. For example, a manager can use capital budgeting to evaluate different proposed projects in the organization to attempt to estimate which one's will return the most value to the organization and its investors.
"When a company is looking at, for example, acquisitions of other companies, development of new lines of business or major purchases of plants or equipment, capital budgeting is the method used to determine whether one option is better than another. There are several capital budgeting methods, each with its pros and cons (Financial Web, N.d.).
There are several methods of using a capital budgeting process and each method can be more appropriate in certain situations over the others.
The misuse of capital budgeting can be extremely costly to organizations because they might devote large capital allocations to projects that fail or do not return the investment that was expected or estimated in the capital budgeting process. Furthermore, much of the capital budgeting process is based on a collective set of subjective estimations. Therefore there can be large margins of error in the estimation process. In some cases, project...
The net present value calculates the sum of the future cash flows and equates this amount in what would be the equivalent of the project's worth in today's money value. The PI uses the same metric but states the figure as a ratio.
"For example, a project with an initial investment of $1 million and present value of future cash flows of $1.2 million would have a profitability index of 1.2. Based on the profitability index rule, the project would proceed. Essentially, the PI tells us how much value we receive per dollar invested. In this example, each dollar invested yields $1.20 (Investopedia, N.d.)."
The internal rate of return is a different type of calculation. This metric uses the interest rate that the entire project is expected to bring to the organization. All three metrics allow different projects to be compared on equal terms; although each metric has different strengths and weaknesses.
This processes focuses more on cash flows that…
References
Financial Web. (N.d.). Advantages and Disadvantages of Capital Budgeting. Retrieved from Financial Web: http://www.finweb.com/financial-planning/advantages-and-disadvantages-of-capital-budgeting.html#axzz3lTAqL6zS
Investopedia. (N.d.). Net Present Value And Internal Rate Of Return - Profitability Index. Retrieved from Investopedia: http://www.investopedia.com/walkthrough/corporate-finance/4/npv-irr/profitability-index.aspx
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This differs from the more static view taken by Mehrotra. There are a couple of reasons for this key difference. One is that Mehrotra only studied spinoff firms. These firms are easier to study because the managers must choose a capital structure for the new firm. However, this makes for an imperfect survey. Barclay on the other hand has studied a much broader basket of companies. This forced the use