Capital budgeting process, methods, and real options in financial decision-making

Capital budgeting process is the process by which firms analyze possible investments. The process typically involves the gathering of critical information, such as costs and estimates of potential revenue. The method of capital budgeting must also be chosen, and would typically include determining an appropriate discount rate for the company as well. There are a number of different methods that can be used to help make capital budgeting decisions. Payback period is the period in which the initial investment is paid back -- typically the shorter the payback period the better. Other methods include the profitability index, return on book value and the internal rate of return (NetMBA, 2010). The most popular method for making capital budgeting decisions in the net present value (NPV). This method focuses on the time value of money, and uses the principles of discounting future cash flows to analyze the incremental cash flows associated with a project. The discount rate reflects the company's cost of capital and/or the project risk, and any project with a positive net present value should theoretically be approved.

The importance of calculating real options in finance is that each option has an opportunity cost. Options to delay, expand and abandon carry value that is associated with the opportunity cost of that option. For example, if a company has an option to abandon a project, this could allow the company an easier means of escaping a project that has turned bad. Such an option could allow for greater cost savings. Thus, a price should be associated with that option.

There are a number of different methods of valuing stocks. The P/E ratio is one method, in that either the P/E of a similar company can be applied to the earnings of the target company, or that the P/E ratio of the company should be within a historic range. Price can also be related to book value. The dividend growth model is another method. This model assumes that dividends are the only cash flows associated with a stock. The future value of these cash flows -- incorporating growth in the current dividend -- is taken as the true value of the stock. Share repurchases can be taken into account as well. Many companies have share repurchase programs designed to increase the value of the stock by reducing the number of shares outstanding. To the extent that these can be reasonably estimated, they can also be taken into account in considering the value of a firm. The expected number of shares outstanding can be amended along with the expected future value of the equity to determine the impact that share repurchases have on the value of the firm.