Capital budgeting methods and investment evaluation processes in companies

Capital Budgeting

What process do you use to evaluate capital investment decisions?

When any firm is using the capital budget process to evaluate investment decisions, they are looking for ways to reduce the overall amounts of risk as much as possible. This is because when a business is making large investments, they have limited amounts of resources that must be used most effectively. As a result, a process was developed to objectively tell managers if the proposed investments will help an organization achieve its long-term goals. Where, they will examine several different aspects of the project to include: defining the project / cash flow estimation, project selection / analysis, project implementation and review. Defining the project / cash flow estimation is when managers are looking at: the overall objectives, purpose of the project and its total costs. Project selection / analysis is when managers are carefully comparing the different capital investment projects side by side and then selecting, one that will have the lowest amounts of risk, with highest reward for the company. Implementation is when management and the staff have begun implementing the required capital investments necessary for the project. Review is when managers / staff are evaluating the total amount of money invested in project. Where, they are looking at if the investment in a specific area had the actual effect that was predicted during the project selection / analysis stage. During this part of the process, there is an emphasis on what factors may have hindered or contributed to the success of the project. This is significant, because the above process allows for managers to be able to effectively determine the underlying amounts of possible risks and compare them with other capital spending projects. At which point, they can effectively utilize the company's resources where they will have the greatest impact, while not affecting the overall short- and long-term liquidity position of an organization. (Cooper, 2001)

What capital budgeting methods do you use (e.g. payback period, IRR or NPV)?

The method that is used as a part of the capital budgeting process is: the internal rate of return (IRR). This is when you are comparing, the return of the investment capital with that of other investments (such as Treasuries). The reason why this method is most often used is: because it provides an effective way of comparing the expected return of investment capital, with other areas. When you are comparing both numbers, this reduces the overall amounts of risk by allowing the company to see the minimum returns that would be obtained in safer areas. At which point, managers can compare the safe return, with the projected return of a capital investment project. Once this is complete, it will provide the greatest insights, as to the total amounts of risk that the company could be exposed to. This helps an organization to determine if utilizing their capital for such purposes would be worth the risk. ("Capital Budgeting Techniques," n.d.)

What do you think are appropriate methods for your company?

The most appropriate methods for evaluating the use of investment capital at the company would include: the net present values (NPV), modified internal rate of return (MIRR) and the Internal Rate of Return (IRR). The NPV method is when the company will discount all possible income received from an investment, to where it is in line with their projected minimum rate of return (hurdle rate). At which point, managers will be able to see if the present value will have a positive or negative return for the organization in the future. Those projects that can provide positive present values will more than likely accepted, because they are providing a return that is in line with the company's minimum expectations. As a result, managers can use this method as another way of determining, if a project can meet their minimum objectives. When evaluating different projects, this provides an effective way of comparing the investment with the minimum returns. At which point, managers can see which project would provide the greatest economic benefit to an organization. ("Techniques of Capital Budgeting," 2009)

The MIRR is when the managers are setting the hurdle rate to be in line with the company's expectations, for the life of the project. This allows managers to conservatively see what will be the minimum projected return to the company, by taking out other factors that could cause the percentage return to become more volatile (such as economic factors). The extra cash flow that is received above the hurdle rate can be reinvested in other projects, at the minimum rate of return. What all of this shows, is that a company can use this method as a way of conservatively accounting for the projected minimum total return. At the same time, this allows management to invest the excess returns in other capital projects, using the same methodology. Over the course of time, this will help an organization to effectively utilize its free cash flow to meet minimum objectives, while simultaneously investing in other capital spending projects. ("Capital Budgeting Techniques," n.d.)