The basic considerations in capital budgeting decisions are:
- Time value of money: According to this factor, a dollar received today is valued highly compared with a dollar to be earned in the future (Bierman & Smidt, 2007). The logic is that a dollar currently held can earn interest into the future i.e. for 1 year, 2 years. Time value of money requires that cash flows should be valued depending on timing of the cash flow. As an example, the present value of $5,500 to be received at the end of one year with an interest rate of 10% is $5,000. The present value of the same amount of money to be received in two years is about $4,546. This shows how cash flows into the future are of less value compared with current ones. In summary, cash flows are converted to present or future values in order to reflect time value.
- Risk: There exist a tradeoff between profitability and risk. This means that profitable projects are perceived to expose a firm to greater risk. The aspect of risk is included in capital budgeting decisions by discounting cash flows. When the discount rate is high, it means that the risk of future cash flows is greater. Alternatively, decision makers can require higher returns for cash flows that have greater risk.
- Alternate investment options: It is essential to understand that firms have limited resource hence the need to allocate the scarce resources to the best option. Even though a company can raise unlimited capital through common stock, such a move will only serve the purpose of distributing ownership. On the other hand, borrowings can be allowed to certain limit. Cognizant of these limitations, resources should be allocated to projects that will realize the highest returns. Some of the tools used in choosing between alternative projects are net present value, internal rate of return, payback period, profitability index, and the modified internal rate of return (Moyer, McGuigan, & Kretlow, 2008).
- Future opportunities: A firm has to do continuous research and development with a view to taking advantage of economic value from changes in market conditions. As an example, a firm can invest in a growing market to benefit from future growth prospects.
Criteria in capital budgeting
Net present value, internal rate of return, and profitability index are usually applied in choosing a project from a range of alternatives. In terms of the new computer network, NPV will be applied to determine whether it is a good investment option. NPV looks at the economic profits received from choosing a project. If a project with a positive NPV is accepted, the market value of the firm will increase. This criterion is considered superior to others because it shows the increment in wealth produced by the project under appraisal.
Since the management is interested in a new computer network system, the focus will be on comparing savings from the new asset against cash flows from the original asset. Assuming that the new system will realize a cash inflow of $10,000 compared with the original system of cash inflow of $5,000, the incremental cash flow will be $5,000. During the appraisal process, the net effect of the new system is determined. It is imperative to take account of depreciation because it affects taxes.
Looking at the project in question, time saving made between ordering and delivering is factored into the equation. Secondly the 10% cost of the investment will be critical in assessing the net present value of the investment. The rationale for using NPV in appraising the new computer network project is that it is easy to calculate and interpret. Furthermore, NPV gives a more objective value or rather decision rule i.e. positive NPV is a good project. Finally, it focuses on the question of whether wealth has increased.
Bierman, H., & Smidt, H. (2007). The Capital Budgeting Decision: Economic Analysis of Investment Projects. New York: Routledge.
Moyer, R., McGuigan, J., & Kretlow, W. (2008). Contemporary Financial Management. Mason, OH: Cengage Learning.