MODULE 7

Introduction to Capital Budgeting
Defining Capital Budgeting

Capital budgeting is the planning process used to determine which of an organization’s long term investments are worth pursuing.

LEARNING OBJECTIVES

Differentiate between the different capital budget methods

KEY TAKEAWAYS

Key Points

Capital budgeting, which is also called investment appraisal, is the planning process used to determine whether an organization’s long term investments, major capital, or expenditures are worth pursuing.
Major methods for capital budgeting include Net present value, Internal rate of return, Payback period, Profitability index, Equivalent annuity and Real options analysis.
The IRR method will result in the same decision as the NPV method for non- mutually exclusive projects in an unconstrained environment; Nevertheless, for mutually exclusive projects, the decision rule of taking the project with the highest IRR may select a project with a lower NPV.
Key Terms

APT: In finance, arbitrage pricing theory (APT) is a general theory of asset pricing that holds, which holds that the expected return of a financial asset can be modeled as a linear function of various macro-economic factors or theoretical market indices, where sensitivity to changes in each factor is represented by a factor-specific beta coefficient.
Modified Internal Rate of Return: The modified internal rate of return (MIRR) is a financial measure of an investment’s attractiveness. It is used in capital budgeting to rank alternative investments of equal size. As the name implies, MIRR is a modification of the internal rate of return (IRR) and, as such, aims to resolve some problems with the IRR.
Capital Budgeting

Capital budgeting, which is also called “investment appraisal,” is the planning process used to determine which of an organization’s long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is to budget for major capital investments or expenditures.

Major Methods

Many formal methods are used in capital budgeting, including the techniques as followed:

Net present value
Internal rate of return
Payback period
Profitability index
Equivalent annuity
Real options analysis