The Goal of Capital Budgeting
The primary goal of capital budgeting is to make investment decisions that increase the value of the firm. It involves analyzing a project's potential cash inflows and outflows to determine whether the expected return meets a set benchmark. These are long-term decisions that can have a significant impact on a company's future.
Key Capital Budgeting Techniques
- Net Present Value (NPV): This is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. A positive NPV indicates that the projected earnings generated by a project (in present dollars) exceeds the anticipated costs. If NPV is positive, the project should be accepted.
- Internal Rate of Return (IRR): The IRR is the discount rate that makes the NPV of all cash flows from a particular project equal to zero. It represents the expected compound annual rate of return that a project will generate. If the IRR is greater than the company's required rate of return (or cost of capital), the project is accepted.
- Payback Period: This is the length of time it takes for an investment to generate enough cash flow to recover its initial cost. While simple to calculate, it ignores the time value of money and cash flows beyond the payback period.
NPV vs. IRR
While both NPV and IRR are widely used, NPV is generally considered the superior method. This is because the IRR method can sometimes give misleading results when evaluating mutually exclusive projects or projects with unconventional cash flows. The NPV method, which calculates a direct measure of the value added to the firm, is more reliable.
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