Capital budgeting (also known as investment appraisal) is the process of project appraisal to decide whether the big investment in such a long term project is worth pursuing. The long term investment may be needed to a company for technology up gradations, purchase of new machinery, expansion programmes, planning creation of new products, research and development unit etc. The project appraisal will look into various factors involved in the budgeting such as the calculation of initial cash investment and the number of years it takes for a project’s cash flow to pay back the initial cash investment, future accounting profit, Net Present Value (NPV), Benefit to Cost Ratio, Internal Rate of Return (IRR), Accounting Rate of Return, Assessment of risk etc. A project is passed for implementation only if assessment satisfies that the proposed project adds value to the company in terms of rate of return on the cost of capital.
The risks involved in capital budgeting:
There are numerous risks involved in a venture which are taken into account while taking a business decision. Different techniques are used to evaluate the probable risks through sensitivity analysis, scenario analysis, and break-even analysis among others. In capital budgeting, following three types of risks viz. stand-alone risk, market risk and corporate risk are invariably assessed.
Stand-Alone Risk: The risks associated with the new projects are determined separately from the company’s other assets.
Market risk: Market risk refers to risk involved due to uncertainty in future market values. The volatility in the market may affect sales of the company, which in turn may affect the amount of operating leverage.
Corporate risk: Corporate risk concentrates on the analysis of the risk that might influence the project in terms of entire cash flow of the company. Corporate risk is also known as the projects’ risks of the company.
- What are NPV, IRR, DCF, Hurdle rate, Accounting rate of return in capital budgeting?
- What is Benefit to cost ratio?
- How to calculate Discount rate/discount factor?