Capital budgeting is the process in which a company makes financial decisions about long-term investments of the company’s capital into operations. These decisions are the most critical decisions that are made by management. “Capital expenditures involve large amounts of money, are critical to achieving the firm’s strategic plan, define the firm’s line of business over the long term, and determine the firm’s profitability for years to come, they are considered the most important investment decisions made by management” (Parrino & Kidwell, 2011, p. 330). Any type of long-term investment decisions are extremely important and should not be taken lightly because these decisions will have a major effect on the company’s operations. The objective of these financial decisions is to capitalize in these long-term investments to increase the value of the company.
There are many things that need to be taken into consideration when trying to determine whether or not to make the long-term investment. Often a company will have several prosed projects and must measure each project’s potential in order to make a comparison and decide which project will be the right one. The goal is to choose to invest in capital projects that will add the greatest value to the company. There are several commonly used methods such as, net present value, internal rate of return, modified internal rate of return, profitability index and DPB, that can help determine if the long-term investment is the correct choice for the company.
Net Present Value Net Present Value (NPV) is a capital budgeting method that “estimates the amount by which the benefits or cash flows from a project exceeds the cost of the project in present value terms”(Parrino & Kidwell, 2011). There are many advantages to this method. This method uses the discounted cash flow valuation technique. This technique is used to estimate the attractiveness of the long-term investment opportunity. This method takes into consideration the time value of the money invested.
The advantages of the net present value method are that it provides a direct measure of how a capital project will increase the value of the company.