Capital budgeting is the planning process used to determine whether a firm's long term investments such as new machinery, replacement machinery, new plants, new products, and research and development projects are worth pursuing.
Many formal methods are used in capital budgeting, including the techniques such as
• Net present value
• Profitability index
• Internal rate of return
• Modified Internal Rate of Return, and
• Equivalent annuity.
These methods use the incremental cash flows from each potential investment, or project. Techniques based on accounting earnings and accounting rules are sometimes used - though economists consider this to be improper - such as the accounting rate of return, and "return on investment." Simplified and hybrid methods are used as well, such as payback period and discounted payback period.
Net present value
Each potential project's value should be estimated using a discounted cash flow (DCF) valuation, to find its net present value (NPV). (First applied to Corporate Finance by Joel Dean in 1951; see also Fisher separation theorem, John Burr Williams: Theory.) This valuation requires estimating the size and timing of all of the incremental cash flows from the project. These future cash flows are then discounted to determine their present value. These present values are then summed, to get the NPV. See also Time value of money. The NPV decision rule is to accept all positive NPV projects in an unconstrained environment, or if projects are mutually exclusive, accept the one with the highest NPV(GE)
The NPV is greatly affected by the discount rate, so selecting the proper rate - sometimes called the hurdle rate - is critical to making the right decision. The hurdle rate is the minimum accepta ...