Capital budgeting 

(or investment appraisal) 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 development projects are worth pursuing. It is budget for major capital, or investment,
expenditures.[1]

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

 Accounting rate of return

 Net present value
 Profitability index
 Internal rate of return
 Modified internal rate of return
 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.

Contents
 [hide]

1 Net present value

2 Internal rate of return

3 Equivalent annuity

method

4 Real options

5 Ranked Projects

6 Funding Sources

7 External links and

references

[edit]Net present value

Main article:  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 toCorporate 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 the incremental cash flows from the project. These future cash flows are then discounted [disambiguation
needed]
 to determine theirpresent 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
acceptable return on an investment. It should reflect the riskiness of the investment, typically measured
by the volatilityof cash flows, and must take into account the financing mix. Managers may use models
such as the CAPM or the APT to estimate a discount rate appropriate for each particular project, and use
the weighted average cost of capital (WACC) to reflect the financing mix selected. A common practice in
choosing a discount rate for a project is to apply a WACC that applies to the entire firm, but a higher
discount rate may be more appropriate when a project's risk is higher than the risk of the firm as a whole.

[edit]Internal rate of return

Main article:  Internal rate of return

The internal rate of return (IRR) is defined as the discount rate that gives a net present value (NPV) of
zero. It is a commonly used measure of investment efficiency.

The IRR method will result in the same decision as the NPV method for (non-mutually exclusive) projects
in an unconstrained environment, in the usual cases where a negative cash flow occurs at the start of the
project, followed by all positive cash flows. In most realistic cases, all independent projects that have an
IRR higher than the hurdle rate should be accepted. Nevertheless, for mutually exclusive projects, the
decision rule of taking the project with the highest IRR - which is often used - may select a project with a
lower NPV.

In some cases, several zero NPV discount rates may exist, so there is no unique IRR. The IRR exists and
is unique if one or more years of net investment (negative cash flow) are followed by years of net
revenues. But if the signs of the cash flows change more than once, there may be several IRRs. The IRR
equation generally cannot be solved analytically but only via iterations.

One shortcoming of the IRR method is that it is commonly misunderstood to convey the actual annual
profitability of an investment. However, this is not the case because intermediate cash flows are almost
never reinvested at the project's IRR; and, therefore, the actual rate of return is almost certainly going to
be lower. Accordingly, a measure called Modified Internal Rate of Return (MIRR) is often used.

Despite a strong academic preference for NPV, surveys indicate that executives prefer IRR over
NPV[citation needed], although they should be used in concert. In a budget-constrained environment, efficiency
measures should be used to maximize the overall NPV of the firm. Some managers find it intuitively more
appealing to evaluate investments in terms of percentage rates of return than dollars of NPV.

[edit]Equivalent annuity method

The equivalent annuity method expresses the NPV as an annualized cash flow by dividing it by the
present value of the annuity factor. It is often used when assessing only the costs of specific projects that
have the same cash inflows. In this form it is known as the equivalent annual cost (EAC) method and is
the cost per year of owning and operating an asset over its entire lifespan.

It is often used when comparing investment projects of unequal lifespans. For example if project A has an
expected lifetime of 7 years, and project B has an expected lifetime of 11 years it would be improper to
simply compare the net present values (NPVs) of the two projects, unless the projects could not be
repeated.

The use of the EAC method implies that the project will be replaced by an identical project.

Alternatively the chain method can be used with the NPV method under the assumption that the projects
will be replaced with the same cash flows each time. To compare projects of unequal length, say 3 years
and 4 years, the projects are chained together, i.e. four repetitions of the 3 year project are compare to
three repetitions of the 4 year project. The chain method and the EAC method give mathematically
equivalent answers.

The assumption of the same cash flows for each link in the chain is essentially an assumption of
zero inflation, so a real interest rate rather than a nominal interest rate is commonly used in the
calculations.Y

[edit]Real options
Main article:  Real options analysis

Real options analysis has become important since the 1970s as option pricing models have gotten more
sophisticated. The discounted cash flow methods essentially value projects as if they were risky bonds,
with the promised cash flows known. But managers will have many choices of how to increase future
cash inflows, or to decrease future cash outflows. In other words, managers get to manage the projects -
not simply accept or reject them. Real options analysis try to value the choices - the option value - that the
managers will have in the future and adds these values to the NPV.

[edit]Ranked Projects
The real value of capital budgeting is to rank projects. Most organizations have many projects that could
potentially be financially rewarding. Once it has been determined that a particular project has exceeded
its hurdle, then it should be ranked against peer projects (e.g. - highest Profitability index to lowest
Profitability index). The highest ranking projects should be implemented until the budgeted capital has
been expended.

[edit]Funding Sources
When a corporation determines its capital budget, it must acquire said funds. Three methods are
generally available to publicly traded corporations: corporate bonds, preferred stock, andcommon stock.
The ideal mix of those funding sources is determined by the financial managers of the firm and is related
to the amount of financial risk that corporation is willing to undertake. Corporate bonds entail the lowest
financial risk and therefore generally have the lowest interest rate. Preferred stock have no financial risk
but dividends, including all in arrears, must be paid to the preferred stockholders before any cash
disbursements can be made to common stockholders; they generally have interest rates higher than
those of corporate bonds. Finally, common stocks entail no financial risk but are the most expensive way
to finance capital projects