CAPITAL BUDGETING 3
Capitalbudgeting describes the process of determining and evaluatingpossible expenses or investments that are huge in nature. Suchexpenses or investments can include putting up a new production firmor long-term ventures. In this case, the cash flows of a project areassessed to determine whether the project is viable (Peterson &Fabozzi, 2002). Some of the methods used in capital budgeting includethe analysis of discounted cash flow (DCF), net present value (NPV),internal rate of return (IRR), and payback period.
Project’srisk can be incorporated into capital analysis through sensitivityanalysis, scenario analysis and Monte Carlo simulation (Peterson &Fabozzi, 2002). Sensitivity analysis deals with determining howsensitive the NPV of a project is. If the NPV is very sensitive tothe changes that are made to the variables used, when calculating it,then that project is likely to be risky. Scenario analysis considersthe probability distribution of variables. This analysis deals withthe estimation of the expected value to conclude if the value of aproject would decrease in case of any adverse occurrence. Monte Carlosimulation involves the generation of random variables of inputs,which are used in calculating new NPVs. This process is repeatedseverally, and the expected value is calculated. The expected valuegenerated is used in the analysis since it indicates things likeinflation (Peterson & Fabozzi, 2002).
Yes.Discounted cash flows such as IRR and NPV should be used in capitalbudgeting since they indicate whether an investment is going to beprofitable or not (Damodaran, 2012). For example, if NPVs of twoprojects are calculated, then the project with the positive or thehighest figures should be chosen over the one with negative figuresbecause it will generate high income than the capital invested.
Damodaran,A. (2012). Investmentvaluation: Tools and techniques for determining the value of anyasset.Hoboken, New Jersey: Wiley.
Peterson,P. P., & Fabozzi, F. J. (2002). CapitalBudgeting: Theory and Practice.Hoboken: John Wiley & Sons.