A team works behind every investment plan of any company. The major work of this team would be analysing the worth of the investment that the company is planning to undertake. Capital budgeting is an interesting stream in finance. Companies adopt this stream when they prefer to take up new investments or expansion. Capital budgeting is also termed as investment appraisal.
To put in a detailed fashion, suppose a company is planning to expand the production, introduce a new plant, planning to enter a new market, expand its services, merging or acquiring etc., these investments has to be analysed to its depth to determine the profitability. This work will be done by the capital budgeting team.
How will the team analyse an investment? There are some highlighting methods to be adopted for this. One of the most commonly used tool is net present value – the team would determine or manipulate the cash inflows for further years and take that as a benchmark for analysis. We usually say, money has time value. So these determined cash flows will be converted to its present value of money. So the final value of cash inflows obtained will be compared to the cash outflow (i.e) the invesment to be made.
The next highlighting tool would be payback perid – this tool would help the team to determine the period taken to break even (i.e) the number of years to get back the investment made. Followed with it, the focus can be made on the next tool Internal rate of return (IRR). This tool would help the team to determine the minimum rate of return to be obtained to attain breakeven. So, any percentage above the IRR would lead the company to gain profits. Since major capital would be employed for these projects, proper analysis should be done to ensure the company’s profitability. So, in general the team would analyse with more than one tool to decide on an investment option.