Capital Budgeting Evaluation Methods

capital budgetingWhen evaluating a project or long term investment of company, it is important to reach right decisions based on the capital budgeting methods. Analysts often use several important criteria to evaluate capital investments. The two most comprehensive measures of whether a project is profitable or unprofitable are the net present value (NPV) and internal rate of return (IRR). In addition to these, there are four other criteria that are frequently used: the payback period . The article gives instructions on each of the evaluation methods.

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Capital Budgeting Basics

Capital budgeting is the whole process of analyzing projects and deciding which ones to accept and thus include in the capital budget. Capital budgeting is key to the long term success of business and companies. A firm’s growth, and even its ability to remain competitive and to survive, depends on a constant flow of ideas for new products, improvements in existing products, and ways to operate more efficiently. Accordingly, well-managed firms go to great lengths to develop good capital budgeting proposals.

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Capital Budgeting Principle

Capital budgeting is a complex process that involves careful analysis and calculation especially for large projects. There are some basic principles you need to take into consideration when performing capital budgeting.

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Marginal Cost of Capital

Cost of capital plays important roles in financial analysis and asset valuation. A chief use of the marginal cost of capital estimate is in capital-budgeting decision making. What role does the marginal cost of capital play in a company's investment program, and how do we adapt it when we need to evaluate a specific investment project?

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Capital Budgeting Cash Flow Estimation

When we estimate a project’s cash flows  and then discount them at the project’s risk-adjusted cost of capital, r, the result is the project’s NPV, which tells us how much the project increases the firm’s value. Cash flow estimation is the foundation of capital budgeting for projects.

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Absolute and Relative Asset Valuation

There are two basic methods of valuing equity stock: absolute evaluation and relative evaluation, these methods have its own advantages and disadvantages. Analysts and investors should make wise decisions on the techniques for the asset valuation.

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Component Cost of Capital

Each source of capital has a different cost because of the differences among the sources, such as seniority, contractual commitments, and potential value as a tax shield. For business, there are mainly three sources of capital: debt, preferred equity, and common equity. Understanding the cost of each part is crucial in knowing the cost of capital of business.

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