The process of evaluation o investments to get a better return of interest is called capital budgeting. Every organization or company face the situation of selecting one thing at a time and second thing to ignore. If you would like to see the example, then suppose you have a mobile phone, and unfortunately, It is stopped working, and the cost of repairing your cell phone is equal to the value of getting the new phone. What will you choose?
The same as capital budgeting. For a company, you need to select between the two options that are best for your company and which can quickly provide you a better return on investments.
Process of Capital Budgeting:
The process of capital budgeting is quite simple. You can read down below in 5 different parts of processing capital budgeting.
- Identifying investments opportunities.
- Evaluating investments proposals.
- Choosing a profitable investment
- Capital Budgeting and Apportionment
- Performance Review
#1 Identifying investments opportunities:
If you are running a business, then the first thing of capital budgeting is to identify the investment opportunities. The new investment opportunity can be anything from the new business product line to purchasing a new asset.
#2 Evaluating investments proposals:
Once you decide with the investment opportunity, the second thing, you need to evaluate how it can make a profit in long term goals. Example, a builder, will always think to prepare a full house for selling it after some time.
#3 Choosing a profitable investment:
Once you are done with evaluating the investment, now you do have an option to choose and make some valuable investment.
#4 Capital Budgeting and Apportionment:
After the company finalizes the investment. The thing they need to do is collect and paid off the required investments. Investments can come from anywhere, like reserves, savings, investments, or loans.
#5 Performance Review:
The last thing is to review the performance of the investment that we made. Compare it with our expectations and the actual returns on investment we are getting. This could give us an estimated idea to run this investment or replace it with a new one for getting better profits.
To make sure the organization is selecting the best investment, there are some techniques for capital budgeting.
- Payback period method
- Net Present value
- Accounting Pace of Return
- Internal Rate of Return (IRR)
- Profitability Index
#1 Payback period method:
It for calculating the period requires for earning a return on investments.
#2 Net Present Value:
The present value calculated by the comparison of the current cash flow value of inflow and ongoing cash flow value of outflow. In the case of multiple investments project the higher cost of NPV is selected.
#3 Accounting rate of return:
In this technique, the total return on investment is divided by the investments made to know the actual rate of returns.
#4 Internal rate of return:
A Discount rate used for NPV computation. IRR is the rate at which the NPV becomes zero. The higher the IRR, the better the chances of getting it selected.
#5 Profitability Index:
Profitability index technique used to calculate the future return on investments and the investments requires in the present.
The process of the capital budget is quite simple if you understand. The techniques which we have mentioned above can be used to make a lot of profits on your investments if used wisely. Every technique comes with an advantage and disadvantage and, the organization has to decide which they have to use.