Capital Budgeting Methods for Corporate Project Selection

Capital Budgeting Methods for Corporate Project Selection In a 2001 Graham and Harvey survey of 392 chief financial officers (CFOs) asked how frequently they utilize different capital budgeting methods? Approximately 75% of the CFOs replied that they use net look value (NPV) or Internal Rate of Return (IRR) always or al approximately always (Smart, Megginson & Gitman, 2004, pg. 251). Projects are viewed as capital investment fundss in the unified world, and as such, are evaluated closely for their possible financial impacts on the rump line due to their higher attempt of failure.Capital investments are those that are considered long-term investments such as manufacturing plants, R&D, equipment, marketing campaign, etcetera , and capital budgeting is the solve of identifying which of these investment projects a firm should undertake (Smart, Megginson & Gitman, 2004, pg. 227). correspond to Smart, Megginson & Gitman, there are three steps in the capital budgeting process * I dentifying probable investments Analyzing the rectify of investment opportunities, identifying those that will create shareholder value, and perhaps prioritizing them * Implementing and Monitoring the investment projects selected This paper will focus on step two, and will contend the strengths and weaknesses of the four most common methods that are utilized for evaluating, selecting and prioritizing projects in the incorporated world. Net Present respect (NPV), Internal Rate of Return (IRR), orderly/Discounted Payback Period and Profitability Index are the four of the most come methods used during step 2 of the capital budgeting process.Four fictional potential capital investments will be used to illustrate how the different methods push aside affect project selection for a portfolio. THEME PARK dandy INVESTMENTS A theme park senior executive management police squad had four capital projects presented during the last capital budget meeting. The projects are a $250M park ex pansion, $50M value resort renovation, $500M new moderate resort bend and $200M new value resort construction. All these projects have similar result time frames and have 20 year life expectancies.Years 1 to 5 cash flows for each project come from the pro formas, and Years 6 -20 are based on an expected 2% per increase in cash flows. The company has $750M to invest on capital projects this year, and they must take root which projects should be approved. NET PRESENT VALUE Net Present Value is the sum of synthesised future cash flows and provides the appropriate adjustments for the time value of money. In short, NPV is the reverse of compounding interest, and this process begins with the selection of a discount rate. According to Smart, Megginson & Gitman, pg. 01, A projects discount risk must be high enough to compensate investors for the projects risk The discount rate can be based on the inherent risk of a project, the required rate of return on shares, cost of equity, etc. Th e discount rate should not be one rate for altogether projects with in a firm, precisely reflect the nature of the project. The formula for NPV is In this calculation, CFt represents the net cash flow of the year and r is the selected discount rate. CF0 unremarkably represents the initial outlay to get the project started, and is usually a negatively charged cash flow.As a rule, projects with a negative NPV are not approved, but a hurdle could be set such as projects with a NPV