Capital Budgeting the process businesses use to evaluate potential long-term investments

It's the process businesses use to evaluate potential long-term investments, such as new equipment, buildings, or product lines.

The main goal of capital budgeting is to ensure these investments will be profitable and create value for the company. Here's a breakdown of what capital budgeting involves:

Analyzing cash flows: This involves estimating the amount of money coming in (inflows) and going out (outflows) from the project over its lifetime.
Considering risk: Capital budgeting takes into account the potential risks associated with the investment.
Using evaluation methods: There are different techniques to assess the project's viability, such as Net Present Value (NPV) and Internal Rate of Return (IRR).

1. Capital Budgeting
D/Ahmed EL Otiefy

2. Capital Budgeting

•Capital budgeting process is the
process of identifying and evaluating
capital projects, that is, projects where the
cash flow to the firm will be received over
a period longer than one year.

3. The typical steps in the capital budgeting process are as follows: (4 Steps)
Generate ideas: Generating good
investment ideas is the most
important step in the process
(external & internal sources of ideas).
Analyzing individual proposal:
Gathering information to forecast cash
flows for each project and the
evaluating the project’s profitability
Planning and Capital budget: Organize
the profitable proposals to fit within
the company’s overall strategies.
Because of financial and real resources
issues, the scheduling and prioritizing
of projects is important.
Monitoring and Post-auditing:
Actual results are compared to
planned or predicted results, and any
differences must be explained

4. Capital Budgeting projects’ categories

Replacement projects:
1. If a piece of equipment breaks down or
wears out: the easiest capital budgeting
decision, it may not require careful analysis,
and it is a waste of resources to overanalyze
the decision. 2. Replacing existing
equipment with newer: these replacement
decisions are often amenable to very
detailed analysis.
Expansion projects:
These expansion decisions may
involve more uncertainties than
replacement decisions, and these
decisions will be more carefully
considered.

5. New products and services:
These investments expose the
company to even more uncertainties
than expansions.
These decisions are more complex
and will involve more people in the
decision-making process.
Regulatory, safety, environmental
projects:
Required by governmental agencies,
insurance companies, or some other
external parties.
Generate no revenue and might be
undertaken by a company maximizing
its own private interests.

6. Describe the basic principles of capital budgeting.

7. CAPITAL BUDGETING TECHNIQUES
Net Present Value (NPV)
internal rate of return (IRR)
payback period
discounted payback period
Profitability index (PI) of a single capital project

8. Net present value (NPV)
The method used by most large companies to evaluate
investment projects is called net present value (NPV). The
intuition behind the NPV method is simple
When firms make investments, they are spending money
that they obtained, in one form or another, from
investors.
Investors expect a return on the money that they give to
firms, so a firm should undertake an investment only if
the present value of the cash flow that the investment
generates is greater than the cost of making the
investment in the first place.

9. Net present value (NPV)
The net present value (NPV) is found by
subtracting a project’s initial investment
(CF0) from the present value of its cash inflows
(CFt) discounted at a rate
equal to the firm’s cost of capital (r).

10. DECISION CRITERIA
When NPV is used to make accept–reject decisions, the
decision criteria are as
follows:
• If the NPV is greater than $0, accept the project.
• If the NPV is less than $0, reject the project.
If the NPV is greater than $0, the firm will earn a return
greater than its cost of capital. Such action should
increase the market value of the firm, and therefore
the wealth of its owners by an amount equal to the NPV.

22. Describe expected relations among an investment's NPV,
company value, and share price

The net present value of the company, NPV, is an
expected measure of the expected change of
the company, and that the company undertakes
any new projects and purchases any assets, this
reflects on the value of the company, and in
theory this should be reflected in the value of
the company’s shares traded in the market