Capital budgeting is essential to use for a firm or company decisions on which investment projects to part take in; based on the revenues or money that investment projects will make. The net present value helps the CEO’s and CFO’s decide whether investing in a specific project would be profitable or unprofitable in the long run, or is it wise to invest in the project at a certain time period. Therefore, capital budgeting is crucially important for any businesses because a vast amount of money can be wasted, if the investment turns out to be wrong or uneconomical for the company. Moreover, most companies use discounted cash flow (DCF) and net present value (NPV) to evaluate new investment projects. Hence, companies would take the investment projects if the net present value (NPV) is positive or zero and reject it, if NPV is negative. On the other hand, many companies are still using outdated capital budgeting techniques; that tends to be more conservative. As a result, the article main point is, some companies may reject a project that they should have taken on because of the conservativeness of the techniques.
On the other hand, the traditional capital budgeting analysis can be categorized into three methods, they are:
1. The payback period method – it is the period in which the proposal generate cash to recover the initial investment made, with emphasis only on the expected future cash inflows from the project.
2. The discounted cash flow method – takes into consideration the interest after the cash inflow and outflow is calculated for the life of the project.
3. The net present value method – has to do with, the cash inflow into the project is discounted at a particular rate for different periods of time. This is the most popular and best capital budget techniques.
Furthermore, making the right capital budgeting is the key to survival and the success of a company. Then most companies have a limited amount of capital that they want to invest in the most effective way; for example, if the company is looking to acquire another company by acquisition, or develop a new product line for its business or a costly purchase of plant or equipment of its business. The capital budgeting methods would be used to determine which option is the best. Likewise, the shortcomings are, for the net present value (NPV) it is dependent on correctly getting the discounted rate; which is subjected to many variables that have to be estimated. However, the limitation for the payback period is that it does not take into account the time value of money. Also, it does not take into consideration the inflow of cash beyond the payback period.
Therefore, NPV may fail to may fail to incorporate the flexibility that management might have to include in projects. The principal types of real options are:
1. option to invest (delay investment),
2. option to expand and
3. option to abandon the operation.
The invest option, which is also the call option is equal to the upfront required when you chose to go ahead with the project, and the underlying value of the asset is present values from the net cash flow from the operation of the project. An example would be, if you want to open a pharmacy, you will have to pay for a permit to operate the pharmacy. Then before the operation of the pharmacy, you will have to pay a certain amount of money or payments for the franchise name. This can be regarded as the option to open operation of the pharmacy. In the option to expand, the exercise price is equal to the cost of expanding operation/service. While, the underlying asset is being purchased as a result of, exercising the option in the present value from the incremental cash flows from expanding the operations. The point is that the right to expand has to value even when the expansion cost currently exceeds the present value of the cash flow from the expanded operation. An example would be, the premium paid upfront for a larger pharmacy. Then the option to abandon operation is the exercise price that is equal to the salvage value that is left after the abandonment of the service. For example, if you chose to operate a small business and sign a contract with the municipality guaranteeing operation in the area for five years irrespective of the market conditions. Then the person chose to give up operating the pharmacy to someone else. In other words, you can make an additional payment for example of $20,000 that will give you the right to cease operating the pharmacy and sell it off to someone else at any time. This is called a put option, because of the abandonment of the project and you will receive a salvage value for this option.
Finally, Monte Carlo simulation.