Techniques for Capital Budgeting (Research Paper Sample)

Introduction
Capital budgeting is an integral part of corporate finance. Businesses are in perpetual strife to increase shareholder value by increasing revenue or profits. This endeavor is achieved by venturing into new investments and starting projects. Most of the time, companies will have multiple ideas at the same time on where to invest. However, a decision has to be made which project is the most attractive in terms of maximizing shareholder value. Enter the time value of money concept; in this concept, an amount of money is more valuable today than tomorrow. For this reason, the future cash flows of the investment must be converted to the present value in a process called the discounted cash flow method (Schmidt, 2016). The tools employed in determining which investment is the most attractive are called capital budgeting techniques.
ABC Corporation is a healthcare company that specializes in the provision of health services such as owning hospitals, urgent care centers, ambulatory surgical centers, and outpatient clinics. In a bid to increase shareholder value, the company has three proposed investment projects and can only choose one. The first proposal is the purchase of new major equipment projected to reduce the cost of sales by 5 percent over an 8-year period. The second project involves expansion into three additional states that is projected to increase revenues and cost of sales by 10 percent over 5 years. The third project is a marketing/advertising campaign that is estimated to cost 2 million dollars every year over six years. This paper aims to apply capital budgeting techniques and appraise the three projects to determine the best one for ABC to invest in. The capital budgeting tools that will be employed include NPV, profitability index, payback period, and internal rate of return.
Literature Review
Capital budgeting is a process undertaken by businesses to evaluate the potential of their investments. An example of a project is purchasing a new plant; typically, the project that will require capital budgeting is an outside venture that necessitates feasibility study before approval or rejection. Capital budgeting typically requires that a company project the future cash flows of the proposed investment to investigate whether it will generate enough potential return; this process is also called investment appraisal. Businesses must pursue those projects that have the most potential to enhance shareholder value. However, companies have limited resources while also having multiple options of investment opportunities. They, therefore, use capital budgeting techniques to determine the best projects; typically, this will be the one(s) with the best returns.
Discounted Cashflow Analysis
This method looks at the initial cash flow required to fund an investment, cash inflows such as revenue from the project, and future outflows such as maintenance and other costs. The present value of the undertaking is the value obtained after these future cash flows have been discounted to the current time (Ross, 2018). Discounting is necessary because the money is analyzed not just in intrinsic value but also with regard to time; naturally, money will have more value now than the same amount at a future date because of inflation and other factors.
The net present value (NPV) is the resulting value after a DCF analysis. Every project decision has an opportunity cost which is the foregone opportunity after one is selected. The cashflows/revenues of an investment should be enough to cover the initial and ongoing costs and also exceed the opportunity costs(Ross, 2018). The present value is typically discounted using the risk-free rate such as the one provided by the US Treasury. Future cash flows will be discounted with this rate and exceed the initial cost; otherwise, it would not be worthwhile to invest in the project.
Cost of Capital
Companies usually borrow capital to finance their projects; the projects therefore need to generate enough revenues to cover the cost of capital. Publicly traded corporations could use credit options such as bonds or bank credit facilities, or stock options. The cost capital typically is the weighted average of equity and debt. The objective is to compute the hurdle rate, which is the minimum amount the project should earn from its cashflows to meet its capital expenses (Ross, 2018). A rate of return that is below this hurdle rate will not be chosen as it does not create value for the company. In contrast, a rate of return bigger than the hurdle rate creates value for the company and can be chosen. The DCF approach can be used to choose the more profitable project; typically, the investment with the higher NPV would be chosen, although other factors would be considered, too, such as risk.