Capital budgeting is essentially used by firm or company to make decisions on which investment projects to part take in. It is the revenues or money that a firm or company will make from investing in projects. Most important, calculating 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 when it is wise to invest in the project at a certain time period. Therefore, capital budgeting is crucially important for a business 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 the discounted cash flow (DCF) and net present value (NPV) to evaluate new investment projects. Hence, it would be more beneficial for companies to take the investment projects if the net present value (NPV) is positive or zero and reject it, if the NPV is negative because the company would lose money. On the other hand, many companies are still using outdated capital budgeting techniques; which tends to be more conservative. In the article a Cure for Outdated Capital Budgeting Techniques, the main point is, “some companies may reject a project that they should have taken on because of the conservativeness of the techniques.”1
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 generates 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. Most companies have a limited amount of capital and they want to make sure that it is invested it in the most effective way; for example, if the company is looking to acquire another company by acquisition, or develop a new line of product for its business or a costly purchase of plant or equipment for the business. Basically, the capital budgeting methods would be used to determine which option is the best. Likewise, shortcomings are, for the net present value (NPV) and it is dependent on correctly getting the discount rate; which is subjected to many changing variables that must be estimated. However, the limitations or shortcomings 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 the following according to, “management accounting quarterly:
1. Option to invest (delay investment),
2. Option to expand and
3. Option to abandon the operation.”2
The option to invest is also the call option. Is based on the cash flow and discount rate at the
time of analysis and this will allow the firm when to choose to go ahead with the project. Also,
the underlying asset is the present values subtract 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 the pharmacy operation. In this 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 cash flows as a result of
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 abandoning of the project and you will
receive a salvage value for this option.
Finally, Monte Carlo simulation is basically a computerized program that uses the real
option as the final alternative in capital budgeting. Also it allows management to account for
the risks involved in the project they are undertaking.
http://www.businessstudynotes.com/finance/financial-management/capital-budgetingStuart, D., Xie, Y., et al. Improving Capital Budgeting Decisions with Real Options. Management Accounting Quarterly vol. 9; No 4;2008.
https://www.coursera.org/learn/capital-budgeting/lecture/uP9l1/1-1-introduction-to-capital-budgeting Cotter, J., Marxum,B., Et al . A Cure for Outdated Capital Budgeting Techniques. The Journal of Corporate Accounting & Finance; March/ April 2003: 14:3.