The Importance of Capital Budget and Project Analysis

Complementary guide for Capital Budget and Project Analysis Template.

Capital budgeting utilizes the process of determining the cash inflows of a project on impact to the contribution of the firm’s value. Different approaches are applied in selecting the projects; they include pay back period, profitability index, internal rate of return and net present value. Each has advantages and disadvantages. Net Present Value method is highly recommended and widely used. The NPV evaluate the project economic value to the firm on the basis of discounted cash flows less initial invested amount, the projects with higher net present value are selected in expense of projects with lower net present value. The underlying principle in selecting the project using net present value is to select the project showing Net Present Value equal to zero or greater than zero. The consideration lies on the value of discounted to the value of the firm.

Discounting rate is chosen depending on individual level of risk acceptance. Different approaches are used in determining the discounting rate; a standard cross business requires understanding the opportunity cost of the firm. Attention ought to be paid on cost of capital when selecting discounting rate, since a rate below the borrowing rate will likely results into the firm loosing the money on project.

The excel capital budgeting template breakdown allows the business to view the project impact on the value of the firm. The template takes into consideration the firm marginal tax rate and the depreciation of the assets impact on cash flow, depreciation is an allowable expense under the taxation rules. The marginal tax rate is used for adjusting fixed coast and variable cost tax impact on cash flow, the adjusted tax effect is added to the cash flow to arrive at net cash inflow. There is taxable amount on salvage value disposable at the end of the project term and the salvage value is adjusted for the purpose taking tax amount into consideration. Adding the adjusted salvage value at the year of disposal shows the project net cash inflow at the year of disposal. The cash flows are discounted at the business selected discounting rate. The template is designed to allow the keying of variables and changes the inputs to suit different project, where variables such as depreciation are not available or not applicable on project being accessed they can be ignored. Taxation and depreciation might presents the challenge of understanding the whole process of project selection, but the user should only be concerned in keying correct variables to give the required out. The calculations will be automatically be performed by the template.

The goal is always to maximize the business value by selecting the project with higher net present value. Since capital is a constrained resources, the approach of capital budgeting requires diligent approach. A good analysis of the project will reduce the chance of investing in unproductive projects. Although there are other means of selecting projects, Net Present Value has been emphasized as the approach of the choice to many business and investors.