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Capital Budgeting Tools Overview

Unlike a company’s short-term operating expenses, calculated as a rule for one reporting period (quarter, year), capital budgeting offers powerful firm tools to analyze long-term investments’ effectiveness. In general, capital budgeting should be understood as a decision-making process through which a firm evaluates the feasibility of purchasing significant assets. Tools of such analysis are NPV (net present value of cash flows), PP (time interval after which the income from the project becomes equal to the amount of invested money), IRR (a specific limit of return on investment, used by analogy with the break-even point of the company), PI (the result of the ratio of discounted income and invested capital), IIRR (instrument of choice of a more profitable investment).

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From offered methods, NPV seems the most reliable and widespread, which allows defining qualitatively those directions of development which bring the most significant benefit to the company. At the same time, the payback period has the least power because it is a measure of time, which does not give an idea of the time value of money: the flows of different years have different weights.

Stand-alone projects are commonly referred to as projects that can be implemented independently of other areas. Consequently, there is no transfer of assets between projects. For example, in one construction company, each contract is a stand-alone project.

On the contrary, mutually exclusive projects are those for which decisions in another project must be considered. An example of such projects is the distribution of assets between two parallel lines of technological development in a large company.

Again, mutually inclusive projects are those that cannot be carried out independently of each other. In particular, a series of consecutive projects to achieve a common goal in the operational transformation plan of the firm are mutually inclusive.

The following analytical rules are appropriate for making positive decisions in the context of investments. More specifically, NPV ≥ 0 (standalone project is selected), IRR > 0 (project is selected), PI > 1 (project is selected), PP < CP (project is selected). For mutually exclusive projects, the following selection rules apply: >>IRR, >> NPV, >> PI, << PP. The profitability index cannot be applied if two or more projects with the same PI but differences in the amount of investment are analyzed. Moreover, the incorrect use of IRR can also give wrong results. More specifically, this applies to projects of different duration (no consideration of the cost of capital), fluctuating dynamics, and excessive overestimation of the annual equivalent rate of return. It is not uncommon when calculated NPV and IRR results do not agree with each other. In this case, it is appropriate to use the following strategies: use NPV (in case of delayed investments), NPV is not positive, IRR does not exist (Nonexistent IRR), use NPV or IRR1 > CC > IRR2 (multiple IRRs).

In addition, if a tough choice between two or more projects (mutually exclusive projects) is necessary, focusing only on IRR results may lead to errors. In particular, a higher IRR does not characterize a more successful project, as investments may not have the same size, timing and risks. In this case, it is appropriate to choose the project that has the highest NPV.

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That said, ranking projects only by NPV rating is also an ineffective strategy for sound investment decisions. In the case of different resource requirements, NPV turns out to be of minor importance for ranking. This is due to the fact that the project with the highest NPV can waste the entire stock of resources on itself, while combining projects with initially lower NPV can lead to synergy effects.

The most optimal combination of projects can be obtained through the use of PI. This statement is justified by the idea that PI allows us to measure the value created by using NPV per unit of resources consumed. In this way, it is possible to create a list sorted by PI.

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