Capital budgeting is evaluating a prospective project’s cash inflows and outflows to reveal a possible profit. Duncombe underlines that “It was first developed in the 1940s.” Based on this definition, it is evident that capital budgeting is an essential part of a company’s financial activities.
Precisely through this process, it is possible to predict profitable or loss-making projects or objects that help a company attain prosperity and avoid bankruptcy. However, individuals also can use this method with the same goals because it is helpful at different scales.
Payback period and NPV are some of the most effective techniques of capital budgeting. The former means the necessary time to cover the cost of the investment. The advantage of this method is that it allows quickly evaluating and calculation of possible profits and losses of assets, but it does not consider the time value of money.
NPV considers all project cash inflows and cash outflows; it is the difference between them over some time. It addresses the time value of money, unlike the payback period, which allows for determining the results of investments more precisely. Plus, it considers a company’s cost of capital, but NPV does not help compare different projects, and it is about only quantitative factors.
Indeed, no one can precisely predict a financial state in the future after investing in one or another project. That is why there is such a process as a risk analysis that is closely linked with capital budgeting. It is a process of studying the uncertainty of some course of action, in this context, of investment policies. Risk analysis can be used to understand what a chance is to invest in something, even if there is a risk of failure.