Principles of Capital Budgeting & Components of Capital Budget

Principles of Capital Budgeting & Components of Capital Budget
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Principles of Capital Budgeting & Components of Capital Budget
Introduction
Capital budgeting refers to the planning process used to determine if the tangible assets or long-term investments such as medical equipment or the new hospital is worth cash deployment. The capital structure, which consists of debt and equity, is used to purchase the asset or investment. Investment projects form the core evaluation basis in the capital budgeting process. Capital budgeting decisions entail the appraisal of the potential capital investment to make appropriate investment decisions. A project is a time-bound endeavor of an organization whose main objective is to accomplish a specific task with limited resources. The project is also subject to dynamic changes in the business environment and uncertainties associated with the business. Capital budgeting principles help the organization with do's and don'ts when assessing the projects that should be considered.
Time value for money
Capital budgeting is based on the time value for money principle. Essentially, there is a valuable time for money if invested over time and earns interest(Vecchi and Casalini 2018). For example, if we invested $1 today with the interest of 5%, then subsequently, the present value after one year will be $1.05.The time value for money specific method is Net value for money (NPV). The sum of the present value for the projected cash flow, which includes investments discounted at a weighted average cost of capital(WACC) being invested, is known as Net Present Value (NPV). United Medical facility's calculations for investment project analysis yielded a positive NPVof of $438,195 after five years. The Project is worth investing in because the NPV is positive; thus, it creates value for the shareholders.
Cash flow calculation
The sequence of cash in and cash out is the main characteristic of any investment project. Generally, cash outflow happens during the installation or the operation phase. A set of variables input has to be defined and understood from the operation side of the research machine investment project being undertaken by United Medical Center. The timing of the project is supposed to be four years, during which the period must be able to remunerate a highly capital intensive project. The variable investment costs should be well spread across the investment period and the value well fixed to accommodate inflation changes. The cost of operating the research investments machine purchase should be adjusted to allow changes in working capital and inflation. Like the research investment project, an ideal capital budgeting project should use cash flows in appraisal instead of accounting profits. Unlike accounting profit, cash flows are considered more relevant in the investment appraisal (Gitman and Forrester 1977).
The Criteria Used
The decision criteria used in the investment appraisal for the research machine investment by United Health Center should be based on accepting or rejecting the project. Generally, the internal rate of return (IRR) and Net present value giv...