Capital Budgeting Models
Capital budgeting, or investment appraisal, is the planning process used to determine whether an organization’s long term investments such as new machinery, replacement of machinery, new plants, new products, and research development projects are worth the funding of cash through the firm’s capitalization structure (debt, equity or retained earnings). It is the process of allocating resources for major capital, or investment, expenditures.
Lease vs. Buy:
The lease vs. buy templates will will find out the periodic cash flows under both options and discount them using the after-tax cost of debt to see where does the present value of the cost of leasing stands as compared to the present value of the cost of buying. The alternative with lower present value of cash outflows is selected.
Determining periodic cash flows in case of leasing is easy. Most leases involve periodic fixed payments and an optional one-time terminal payment. They may also involve payment of insurance, etc. associated with the asset which also need to be accounted for. These payments have associated tax shield, i.e. they are allowed as deduction from the company’s taxable income which results in a decrease in net tax liability of the company.
Capital Expenditure Justification:
The capital spending analysis templates recognize that ideally, many businesses would like to pursue all projects and opportunities that enhance shareholder value. However, because the amount of capital available at any given time for new projects is limited, management needs to use capital budgeting techniques to determine which projects will yield the most return over an applicable period of time. Various methods of capital budgeting can include throughput analysis, net present value (NPV), internal rate of return (IRR), discounted cash flow (DCF) and payback period.