Running head: THE ANALYSIS TOOLS USED IN THE CAPITAL BUDGET DECISIONS 1

The Analysis tools used in the capital budget decisions

BUS 5110 Managerial Accounting Term 4

Portfolio Assignment Unit 6

University of the People

2020, May 21
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The Analysis tools used in the capital budget decisions

In the investment world, capital budget decisions play a substantial role to ascertain the

long-term lucrative options for investors’ portfolios. Due to the occurrence of unstable global

economy has led the investor or venture capitalist to find less risky investment options (Adams,

n.d). The motive of every business is to increase the wealth of investors and minimize the risks

or losses. In effect, investment bankers, managers, and financial analysts capitalized on capital

budgeting decisions to ascertain which of investment portfolio or projects yield the maximum

returns over the investment period (Kenton, 2020).

Capital budget decisions enable the company to make effective investment decisions

toward accomplishing company strategic goals. The investment decision as to whether to

expand, acquire, replace, produce a new product, etc. require critical financial analysis. Capital

budget decisions cannot be overlooked when considering the capital structure of the business

such as debts or equity to finance a project or an investment (Wall Street, n.d).

Businesses incorporated different approaches to ascertain to make a decision as to which

long-term investment is fruitful or not. The factors to take into account when investing in long-

term investment project include the time value of money, the future returns expected from the

project or investment, the risks associated with cash flows, and the strategies employed when

choosing the project (Woodruff, 2019).

The financial analysis tools employed in capital budget decisions (Woodruff, 2019):

The Payback period has to do with the amount of time required to recuperate or recoup

the investment cost. According to Kagan (2020) stated, “The payback period is the length of time

an investment reaches a break-even point” (para. 1). The Payback period method is simple to

calculate. The shorter the time frame to recoup the investment cost, the more attractive or
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desirable the investment portfolio or the project. The payback period can be ascertained by

dividing the cost of the investment by the yearly cash flow.

The “Net Present Value” (NPV) encompasses the sum total of the present values of the

future expected cash flows from a project or investment undertaken. The corporate financial

analyst, investment bankers, businesses, etc. utilized NPV financial analysis tool to gain

knowledge on how to value numerous investments or projects to ascertain its profit performance.

The “internal rate of return” (IRR) is also an analysis tool used for making capital budget

decisions. “IRR is the discount rate when the present value of the expected incremental cash

inflows equals the initial cost of the project” (Wall Street, n.d., para. 4). It is a rate when NPV

from the investment equals zero. IRR takes into account the risk associated with the project’s

cash flows by utilizing the “cost of capital”.

I believe these three financial analysis tools are useful in determining the profitability of a

project or an investment portfolio. However, the most effective and widely used financial

analysis tool to determine the lucrativeness of a project or investment portfolio is Net Present

Value (NPV). The corporate financial analyst, investment bankers, businesses, etc. tends utilize

Net Present Value because it includes all the parameters necessary to determine the worth or the

risk related to a project or an investment portfolio. These parameters include the following

(Woodruff, 2019):

 it takes into consideration the “time value of money”,

 it takes into account future expected cash flows of the project,

 it considers the risk associated with the project cash flows by utilizing the “cost of

capital”

 Point out whether an investment will maximize the wealth or value of the business.
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References

Adams, D. (n.d).The Best Ways to Incorporate Risk Into Capital Budgeting .Retrieved from

https://smallbusiness.chron.com/ways-incorporate-risk-capital-budgeting-15317.html

Kagan, J. (2020, May 5,).Payback Period. Retrieved from

https://www.investopedia.com/terms/p/paybackperiod.asp

Kenton, W. (2020, May 10). Capital Budgeting. Retrieved from

https://www.investopedia.com/terms/c/capitalbudgeting.asp

Woodruff, J. (2019, March 06).Three Primary Methods Used to Make Capital Budgeting

Decisions. Retrieved from https://smallbusiness.chron.com/three-primary-methods-used-

make-capital-budgeting-decisions-11570.html

Wall street. (n.d).Capital Budgeting. Retrieved from https://www.wallstreetmojo.com/capital-

budgeting/