Capital budgeting is a tool employed by businesses to study potential viable investments or projects. Before managers approve or reject projects, they first have to carry out capital budgeting. For example, a company might want to know if returns that would be generated by a project are in line with the target benchmark. To do this, the company might assess the lifetime cash inflows and outflows required for the prospective project. Capital budgeting is also sometimes referred to as investment appraisal.
There are several capital budgeting techniques that help firms to decide on projects that they should invest in. We have discussed some of them below:
Discounted Cash Flow Analysis
Discounted cash flow analysis is concerned with the capital required to start a project, the revenue it will generate, and expenses such as maintenance costs.
Although payback analysis is one of the uncomplicated types of capital budgeting, it also lacks accuracy. This method is still popular because it is quick and offers a “back of the enveloper” understanding of what to expect from the project that has been proposed.
Throughput analysis is the most accurate but also the most complicated capital budgeting technique. This method considers the firm as a single system that generates profit. Throughput is regarded as the number of activities that are passed through this system.
Value analysis is a technique used to understand how the value of a product can be improved. It involves evaluating the constituent components of the product and the cost associated with them. Value analysis seeks to improve the components of the product by increasing the value of their functions or reducing their costs.
To understand value analysis, you must be acquainted with the following concepts:
Valueit is the ratio between a function that guarantees customer satisfaction and the cost of that function. Functions can be basic or secondary.
Needit is the desire of the client or something that they need
The process of value analysis depends on the application of a systematic plan. This work plan can be divided into six steps:
- Analysis of information
- Creativity and innovation
Critical Path Analysis
Critical path analysis is an approach used to map out every key task that is necessary to complete an investment or project. This technique involves identifying the timeframe of each activity in the project and the dependencies of these activities. Critical path analysis helps managers set timelines that can be met for their projects and also track how things are going.
In critical path analysis, you must understand that the execution of some activities in the project will depend on achieving other tasks. Also, there are activities that cannot be executed until others are done. For this reason, you should outline the vital and less important activities in a work plan and know the maximum and minimum time for each.
Critical path analysis can also help you note the dependencies among activities that might tell you the amount of slack time for each activity. This will help you arrive at a reasonable deadline date.
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