Capital Budgeting is implemented to determine the value of a project and helps to determine whether that project is worth the investment or not. This hypothetical project can range anywhere from developing a new product, to purchasing a new machine, or even buying a company. In the world of finance, the value of an object is reflected by the present value of the object’s future benefit or benefits. The process of capital budgeting enables users to determine this value.
Capital budgeting involves three major categories. These categories are important and a proper valuation cannot be obtained without them. These categories include the capital asset pricing model, free cash flows, and the weighted average cost of capital. The major categories in the capital budgeting process also include other variables that are going to be discussed in further detail below. To illustrate, a spreadsheet with a hypothetical company known as Whale Inc. is provided along with this guide.
First, we start with the capital asset pricing model widely known by its abbreviation CAPM. One of the first topics discussed in beginners finance recommends that the higher the risk of an asset the greater the expected return. Of course, why not? If I am a lender why should I give a subprime candidate similar terms as a prime member. The subprime borrower is less likely to pay me back. Therefore, the rate of return I would expect from him should be higher since it is more likely that he will renege and not pay me back. The difference between the two rates is considered the Risk Premium. The CAPM helps to determine what that expected return on an asset should be, given the expected return of the general market. Hence, CAPM or Expected Return (i) is equal to:
The risk free rate or as denoted in the equation above, is the rate of return on an asset with zero risk. Such assets include, treasury bills, certificate of deposits, and savings accounts. However, in this scenario,...