What is meant by capital planning?
Capital planning is the “decision-making process with respect to investments in fixed assets.” In other words, it is the process of finding and selecting profitable projects or proposals in which to invest company resources. Financial Management covers five approaches to calculating the potential return on a project or proposal: The payback period, net present value, profitability index, internal rate of return, and modified internal rate of return.
Why is IRR important to an organization?
IRR, or internal rate of return, is important to an organization because the calculation connects the project back to the primary goal of every organization—creating wealth for its shareholders. Organizations want to pursue projects that generate a rate of return higher than that required by its investors. The IRR calculation provides the internal rate of return needed to perform the comparison. “If the internal rate of return on a project is equal to the shareholders’ required rate of return, then the project should be accepted, because the firm is earning the rate that its shareholders require” (Keown, Martin, Petty, & Scott, 2005, p. 300).
Why is NPV important to a project?
NPV, or net present value, calculates future cash flows expected from a project, discounted to present value, and compared against the initial outlay required for the project. If the discounted cash flow projection is equal to or greater than the initial outlay, the project is profitable and should go forward. If the net present value is negative, the company should pursue other opportunities.
How would you select from multiple projects presented to your organization?
At my company, we also focus on wealth creation for our investors (as described above for IRR). However, we use EVA for project selection instead of MVA (market value added measures the total wealth created by a firm at a particular point in time). EVA is a way to determine the value created that is over and above the shareholders required return, but EVA allows us to compare that value over specific periods of time (like comparing one quarter to another). We evaluate all financial decisions using the EVA model. Not all of our decisions generate positive EVA. In some situations we choose between the options that generate the less negative EVA (I will explain this further if anyone is interested). Ultimately it is about generating wealth for the investor. “Managing the firm in ways that increase EVA will generally lead to a higher MVA” (p. 446).
Works Cited
Keown, A. J., Martin, J. D., Petty, J. W., & Scott, J. D. (2005). Financial Management: Principles and Applications. Upper Saddle River: Pearson Education, Inc.
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