CAPITAL BUDGETING FOR CONSTRUCTION PROJECTS

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1. INTRODUCTION TO CAPITAL BUDGETING
Capital budgeting is the planning process used to determine whether a firm's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is budget for major capital, or investment, expenditures. The most important part for the capital budgeting is the cash flow analysis & cash flow projections with consideration of all internal & external factors that can affect the expenditure, investment, capital for the said project.

Net present value (NPV) Method
Net Present Value [discounted cash flow] (DCF) valuation, to find its net present value (NPV). (First applied to Corporate Finance by Joel Dean in 1951). This valuation requires estimating the size and timing of all of the incremental cash flows from the project. These future cash flows are then discount needed to determine their present value. These present values are then summed, to get the NPV.


Benefit Cost Ratio Method
It is the Ratio of Cash Flow to the Initial investment of a project & always should be positive in terms of profit analysis.
Benefit Cost Ratio (B/C) = Cash Flow / Investments.
It is a good method, but does not give optimum results for large construction Projects.

2. LITERATURE REVIEW:
The long-term investments we make today determines the value we will have tomorrow. Therefore, capital budgeting analysis is critical to creating value within financial management.
And the only certainty within capital budgeting is uncertainty. Therefore, one of the biggest challenges in capital budgeting is to manage uncertainty.
We deal with uncertainty through a three-stage process:
a) Build knowledge through decision analysis.
b) Recognize and encourage options within projects.
c) Invest based on economic criteria that have realistic economic assumptions


Internal rate of return (IRR) Method
The internal rate of return (IRR) is defined as the discount rate that gives a net present value (NPV) of zero. It is a commonly used measure of investment efficiency. The IRR method will result in the same decision as the NPV method for (non-mutually exclusive) projects in an unconstrained environment, in the usual cases where a negative cash flow occurs at the start of the project, followed by all positive cash flows. In most realistic cases, all independent projects that have an IRR higher than the hurdle rate should be accepted. Nevertheless, for mutually exclusive projects, the decision rule of taking the project with the highest IRR - which is often used - may select a project with a lower NPV.


Payback Period Method
In this method the payback period is defined as the time at which the initial investment is recovered from the revenues as the project is progressing.