Chapter 28

An Overview of Capital Budgeting

Methods

Yusuf KALKAN1

1
Dr. Öğr. Üyesi; Gümüşhane Üniversitesi Kelkit Aydın Doğan MYO Muhasebe ve Vergi Bölümü.
yusufkalkan@gumushane.edu.tr ORCID No: 0000-0003-4246-8624

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 1. INTRODUCTION
In today's world, where global economies are more interconnected and
international trade, communication, and financial transactions have increased
significantly across borders, significant changes have occurred in the business
world, creating a highly competitive environment. In a market characterized by
intense competition, businesses prioritize long-term investments in strategy,
innovation, and efficiency to gain and maintain a competitive advantage.
Long-term investment decisions are made based on the business's strategic
plans. The business identifies the types of investments it needs to achieve its long-
term objectives. Long-term investments enable the business to continuously meet
demand by adapting to future market changes and consumer expectations. Long-
term investment decisions require the effective allocation of the business's
financial resources and a balanced distribution of resources among different
projects and activities. Businesses typically make investments for expansion,
renovation, or upgrading projects. Expansion projects aim to increase the
business's capacity or enter new markets. Renovation or upgrade projects involve
the maintenance, updating, or improvement of assets. Investment projects
encompass activities such as developing new products, implementing new
technologies, or investing in new business areas. Long-term decisions are often
irreversible and non-reversible, so businesses should carefully plan and analyze
such decisions.
Capital budgeting is a significant financial process that aids businesses in
planning and evaluating their future investment decisions. The primary objective
of capital budgeting is to identify investment opportunities that will enhance the
business's long-term value and select the most suitable ones. Additionally, the
expected cash inflows and outflows over the project's lifetime are analyzed.
Capital budgeting helps businesses develop sustainable growth strategies and
encourages a careful and analytical approach when choosing investment projects.
Each investment decision can impact the long-term success of the business, and
therefore, these decisions should be carefully evaluated.
In this section, the concept of capital budgeting, used in the decision-making
process for investment projects, has been explained within the framework of the
literature, and various capital budgeting techniques have been evaluated and
compared with examples.

2. CAPITAL BUDGETING CONCEPT

Larger investments are typically of longer-term and involve larger financial
commitments. These investments are scrutinized in greater detail compared to
smaller ones, as they have a significant impact on a company's value and

581
sustainability. Therefore, it is essential for companies to make long-term
investment decisions through an effective planning method. This planning
process is referred to as capital budgeting (Tükenmez et al., 1999).
Capital budgeting is a versatile process that involves researching new,
profitable, and efficient investment projects and examining all factors, including
technical, marketing, and management, to forecast the consequences of accepting
an investment proposal. Additionally, it encompasses conducting economic
analyses to determine the profit potential of each investment proposal (Akgüç,
1998). Capital budgeting involves the systematic procedure of recognizing and
choosing investments in durable assets or assets anticipated to generate returns
over a period exceeding one year (Fabozzi and Peterson, 2002). Seitz and Ellison
(2005) have defined capital investments as expenditures that will provide benefits
in the future and explained capital budgeting as the process of identifying such
investments. Capital budgeting involves making cash expenditure decisions with
the aim of obtaining future cash flows. If future cash inflows exceed the present
expenditures, shareholders' wealth increases. It is at this stage that the critical
importance of capital budgeting for long-term and substantial investments
becomes evident (Hall and Millard, 2010). Serving as a planning tool, capital
budgeting aims to allocate financial resources accurately among investment
projects to make sound investment decisions and assess project feasibility (Mota
and Moreira, 2023).
Effective and successful capital budgeting practices are of paramount
importance because they have a long-term impact on a firm's survival and
performance (Batra and Verma, 2017). According to the International Federation
of Accountants (IFAC), a systematic, logical, and comprehensive investment
appraisal approach, along with prudent and objective decision-making, must be
implemented to maintain and ensure a sustainable economy and growth.
Therefore, capital budgeting has become a topic of theoretical and empirical
interest in the financial literature and is increasingly gaining significance (Al-
Mutairi et al., 2018).
In the capital budgeting process, several critical factors that play a significant
role in evaluating an investment project include the amount of investment
required, working capital requirements, projected cash flows from the
investment, the economic life of the investment, salvage value, and the expected
rate of return, all of which should be carefully determined (Düzakın, 2013).

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 3. CAPITAL BUDGETING METHODS
In evaluating investment proposals, all details related to the market, technical
aspects, project feasibility, and financial considerations should be analyzed to
select the most suitable investment. The criteria or approaches that businesses use
to assess investment projects are examined under two main categories: Static
methods and dynamic methods. Dynamic methods take into account the time
value of money, whereas static methods are approaches that do not consider the
time value of money (Özekenci, 2022).

3.1. Static Methods

These methods, which do not take into account the time value of money,
include average rate of return, payback period, cost comparison, and profit
comparison.

3.1.1. Average Rate of Return (ARR)

This method, also known by different names such as accounting rate of return,
average profitability of investment, profitability ratio, compares the profit
generated from the project with the investment expenditures for the project. ARR
is calculated using the following formula.

n (ATP)
∑ t
Average Net Profit t=1 n
ARR = = FIE – SV
Average Investment Amount
2

ARR, the average rate of return for the project; ATP, the after-tax profit; FIE,
the fixed investment expenditures; SV, the salvage value; n, the economic life of
the project; and t represents the years. The accounting rate of return is preferred
due to its simplicity in calculation and consistency with data available in
accounting records.
Example: Project X, with an initial investment of 450,000$ and a salvage
value of 40,000$, is expected to generate a net profit of 200,000$ for 3 years.
Project Y, with an initial investment of 700,000 $ and a salvage value of 50,000$,
is expected to generate net profits of 200,000$, 250,000$, 300,000$, and
350,000$ over 4 years, respectively. What is the investment decision for the
company regarding these two projects according to the ARR method?

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 Answer:
200.000+200,000+200.000
200,000
ARRX = 3
450,000 – 40,000 = = 0.97
205,000
2
200,000+250,000+300,000+350,000
275,000
ARRY = 4
700,000 – 50,000 = = 0.85
325,000
2
When comparing the ARR values of Project X and Project Y, since ARRX >
ARRY, the company should prefer to invest in Project X.

3.1.2. Payback Period (PP)

The method is based on determining the number of years required for the net
cash inflows generated by an investment to cover the investment expenditures
(Aydın, Başar and Coşkun, 2015).
The payback period can be calculated in two ways, depending on whether the
expected net cash inflow from the project fluctuates over time (Walther and
Skousen, 2009). If the net cash inflow from the project remains constant over the
years, the payback period (PP) is calculated using the following formula.
Fixed Investment Amount
PP=
Annual Net Cash Inflow

If the expected net cash inflows from the project fluctuate over the years, in
this case, the payback period is calculated by summing up the net cash inflows
from the project until they equal the fixed investment amount.
In order to make a decision regarding the project, it is necessary to calculate
the Weighted Average Cost of Capital (WACC). The commonly used model for
calculating WACC is as follows:

WACC = WD.CD + WE.CE

WD = Weight of Debt = Total Debt / Total Liabilities

CD = Cost of Debt = n.(1-v) n : Interest rate v: Tax Rate
WE = Weight of Equity = Equity / Total Liabilities
CE = Cost of Equity = rf + ( rm - rf ).d
rf: riskless interest rate, rm: market return rate, d: stock sensitivity to the
market.
The maximum acceptable payback period is typically calculated using the
formula 1/WACC. This value is referred to as the PP Criterion (PP'). Therefore,
if PP ≤ PP', it is said that the project will be accepted; otherwise, it will be
rejected.

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 Example: The fixed investment amount is 20,000$, and the economic life
of the project is 10 years, with a constant annual net cash inflow of 4,000$. The
weighted average cost of capital is 0.25. What is the investment decision for the
company regarding this project according to the PP method?

Answer:
Fixed Investment Amount 20,000
PP = = = 5 years
Annual Net Cash Inflow 4,000

1 1
PP' = = = 4 years
WACC 0.25

Since PP > PP', the project is rejected.

If we assume that the cash inflows and outflows for the same project are not
constant each year and that the cash flow statement looks as follows, what would
be the company's decision?

Years 1 2 3 4 5 6 7 8 9 10
Cash -
-6000 2600 3550 3500 3450 3400 2350 1300 1250
Flows 14000

Cash Outflows Cash Inflows

20,000 (2600+3550+3500+3450+3400+2350=18,850)
2 year PP = 6 + 1150 / 1300 = 6.88 years

As calculated earlier, we found PP' to be 4 years, and PP is found to be 6.88

years. Since PP > PP', the project is rejected.

3.1.3. Cost Comparison

This method is based on the assumption that investment projects generate the
same revenues and takes into consideration the costs of these projects. Under the
assumption of equal revenues, among multiple alternative investment projects,
the one with lower costs is preferred (Götze, 2008). The cost comparison method
is easy to calculate mathematically. However, it is criticized for considering only
one-year expenses and not accounting for potential other costs.

3.1.4. Profit Comparison

Unlike the cost comparison method, the profit comparison method includes both
costs and the sales revenues generated from investment projects in its calculations.
Therefore, when evaluating an investment project, more emphasis is placed on the

585
project's income rather than its costs. If two or more investment projects are being
evaluated, the one with higher annual profit should be preferred (Dilmen, 2018).

3.2. Dynamic Methods

These methods take into account the time value of money but do not consider
risk. These methods include net present value, profitability index, internal rate of
return, and Kepner-Tregoe method.

3.2.1. Net Present Value (NPV)

They have defined the Net Present Value as the difference between the market
value and the cost of the investment (Ross, Randolph and Jordan, 2002). The Net
Present Value of an investment is calculated as follows by subtracting the initial
cash outflow from the sum of the present values of expected cash inflows, as
described below (Van Horne and Wachowicz, 2005).

n+s s
SVn CItCOt
NPV = ( ∑ t + n) –∑
(1+k) (1+k) (1+k)t
t=n+1 t=0

NPV net present value; CI cash inflows; CO cash outflows; SV salvage value;
k discount rate; n project's economic life; t years; s completion time. If the net
present value of the project is positive or equal to zero, the project is accepted;
otherwise, it is rejected.
Example: For an investment project with a fixed investment amount of
52,000$, it is expected to generate a constant cash inflow of 14,000$ annually.
This investment project has an economic life of 5 years, and a discount rate of
10% is applied. What would be the decision of the company using the NPV
method?

Answer:
5
14,000 0 52,000
NPV = ( ∑ t + 5) –
t=1
(1+0.10) (1+0.10) (1+0.10)0

14000 14000 14000 14000 14000

NPV = ( + + + + ) – 52,000
(1+0.10)1 (1+0.10)2 (1+0.10)3 (1+0.10)4 (1+0.10)5

NPV = 53,046 – 52,000 = 1,046

Since NPV ≥ 0, the project is accepted.

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 Example: The investment expenditures are 400,000$ in the first year,
600,000$ in the second year, and the economic life is 5 years. The discount rate
is 15%, and the salvage value of the investment is 100,000$. The cash inflows
from the investment are 400,000$ in the 3th year, 500,000$ in the 4th year, and
800,000$ in the 5th year. According to the NPV method, what is the decision of
the company?
Answer:
5 2
CI 100.000 COt
NPV = ( ∑ t + 5) – ∑
(1+0.15) (1+0.15) (1+0.15)t
t=3 t=1

400,000 500,000 800,000 100,000 400,000 600,000

NPV = + + + – –
(1+0.15)3 (1+0.15)4 (1+0.15)5 (1+0.15)5 (1+0.15)1 (1+0.15)2

NPV = 263,200 + 286,000 + 397,600 + 49,700 – 348,000 – 478,200

NPV = 170,300

Since NPV ≥ 0, the project is accepted.

3.2.2. Profitability Index (PI)

The benefit-cost ratio or profitability index of an investment is the ratio of

the present value of the cash inflow the investment is expected to generate over
its economic life to the present value of the cash outflows required by the
investment (Brooks, 2016). The profitability index is formulated as follows:

n+s
CIt SVn
∑
( 1+k ) t + (1+k)n
t=n+1
PI = s
COt
∑
t=0 ( 1+k )t

PI profitability index; CI cash inflows; CO cash outflows; SV salvage

value; k discount rate; n project's economic life; t years; s completion time. If the
profitability index is equal to or greater than 1, the project is accepted; otherwise,
it is rejected.

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 Example: For an investment project with a fixed investment amount of
52,000$, it is expected to generate a constant cash inflow of 14,000$ annually.
This investment project has an economic life of 5 years, and a discount rate of
10% is applied. What would be the decision of the company using the PI method?

Answer:
14,000 0
∑5t=1 +
(1+0.10)t (1+0.10)5 53,046
PI = 52,000 = ≈ 1.02
52,000
(1+0.10)0

Since PI ≥ 1, the project is accepted.

Even without these calculations, it could be said that the project could be
accepted based on the positive NPV.

3.2.3. Internal Rate of Return (IRR)

The discount rate that equates the present value of future cash inflows with
the present value of cash outflows for an investment is called the internal rate of
return (IRR). Additionally, this rate can be defined as the discount rate that sets
the NPV of the investment equal to zero. IRR is formulated as follows:

n+s s
CItSVn COt
∑ t + n =∑
(1+r) (1+r) (1+r)t
t=n+1 t=0

The internal rate of return can be found by solving for r in the equation above.
If the internal rate of return is greater than or equal to the WACC, the project is
accepted; otherwise, it is rejected. The trial and error method is used to find the
internal rate of return (Aydın, Başar and Coşkun, 2015).

Example: The initial investment amount of a project is 1,500,000$, its

economic life is 5 years, and the WACC is 0.12. The cash inflows of the project
are 200,000$ in the 1st year, 400,000$ in the 2nd year, 500,000$ in the 3rd year,
600,000$ in the 4th year, and 700,000$ in the 5th year. What is the decision when
this project is evaluated with IRR?

Answer:
5 s
𝐶𝐶𝐶𝐶t 0 1,500,000
∑ t + =∑
t=1
(1+r) (1+r)5 t=0 (1+r)0

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 Let's start with a discount rate of 10%.

5
CIt 200,000 400,000 500,000 600,000 700,000
∑ t = 1+ 2+ 3+ 4+
t=1
(1+0.10) (1+0.10) (1+0.10) (1+0.10) (1+0.10) (1+0.10)5

5
CIt
∑ =181,800 + 330,400 + 375,500 + 409,800 + 434,000 = 1,731,500
(1+0.10)t
t=1

With a 10% discount rate, the net present value of cash inflows was found to
be 1,731,500. Since this value is greater than the required cash outflow of
1,500,000 for the investment, a higher discount rate should be selected. Let's try
a discount rate of 16% this time.

5
CIt 200,000 400,000 500,000 600,000 700,000
∑ t = 1+ 2+ 3+ 4+
t=1
(1+0.16) (1+0.16) (1+0.16) (1+0.16) (1+0.16) (1+0.16)5

5
CIt
∑ =172,400 + 297,200 + 320,000 + 331,200 + 333,200 = 1,454,000
(1+0.16)t
t=1

With a 16% discount rate, the net present value of cash inflows is 1,454,500,
which falls short of 1,500,000. It is understood that the discount rate should be
lower. Therefore, the discount rate lies between 10% and 16%. The internal rate
of return can be calculated from this range.

1,454,000 ⎯ 1,500,000 ⎯ 1,731,500

%16 ⎯ ? ⎯ %10

1,731,000 - 1,454,000 = 277,500

16% - 10% = 6%
1,500,000 - 1,454,000 = 46,000
IRR = [16% - (46,000 x 6% / 277,500)] = 15%

Since r = 15% ≥ WACC, the project is accepted.

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 3.2.4. Kepnoe-Tregoe Method
The fundamental elements on which this method is based are the evaluation
statement, mandatory criteria, preference criteria, and evaluation matrix. For the
analysis and selection of proposals, evaluation statements are put forward
depending on the objectives and limitations to be achieved. An example of an
evaluation statement could be "The best project proposal researched from a
technical and financial perspective should be selected." According to this method,
project proposals must meet all mandatory criteria. Project proposals that meet
all mandatory criteria are then re-evaluated based on preference criteria.
Preference criteria are weighted according to the importance level in achieving
the company's goals to create an evaluation matrix. The project proposal with the
highest weighted score in the evaluation matrix is accepted (Aydın, Başar and
Coşkun, 2015).

4. METHODS CONSIDERING the RISK ELEMENT

The determinants of investment decisions are risk and return. Therefore,
investors must consider not only the return but also the risk. Methods that take
into account the risk element in the evaluation of investment projects include
varying the discount rate of the investment, probability distribution approach, and
real options.

4.1. Varying the Discount Rate of the Investment

The discount rate used to determine the net present value of an investment is
adjusted based on the risk. By adding the specified risk premium to the discount
rate, a new rate is determined (Moyer, McGuigan and Rao, 2015). The varying
the discount rate of the investment is formulated as follows:

n+s s
CIt SVn COt
NPV = ( ∑ t + n) –∑
[1+(k+𝑟𝑟𝑝𝑝 )] [1+(k+𝑟𝑟
𝑝𝑝 )] [1+(k+𝑟𝑟𝑝𝑝 )]t
t=n+1 t=0

NPV net present value; CI cash inflows; CO cash outflows; SV salvage value;
k discount rate; rp risk premium; n project's economic life; t years; s completion
time. In this method, adding the risk premium to the discount rate reduces the
project's NPV. The rationale for this adjustment is to determine the level at which
the company compensates for a higher risk level. Without this adjustment,
projects with above-average risk can actually decrease the company's value (Scott
et al., 1998).

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 Example: Initially, a project requiring an investment of 1,000,000$ has cash
inflows of 150,000$ in the 1st year, 200,000$ in the 2nd year, 250,000$ in the
3rd year, 500,000$ in the 4th year, and 500,000$ in the 5th year. The discount
rate is 12%, and the risk premium set by managers for this project is 8%.
According to the method of varying the discount rate, should this project be
accepted?
Answer: New discount rate k + rp = 0.12 + 0.08 = 0.20

5 0
CI
0 COt
NPV = ( ∑ t + n)– ∑
(1+0.20) (1+0.20) (1+0.20)t
t=1 t=0

150,000 200,000 250,000 500,000 500,000

NPV = + + + + - 1,000,000
(1+0.20)1 (1+0.20)2 (1+0.20)3 (1+0.20)4 (1+0.20)5

NPV = 124,950 + 138,800 + 144,750 + 241,000 + 201,000 – 1,000,000

NBD = 850,500 – 1,000,000 = -149,500

When considering risk, the NPV has been found to be negative. Therefore, the
project is rejected.

4.2. Probability Distribution Approach

In this method, standard deviation is used to measure risk, and a high
calculated value indicates high risk, while a low value indicates low risk (Smith,
1994). In probability analysis, the possible cash inflows of the project and the
probability of their occurrence are determined. Then, the expected value of cash
inflows is multiplied by the assigned probabilities. The resulting values are
discounted to their present value using the discount rate, and the project is
evaluated (Higgins, 2016).

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 Example: A project with an investment amount of 460,000$ has an economic
life of 2 years. The expected cash inflows from the investment project for each
year and their probabilities are as follows:

Expected Cash Inflows (A) Probability Value (B) AxB

410,000 0.15 61,500
420,000 0.20 84,000
1st year
430,000 0.30 129,000
440,000 0.35 154,000
Total for
1,700,000 1 428,500
Year 1
440,000 0.10 44,000
450,000 0.20 90,000
2st year
460,000 0.30 138,000
480,000 0.40 192,000
Total for
1,830,000 1 464,000
Year 2

When assuming a discount rate of 40%, the net present value of the investment is;

428,500 464,000
NPV = [ + ] - 460,000 = 305,949 + 236,640 - 460,000 = 82,589
(1+0.40)1 (1+0.40)2

To calculate the project's risk, standard deviation should be computed.

Standard deviation is calculated as follows:

σ = √∑ (ECI - NCI)2 x Pi
t=1
σ represents the standard deviation, ECI stands for expected cash inflow, NCI
for net cash inflow, and Pi represents the probability value.

(410,000-428,500)2 x 0.15 + (420,000-428,500)2 x 0.20 + (430,000-428,500)2 x 0.30 +

σ1 = √
(440,000-428,500)2 x 0.35

σ1 = √51,337,500+14,450,000+675,000+46,287,500 = 10,630

(440,000-464,000)2 x 0.10 + (450,000-464,000)2 x 0.20 + (460,000-464,000)2 x 0.30 +

σ2 = √
(480,000-464,000)2 x 0.40

σ2 = √57,600,000+ 39,200,000+4,800,000+102,400,000 = 14,282

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 n
σ2i
σ = √∑
t=1
(1+i)2t

10,6302 14,2822 112,996,900 203,975,524

σ=√ 2 + =√ + = 10,525
(1+0.40) (1+0.40)4 1.96 3.84

In some cases, the standard deviation can be large depending on the magnitude
of the distribution. In such situations, the coefficient of variation (CV) can be
used as a measure of risk. The coefficient of variation is determined by dividing
the standard deviation by the net present value.

10,525
CV = = 0.13
82,589

4.3. Real Options

The decisions related to investment, postponement, expansion, contraction,
and budget of a company are real options. Managerial decisions create options to
purchase and sell real assets. These options grant the management rights to
achieve the firm's objectives and maximize its profit (Brach, 2003). In traditional
methods, calculations result in a value, and after various comparisons, a decision
is made whether to invest or not. However, in real options, while a value is
calculated, a useful framework is also established for strategic decisions (Walters
and Giles 2000, 2).
Uncertainty about the future, expiration date, time value of money, and the
value of the underlying asset all affect the price of a real options contract (Bruun
and Bason, 2001). Real options provide owners with the right to benefit from
future opportunities. If there are options such as investment, expansion,
contraction, sale, or abandonment at one or more points in the future, it is referred
to as a real option. Real options can be classified based on the flexibility they
provide into options for postponement, expansion or contraction, abandonment,
staging, modification, and growth (Alper, 2011). In the evaluation of investment
projects, the option approach, especially in environments with high uncertainty
and risk, provides more accurate results compared to other traditional project
evaluation approaches (Uysal, 2001). The strategic net present value is equal to
the sum of the traditional net present value and the value of options.

Strategic NPV = Traditional NPV + Value of Options

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 The most recognized method developed for calculating option value is the
model derived from mathematical formulas by Fisher Black and Myron Scholes,
based on the assumption that the continuous returns of the stock follow a normal
distribution. The basic variables and relationships of the model are provided
below:

C = P x N(d1) – K x e-rt x N(d2)

P σ2
ln( )+(rf + )t
K 2
d1 =
σ√t

d2 = d1 - σ√𝑡𝑡

In this context, C represents the present value of the option, P stands for the
present value of cash flows, K denotes the option exercise cost, 𝑟𝑟𝑓𝑓 represents the
risk-free interest rate, t is the time remaining until maturity, σ signifies the
standard deviation of cash flows (risk), and N(d) represents the standard normal
distribution function.
Example: The initial investment amount for an investment project is
1,500,000$, and the economic life of the project is 5 years. There is an option to
expand the project by making an additional investment in the 3rd year. The
exercise price of the option is 1,000,000$. The risk of cash flows for the project
is 20%, the discount rate is 12%, and the risk-free interest rate is 6%. If the option
is not exercised, the cash flows for the project are 300,000$ in the 1st year,
400,000$ in the 2nd year, 500,000$ in the 3rd year, 700,000$ in the 3th year, and
750,000$ in the 5th year. If the option is exercised, the cash flows are 300,000$
in the 1st year, 400,000$ in the 2nd year, 500,000$ in the 3rd year, 1,100,000$ in
the 4th year, and 1,200,000$ in the 5th year. Evaluate the project using the real
options method.
Answer:
n+s s
CIt COt
NPV = ( ∑ t –∑
(1+k) (1+k)t
t=n+1 t=0

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 The net present value (NPV1) of cash flows without the option is as follows:

300,000 400,000 500,000 700,000 750,000

NPV1 = + + + + – 1,500,000
(1+0.12)1 (1+0.12)2 (1+0.12)3 (1+0.12)4 (1+0.12)5

NPV1 = 267,857 + 318,877 + 355,890 + 444,863 + 425,570 - 1,500,000

NPV1 = 313,057 TL

The net present value (NPV2) of cash flows if the option is exercised is as
follows. The important point to note here is that there is a cost to exercising the
option in the third year, so the present value of the cash flow in the third year
should be subtracted.

300,000 400,000 500,000 1,100,000 1,200,000

NPV2 = + – + + – 1,500,000
(1+0.12)1 (1+0.12)2 (1+0.12)3 (1+0.12)4 (1+0.12)5

NPV2 = 267,857 + 318,877 – 355,890 + 699,070 + 680,912 – 1,500,000

NPV2 = 110,826 TL

At first glance, it may appear that the use of the option has reduced NPV.
However, the fundamental reason for this illusion is the inability of the net present
value (NPV) method to accurately measure the value of the growth option. This
problem is resolved using the Black & Scholes method for real options. The
present value of cash flows obtainted after using the option is 1,379,982, which
is the sum of 699,070 and 680,912. The value of the option will be calculated as
follows using the Black & Scholes method:

P σ2
ln( )+(rf + )t
K 2
d1 =
σ√t

1,379,982 0.04
ln( )+(0.06+ 2 )2 ln(1.38)+0.08x2 0.32+0.16
1,000,000
d1 = = = = 1.714
0.2√2 0.28 0.28

d2 = d1 - σ√𝑡𝑡 = 1.714 - 0.2√2 = 1.434

C = P x N(d1) – K x e-rt x N(d2)

595
 C = 1,379,982 x (0.4564) – 1,000,000 x 2.710.06x2 x 0.4236

C = 629,824 - 477,433 = 152,391

Strategic NPV = Traditional NPV + Value of Options

Strategic NPV = 313,057 + 152,391 = 465,448

As seen, the utilization of the growth option significantly enhances the

project's value.

5. CONCLUSION
The primary objective of businesses is to maximize firm value. In order to achieve
this goal, managers should invest in projects that will increase the firm's value.
Investment alternatives should be ranked in order of priority and importance based on
their potential to create the most value for the firm, and investments that make the most
effective use of limited resources should be selected. To do this, businesses make
decisions about which projects to invest in or eliminate using various capital budgeting
methods.
Capital budgeting methods are of critical importance when making long-term
investment decisions for a business. Capital budgeting methods assist the business in
comparing different investment opportunities, utilizing the business's limited capital
resources most effectively, and determining which projects will provide the highest
value. This allows the business to allocate its capital more efficiently while avoiding
unnecessary investments. Capital budgeting methods are also used to evaluate the
financial risks of investment projects. This helps the business identify risky projects and
take measures to manage them better. The capital budgeting process structures the
decision-making process of the business and helps it make decisions based on objective
data, thus preventing emotional or arbitrary decisions. Through the capital budgeting
process, a business can achieve sustainable growth and success. Capital budgeting
helps the business identify the necessary resources to finance its investment projects.
The business can obtain these resources through internal sources (such as equity) or
external sources (such as debt or stocks).
As a result, successful investment decisions not only enhance the reputation of
the business but also increase the trust placed in the business. In order to make
successful investment decisions, investment projects should be thoroughly analyzed
using capital budgeting methods. Each method has its own advantages and
disadvantages. Therefore, in order to manage and implement the capital budgeting

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process correctly, one should not rely on a single method but should evaluate it in
conjunction with other methods.

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