Capital budgeting is the process of making investment decisions in long term assets. It is the process of deciding whether to invest in a particular project as all the investment possibilities may not be rewarding.
Thus, the manager must choose a project that gives a rate of return more than the cost financing such a project. That is why he must value a project in terms of cost and benefit.
Following are the categories of projects that can be examined using capital budgeting process:
- The decision to buy new machinery
- Expansion of business in other geographical areas
- Replacement of an obsolete equipment
- New product or market development etc
Thus, capital budgeting is the most important responsibility undertaken by a financial manager. This is because:
- It involves the purchase of long-term assets and such decisions may determine the future success of the firm.
- These decisions help in maximizing shareholder’s value.
- Principles applicable to capital budgeting process also apply to other corporate decisions like working capital management.
Process of Capital Budgeting
Following are the steps of capital budgeting process:
Idea Generation
The most important step of the capital budgeting process is generating good investment ideas. These investment ideas can come from several sources like the senior management, any department or functional area, employees, or sources outside the company.
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Analysing Individual Proposals
A manager must gather information to forecast cash flows for each project to determine its expected profitability. This is because the decision to accept or reject a capital investment is based on such an investment’s future expected cash flows.
Planning Capital Budget
An entity must give priority to profitable projects as per the timing of the project’s cash flows, available company resources, and a company’s overall strategies. The projects that look promising individually may be undesirable strategically. Thus, prioritizing, and scheduling projects is important because of the financial and other resource issues.
Monitoring and Conducting a Post Audit
It is important for a manager to follow up or track all the capital budgeting decisions. He should compare actual with projected results and give reasons as to why projections did not match with actual performance. Therefore, a systematic post-audit is essential to find out systematic errors in the forecasting process and hence enhance company operations.
Techniques of Capital Budgeting
Capital budgeting techniques are the methods to evaluate an investment proposal to help the company decide upon the desirability of such a proposal. These techniques are categorized into two heads: traditional methods and discounted cash flow methods.
Traditional Methods
Traditional methods determine the desirability of an investment project based on its useful life and expected returns. Furthermore, these methods do not consider the concept of time value of money.
Pay Back Period Method
Payback period refers to the number of years it takes to recover the initial cost of an investment. Therefore, it is a measure of liquidity for a firm. Thus, if an entity has liquidity issues, in such a case, shorter a project’s payback period, better it is for the firm.
Therefore,
Payback period = Full years until recovery + (unrecovered cost at the beginning of the last year)/ Cash flow during the last year
Here, full years until recovery is nothing but the payback that occurs when cumulative net cash flow equals to zero. Cumulative net cash flow is the running total of cash flows at the end of each time.
Average Rate of Return Method (ARR)
Under ARR method, the profitability of an investment proposal can be determined by dividing average income after taxes by average investment, which is average book value after depreciation.
Thus, ARR = Average Net Income After Taxes/Average Investment x 100
Where, Average Income After Taxes = Total Income After Taxes/Total Number of Years
Average Investment = Total Investment/2
Based on this method, a company can select those projects that have ARR higher than the minimum rate established by the company. And, it can reject the projects having ARR less than the expected rate of return.
Discounted Cash Flow Methods
As mentioned above, traditional methods do not take into the account time value of money. Rather, these methods take into consideration present and future flow of incomes. However, the DCF method accounts for the concept that a rupee earned today is worth more than a rupee earned tomorrow. This means that DCF methods consider both profitability and time value of money.
Net Present Value Method (NPV)
NPV is the sum of the present values of all the expected incremental cash flows of a project discounted at a required rate of return less than the present value of the cost of the investment.
In other words, NPV is the difference between the present value of cash inflows of a project and the initial cost of the project. As per this technique, the projects whose NPV is positive or above zero shall be selected.
If a project’s NPV is less than zero or negative, the same must be rejected. Further, if there is more than one project with positive NPV, then the project with the highest NPV shall be selected.
NPV = CF1/ (1 + k)1 + ………. CFn/ (1 + k) n + CF0
where CF0 = Initial Investment Outlay (Negative Cash flow)
CFt = after tax cash flow at time
t k = required rate of return
Internal Rate of Return (IRR)
Internal Rate of Return refers to the discount rate that makes the present value of expected after-tax cash inflows equal to the initial cost of the project. In other words, IRR is the discount rate that makes present values of a project’s estimated cash inflows equal to the present value of the project’s estimated cash outflows. If IRR is greater than the required rate of return for the project, then accept the project. And if IRR is less than the required rate of return, then reject the project.
PV (inflows) = PV (outflows)
NPV = 0 = CF0 + CF1/ (1 + IRR)1 + ……….. CFn/ (1 + IRR) n + CF0
Profitability Index
Profitability Index is the present value of a project’s future cash flows divided by initial cash outlay. Thus, it is closely related to NPV. NPV is the difference between the present value of future cash flows and the initial cash outlay. Whereas PI is the ratio of the present value of future cash flows and initial cash outlay. PI = PV of future cash flows/CF0 = 1 + NPV/CF0 Thus, if the NPV of a project is positive, PI will be greater than 1. If NPV is negative, PI will be less than 1. Therefore, based on this, if PI is greater than 1, accept the project otherwise reject.
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