Capital budgeting is an accounting principle that companies use to determine which investments to pursue. Unlike some other types of investment analysis, capital budgeting focuses on cash ﬂows rather than proﬁts. Understanding the different capital budgeting methods can help you understand the decision-making process of companies and investors.
In this article, we are going to talk about what capital budget is, why is it important and what it can do for your business.
- What is Capital Budgeting?
- How does Capital Budgeting Work?
- Why is Capital Budgeting Important?
- What are the Methods of Capital Budgeting?
- What are the Processes Involved in Capital Budgeting?
- What is Capital Budgeting Formula?
- What are the Advantages and Disadvantages of Capital Budgeting?
- Capital Budgeting Examples
What is Capital Budgeting?
Capital Budgeting is defined as the process by which a business determines which fixed asset purchases or project investments are acceptable and which are not. Using this approach, each proposed investment is given a quantitative analysis, allowing rational judgment to be made by the business owners.
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Capital asset management requires a lot of money; therefore, before making such investments, they must do capital budgeting to ensure that the investment will procure profits for the company. The companies must undertake initiatives that will lead to a growth in their profitability and also boost their shareholder’s or investor’s wealth.
Capital Budgeting is characterized by the following features:
- There is a long duration between the initial investments and the expected returns.
- The organizations usually estimate large profits.
- The process involves high risks.
- It is a fixed investment over the long run.
- Investments made in a project determine the future financial condition of an organization.
- All projects require significant amounts of funding.
- The amount of investment made in the project determines the profitability of a company.
How does Capital Budgeting Work?
It is of prime importance for a company when dealing with capital budgeting decisions that it determines whether or not the project will be profitable. Although we shall learn all the capital budgeting methods, the most common methods of selecting projects are:
- Payback Period (PB)
- Internal Rate of Return (IRR) and
- Net Present Value (NPV)
It might seem like an ideal capital budgeting approach would be one that would result in positive answers for all three metrics, but often these approaches will produce contradictory results. Some approaches will be preferred over others based on the requirement of the business and the selection criteria of the management. Despite this, these widely used valuation methods have both benefits and drawbacks.
Investing in capital assets is determined by how they will affect cash flow in the future, which is what capital budgeting is supposed to do. The capital investment consumes less cash in the future while increasing the amount of cash that enters the business later is preferable.
Keeping track of the timing is equally important. It is always better to generate cash sooner than later if you consider the time value of money. Other factors to consider include scale. To have a visible impact on a company’s final performance, it may be necessary for a large company to focus its resources on assets that can generate large amounts of cash.
In smaller businesses, a project that has the potential to deliver rapid and sizable cash flow may have to be rejected because the investment required would exceed the company’s capabilities.
The amount of work and time invested in capital budgeting will vary based on the risk associated with a bad decision along with its potential benefits. Therefore, a modest investment could be a wiser option if the company fears the risk of bankruptcy in case the decisions go wrong.
Sunk costs are not considered in capital budgeting. The process focuses on future cash flows rather than past expenses.
Why is Capital Budgeting Important?
Capital budgeting is a valuable tool because it provides a means for evaluating and measuring a project’s value throughout its life cycle. It allows you to assess and rank the value of projects or investments that require a large capital investment. For example, investors can use capital budgeting to analyze investment options and decide which ones are worth investing in.
Capital budgeting helps financial decision-makers make informed financial decisions for projects they expect to last a year or more that require a large capital investment. Such projects can include:
- Investing in new equipment, technology and buildings
- Upgrading and maintaining existing equipment and technology
- Completing renovation projects on existing buildings
- Expanding their workforce
- Developing new products
- Expanding into new markets
Before a company approves a specific project, capital budgeting helps them create a budget for the project’s costs, estimate a timeline for the project’s return on investment and decide whether the project’s potential value is worth its necessary capital investment. Once a project begins, they can use capital budgeting to measure the project’s progress and the effectiveness of their investment decisions.
What are the Methods of Capital Budgeting?
Companies have several different valuation methods they can use to determine whether a project is likely to be valuable and worth pursuing. Ideally, a company would come to the same conclusion about a project’s value regardless of the valuation method they use, but each evaluation method may provide a different result. This means a company’s decision-makers need to decide which capital budgeting method they prefer.
Capital budgeting can be classified into two types: traditional and discounted cash flow. Within each type are several budgeting methods that can be used.
Traditional capital budgeting
This technique has two methods. They include:
- 1. Payback period
The payback period method is the simplest way to budget for a new project. It measures the amount of time it will take to earn enough cash inflows from your project to recover what you invested.
When using this method, a shorter payback period makes a project more appealing because it means you will recover your investment cost in a shorter amount of time. The payback period method is popular for those people who have a limited amount of funds to invest in a project and need to recover their initial investment cost before they can start another project.
For example, you are using the payback period method to help your company choose between a project that has an initial investment cost of $50,000 with a payback period of 10 years and one that has an initial investment cost of $70,000 with a payback period of eight years. Using the payback period method, you would likely recommend the project with a payback period of eight years.
- 2. Average rate of return (ARR)
The accounting rate of return (ARR) method is also known as the return on investment (ROI) method. It uses accounting information obtained from financial statements to measure the profitability of a possible investment. Some companies prefer the ARR method since it considers the project’s earnings over its entire economic life.
Discounted cash flow methods
Discounted cash flow (DCF) methods are also known as “time-adjusted techniques.” They consider the time value of money while evaluating the costs and benefits of a project. The cash flows associated with the project are discounted at the cost of capital. These methods also take into account all benefits and costs occurring during the project’s life cycle.
- 1. Net present value (NPV)
The net present value capital budgeting method measures how profitable you can expect a project to be. When using this method, any project with a positive net present value is acceptable, while any project with a negative net present value is not acceptable. The NPV method is one of the most popular capital budgeting methods because it helps you to choose the most profitable projects or investments.
You can use the net present value method to select only one project or investment or several projects to invest in at the same time. For example, a company is considering three different projects but only has enough capital to invest in one. They may use the net present value method to choose the one project that is likely to be the most profitable.
Likewise, an investor who is considering eight investment portfolio options but only has enough capital to fund three of the options may use the net present value method to choose the three portfolio options they expect to be the most profitable.
- 2. Internal rate of return (IRR)
The internal rate of return method measures the return percentage you can expect to receive from a specific project. When using this method, the more the rate of return percentage exceeds the project’s initial capital investment percentage, the more appealing the project becomes. It is common for a company to use the IRR method to choose between conflicting project options.
For example, a company can use this method to compare the internal rate of return of expanding operations in an existing facility to the internal rate of return of expanding operations by building and opening a new one. The two project options are conflicting because the company needs only one site to expand operations. In this scenario, the company would choose the project that has a greater IRR percentage that exceeds the cost of investment percentage.
- 3. Profitability index (PI)
Profitability index (PI) is one of the essential capital budgeting techniques. This technique is also known as “profit investment ratio (PIR),” “benefit-cost ratio (BCR)” and “value investment ratio (VIR).” The index signifies a relationship between the investment of the project and the payoff of the project. It is mainly used for ranking projects.
According to the rank of the project, a suitable project is chosen for investment. For example, a company must choose between two projects. One has a PI greater than one while the other has a PI less than one. Using an accept-reject rule, or basically either one or the other, the company chooses the project with the greater PI.
What are the Processes Involved in Capital Budgeting?
The process of Capital Budgeting involves the following points:
Identifying and generating projects
Investment proposals are the first step in capital budgeting. Taking up investments in a business can be motivated by a number of reasons. There could be the addition or expansion of a product line. An increase in production or a decrease in production costs could also be suggested.
Evaluating the project
It mainly consists of selecting all criteria necessary for judging the need for a proposal. In order to maximize market value, it has to match the company’s mission. It is crucial to consider the time value of money here.
In addition to estimating the benefits and costs, you should weigh the pros and cons associated with the process. There could be a lot of risks involved with the total cash inflows and outflows. This needs to be scrutinized thoroughly before moving ahead.
Selecting a Project
Since there is no ‘one-size-fits-all’ factor, there is no defined technique for selecting a project. Every business has diverse requirements and therefore, the approval over a project comes based on the objectives of the organization.
After the project has been finalized, the other components need to be attended to. These include the acquisition of funds which can be explored by the finance department of the company. The companies need to explore all the options before concluding and approving the project. Besides, the factors like viability, profitability, and market conditions also play a vital role in the selection of the project.
Once the project is implemented, now come the other critical elements such as completing it in the stipulated time frame or reduction of costs. Hereafter, the management takes charge of monitoring the impact of implementing the project.
This involves the process of analyzing and assessing the actual results over the estimated outcomes. This step helps the management identify the flaws and eliminate them for future proposals.
What is Capital Budgeting Formula?
1. Method of Payback Period Assessment:
The payback period is the time taken for the firm’s project proposal to get sufficient income from it to cover the initial cost of capital investment. You always should choose the quickest payback period.
The formula applied here is:
The payback period is the Initial Investment divided by the Annual Cash Flow.
Consider an example of a fictitious firm named ‘ABC’ that invests an amount of 125,000 ₹ on two products ‘Relays’ costing 250 ₹ each and Junction Boxes costing 150 ₹ each. ABC Company plans to increase the production of relays by 500 units and the junction boxes by 1,000 units.
The revenue to be generated is hence 250x 500= 125,000₹ for relays and 1000x 150= 150,000 ₹ for the junction boxes. Now calculate the Payback periods for each.
The payback period for relays is 125,000 /125,000 or 1 year.
Payback Period for Junction Boxes is 125,000/150,000= 0.833 or 8 months and 10 days.
Capital budgeting decisions examples:
Let us consider an example to define the capital budgeting formula. Going on just the payback period the Junction Boxes proposal has a shorter payback period and hence should be preferred.
|Proposal for Relays
|Proposal for Junction Boxes
|Cost per unit
|Income to be generated
|8 months and 10 days
If both proposals have the same payback period, you should consider the time-efficient proposal with better cash flows in the early stages to factor in the value of your money.
2. NPV or Nett Present Value Method:
This method helps if the cash flows over some specified time period are inconsistent with expected values. At this point, the evaluation of the NPV is a must to decide if the proposal is sustainable or should be dropped. The method is time and value-of-money considerate.
The formula used here is NPV is the value of cash inflow into the rate of discount.
Capital budgeting examples for NPV and IRR methods:
Let’s take an example of an ABC Company whose expectations of a project proposal are as follows:
Capital investment = 100,000 ₹
First Year inflow expected = 110,000 ₹
Second Year inflow expected = 150,000 ₹
Third Year inflow expected = 200,000 ₹
Fourth Year inflow expected = 250,000 ₹
Fifth Year inflow expected = 300,000 ₹
Rate of Discount = 10%
The Net Present Value (NPV) is calculated as follow:
The NPV calculation is tabulated below.
This has a positive increase in the Net Present Value i.e. 1,200,000 over 5 years and therefore makes for an excellent choice of proposal.
3. Internal Return Rate Method (IRR):
This capital budgeting formula method is especially useful when the NPV is nil or zero meaning the cash outflow rate is the same as the cash inflow rate. A company normally accepts a proposal when the average capital cost is more than the IRR and the IRR is greater than the acceptable threshold rate of IRR. In the case of many project proposals, it is wisest to accept the proposal with the best IRR.
The formula used here is the IRR is the discounted cash flows of a period.
|Proposal-1 Returns in ₹
|Proposal-2 Returns in ₹
|7.9 per cent
|15.2 per cent
Suppose the threshold IRR is 7 %. Since Proposal-1 has an IRR of 7.9 it just scrapes through. If the threshold IRR is 8, then the proposal should be rejected. However, Proposal-2 has an IRR of 15.2 % and should thus be taken as the better proposal.
What are the Advantages and Disadvantages of Capital Budgeting?
- Helps in making decisions in the investments opportunities
- Adequate control over expenditures of the company
- Promotes understanding of risks and its effects on the business
- Increase shareholders’ wealth and improve market holding
- Abstain from Over or Under Investment
- Therefore, decisions are for the long term and not reversible in most cases.
- Reflective in nature due to the subjective risk and discounting factor
- Few techniques or calculations are based on assumptions – uncertainty might lead to incorrect application
Capital Budgeting Examples
A company is considering two projects to select anyone. The projected cash flows are as follows.
WACC for the company is 10 %.
Using the more common capital budgeting decision tools, let us calculate and see which project should be selected over the other.
NPV For Project A –
The NPV For Project A = $1.27
NPV For Project B-
NPV For Project B = $1.30
Internal Rate of Return For Project A-
The Internal Rate of Return For Project A = 14.5%
Internal Rate of Return For Project B-
Internal Rate of Return For Project B = 13.1%
The net present value for both the projects is very close, and therefore taking a decision here is very difficult.
Therefore, we pick the next method to calculate the rate of return from the investments if done in each of the two projects. It now provides an insight that Project A would yield better returns (14.5%) than the 2nd project, which is generating good but lesser than Project A.
Hence, Project A gets selected over Project B.
In selecting a project based on the Payback period, we need to check for the inflows each year and which year the inflows cover the outflow.
There are two methods to calculate the payback period based on the cash inflows – which can be even or different.
Payback Period for Project A-
10 years, the inflow remains the same as $100 mn always
Project A depicts a constant cash flow; hence the payback period, in this case, is calculated as Initial Investment / Net Cash Inflow. Therefore, for project A to meet the initial investment, it would take approximately ten years.
Payback Period for Project B-
Adding the inflows, the investment of $1000 mn is covered in 4 years
On the other hand, Project B has uneven cash flows. In this case, if you add up the yearly inflows, you can easily identify in which year the investment and returns would close. So, the initial investment requirement for project B is met in the 4th year.
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In comparison, Project A is taking more time to generate any benefits for the entire business, and therefore project B should be selected over project A.
It is an extended form of payback period, where it considers the time value of the money factor, hence using the discounted cash flows to arrive at the number of years required to meet the initial investment.
Given the below observations:
There are certain cash inflows over the years under the same project. Using the time value of money, we calculate the discounted cash flows at a predetermined discount rate. In column C above are the discounted cash flows, and column D identifies the initial outflow that is covered each year by the expected discount cash inflows.
The payback period would lie somewhere between years 5 & 6. Now, since the project’s life is seen to be six years, and the project gives returns in a lesser period, we can infer that this project has a better NPV. Therefore, it will be a good decision to pick this project that can add value to the business.
Using the budgeting method of the Profitability index to select between two projects, which are the options tentative with a given business. Below are the cash inflows expected from the two projects:
Profitability Index for Project A-
The Profitability Index for Project A =$1.16
Profitability Index for Project B-
Profitability Index for Project B = $0.90
The profitability index also involves converting the regular estimated future cash inflows using a discount rate, which is mostly the WACC % for the business. The sum of these present values of the future cash inflows is compared with the initial investment, and thus, the profitability index is obtained.
If the Profitability index is > 1, it is acceptable, which would mean that inflows are more favorable than outflows.
In this case, Project A has an index of $1.16 compared to Project B, which has the Index of $0.90, which is clearly that Project A is a better option than Project B, hence, selected.