Introduction
Capital budgeting is a process of evaluating investments and huge expenses in order to obtain the best returns on investment. It is the process of deciding whether or not to invest in a particular project as all the investment possibilities may not be rewarding.
A company’s manager has to plan for the expenditure and benefits an entity would derive from investing in an underlying project. These investment decisions are typically pertaining to the long term assets that are expected to produce benefits over more than one year. All such evaluation forms part of the capital budgeting process.
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.
It also includes the process of decision regarding disinvestment, i.e., a decision
to sell off an undertaking or a part of it.
Importance of Capital Budgeting Decisions
- Involvement of Substantial Expenditure
- Long Term Effect/Growth
- Involvement of High Risk
- Irreversibility
- Complex Decisions
Process of Capital budgeting
To Identify Investment Opportunities
The first step is to explore the available investment opportunities. Next, the organization’s capital budgeting committee is required to identify the expected sales shortly. After that, they recognize the investment opportunities keeping in mind the sales target set up by them.
Gathering of the Investment Proposals
After identifying the investment opportunities, the second process in capital budgeting is to collect investment proposals. Before reaching the committee of the capital budgeting process, these proposals are seen by various authorized persons in the organization to check whether the bids given are according to the requirements.
Decision Making Process in Capital Budgeting
Decision-making is the third step. In the stage of decision making, the executives will have to decide which investment needs to be made from the investment opportunities available, keeping in mind the sanctioning power open to them.
Capital Budget Preparations and Appropriations
After the decision-making step, the next step is to classify the investment outlays into the higher value and the smaller value investment.
Implementation
After completing all the above steps, the investment proposal under consideration is implemented, i.e., put into a concrete project. For the implementation at a reasonable cost and expeditiously, the following things could be helpful: –
- Formulation of the project adequately: Inadequate formulation is one of the main reasons for the project’s delay.
- Use of responsibility accounting principle: For the expeditious execution of the various tasks and the cost control, one should assign specific responsibilities to the project managers, i.e., the timely completion of the project within the specified cost limits.
- Network technique use: Several network techniques like the Critical Path Method (CPM) and Program Evaluation and Review Technique (PERT) are available for project planning and control, which will help monitor the projects properly and efficiently.
Review of Performance
Review of performance is the last step in capital budgeting. First, the management must compare the actual results with the projected results. The correct time to make this comparison is when the operations get stabilized.
Capital Budgeting Methods
There are different methods adopted for capital budgeting.
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Payback Period
This method refers to the period in which the proposal will generate cash to recover the initial investment made. It purely emphasizes on the cash inflows, economic life of the project and the investment made in the project, with no consideration to time value of money. With simple calculations, selection or rejection of the project can be done, with results that will help gauge the risks involved.
Payback period = Cash outlay (investment) / Annual cash inflow
| Project A | Project B | ||
|---|---|---|---|
| Cost | 1,00,000 | 1,00,000 | |
| Expected future cash flow | |||
| Year 1 | 50,000 | 1,00,000 | |
| Year 2 | 50,000 | 5,000 | |
| Year 3 | 1,10,000 | 5,000 | |
| Year 4 | None | None | |
| TOTAL | 2,10,000 | 1,10,000 | |
| Payback | 2 years | 1 year |
Payback period of project B is shorter than A, but project A provides higher returns. Hence, project A is superior to B.
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Accounting rate of return (ARR)
This method helps to overcome the disadvantages of the payback period method. The rate of return is expressed as a percentage of the earnings of the investment in a particular project. It works on the criteria that any project having ARR higher than the minimum rate established by the management will be considered and those below the predetermined rate are rejected.
ARR= Average income/Average Investment
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Discounted cash flow method
The discounted cash flow technique calculates the cash inflow and outflow through the life of an asset. These are then discounted through a discounting factor. The discounted cash inflows and outflows are then compared.
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Net present Value (NPV) Method
This is one of the widely used methods for evaluating capital investment proposals. In this technique the cash inflow that is expected at different periods of time is discounted at a particular rate. The present values of the cash inflow are compared to the original investment. If the difference between them is positive (+) then it is accepted or otherwise rejected.
The equation for the net present value, assuming that all cash outflows are made in the initial year (tg), will be:
Where A1, A2…. represent cash inflows, K is the firm’s cost of capital, C is the cost of the investment proposal and n is the expected life of the proposal. It should be noted that the cost of capital, K, is assumed to be known, otherwise the net present, value cannot be known.
NPV = PVB – PVC
where,
PVB = Present value of benefits
PVC = Present value of Costs
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Internal Rate of Return (IRR)
This is defined as the rate at which the net present value of the investment is zero. The discounted cash inflow is equal to the discounted cash outflow. This method also considers time value of money.
It can be determined by solving the following equation:
If IRR > WACC then the project is profitable.
If IRR > k = accept
If IR < k = reject
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Profitability Index (PI)
It is the ratio of the present value of future cash benefits, at the required rate of return to the initial cash outflow of the investment. It may be gross or net, net being simply gross minus one. The formula to calculate profitability index (PI) or benefit cost (BC) ratio is as follows.
PI = PV cash inflows/Initial cash outlay A,
PI = NPV (benefits) / NPV (Costs)
All projects with PI > 1.0 is accepted.
Conclusion
The manager has to evaluate the project in terms of costs and benefits as all the investment possibilities may not be rewarding. This evaluation is done based on the incremental cash flows from a project, opportunity costs of undertaking the project, timing of cash flows and financing costs. Therefore, it is the planning of expenditure and benefit that spreads over a number of years.
