A company’s manager must plan for the expenditure and benefits an entity would receive from investing in an underlying project.
These investment decisions typically pertain to the long-term assets that are expected to produce benefits over a period of time greater than one year. These evaluations form part of the capital budgeting process.
In this article, you will learn:
Capital budgeting is the process of making investment decisions regarding long-term assets, such as building a new production facility or investing in machinery and equipment. It is the process of deciding whether or not to invest in a particular project, since alternative investment possibilities may not be beneficial.
As a manager, it is important for you to understand the characteristics of capital budgeting and how these can affect your business.
Some of the characteristics of capital budgeting are:
Keeping this in mind, a manager must choose a project that provides a rate of return that is more than the cost of financing a particular project, and they must therefore value a project in terms of cost and benefit.
The following are the categories of projects that can be examined using the capital budgeting process:
Capital budgeting is the most important responsibility undertaken by a financial manager because:
Below are the steps of the capital budgeting process:
The most important step of the capital budgeting process is generating good investment ideas. These investment ideas can come from sources such as senior management, any department or functional area, employees, or sources outside the company.
A manager must gather information to forecast cash flows for each project to determine its expected profitability because the decision to accept or reject a capital investment is based on such an investment’s expected cash flows.
An entity must give priority to profitable projects following the timing of a project’s cash flows, available company resources, and a company’s overall strategies. Projects that seem promising individually may be undesirable strategically. Thus, prioritising and scheduling projects is important because of financial and other resource issues.
A manager needs to follow up or track all capital budgeting decisions. Managers should compare actual results with projected results and provide reasons as to why projections do not match with actual performance. Therefore, a systematic post-audit is essential to discover systematic errors during the forecasting process and should enhance company operations.
Capital budgeting techniques are the methods to evaluate an investment proposal to help a company decide upon the desirability of such a proposal. Each of the techniques uses a capital budgeting formula that will help you determine the success of your potential investment.
These techniques are categorised into two methods, 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 take into account the concept of the time value of money.
Payback Period Method
The 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. If an entity has liquidity issues, a shorter project payback period is better for a firm.
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 the payback that occurs when cumulative net cash flow is equal to zero. Cumulative net cash flow is the running total of cash flows at the end of each period.
Average Rate of Return Method (ARR)
Under the ARR method, the profitability of an investment proposal can be determined by dividing average income after taxes by average investment, which is the average book value after depreciation.
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 projects with an ARR higher than the minimum rate established by the company. It can also reject projects with an ARR less than the expected rate of return.
Discounted Cash Flow Methods
As mentioned above, traditional methods do not take into account the time value of money. Instead, these methods take into consideration the present and future flow of incomes. However, the DCF method accounts for the concept that a dollar earned today is worth more than a dollar earned tomorrow. This means that DCF methods consider both profitability and time value of money.
Net Present Value Method (NPV)
The 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 that is less than the present value of the cost of the investment.
In other words, the 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 a positive NPV, then the project with the highest NPV should 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, the IRR is the discount rate that makes the present values of a project’s estimated cash inflows equal to the present value of the project’s estimated cash outflows.
If the IRR is greater than the required rate of return for the project, then you can accept the project. If the 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 the NPV. The NPV is the difference between the present value of future cash flows and the initial cash outlay.
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.
A manager must evaluate the project in terms of costs and benefits if certain investment possibilities may not be beneficial. 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 lasts some years.
The capital budgeting process used by managers depends on the size and complexity of the project to be evaluated, the size of the organisation, and the position of the manager in the organisation.
Establish norms for a company depending on whether it accepts or rejects an investment project.
These methods are used to evaluate the worth of an investment project depending on the accounting information available from a company’s books of accounts.
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