What is Capital Budgeting?

What is Capital Budgeting?

Capital budgeting is finance terminology which helps the investor to invest in projects, Assets,
Ventures etc. It will tell you about the investment weather it will going to be benefitalo or not
mean that investor will get return out of his investment or not. So with the help of capital
Budgeting an investor should known wheather he should take project or not.

Capital budgeting, and investment appraisal, is the planning process used to determine whether
an organization's long term investments such as new machinery, replacement of machinery, new
plants, new products, and research development projects are worth the funding of cash through
the firm's capitalization structure (debt, equity or retained earnings). It is the process of allocating
resources for major capital, or investment, expenditures.[1] One of the primary goals of capital
budgeting investments is to increase the value of the firm to the shareholders.

Many formal methods are used in capital budgeting, including the techniques such as

 Accounting rate of return

These methods use the incremental cash flows from each potential investment, or project.
Techniques based on accounting earnings and accounting rules are sometimes used - though
economists consider this to be improper - such as the accounting rate of return, and "return on
investment." Simplified and hybrid methods are used as well, such as payback period and
discounted payback period.
Payback period

The payback period is the time required to earn back the amount invested in an asset from its net
cash flows. It is a simple way to evaluate the risk associated with a proposed project. An
investment with a shorter payback period is considered to be better, since the investor's initial
outlay is at risk for a shorter period of time. The calculation used to derive the payback period is
called the payback method. The payback period is expressed in years and fractions of years. For
example, if a company invests $300,000 in a new production line, and the production line then
produces positive cash flow of $100,000 per year, then the payback period is 3.0 years ($300,000
initial investment ÷ $100,000 annual payback).

The formula for the payback method is simplistic: Divide the cash outlay (which is assumed to
occur entirely at the beginning of the project) by the amount of net cash inflow generated by the
project per year (which is assumed to be the same in every year).

Payback Period Example

Alaskan Lumber is considering the purchase of a band saw that costs $50,000 and which will
generate $10,000 per year of net cash flow. The payback period for this capital investment is 5.0
years. Alaskan is also considering the purchase of a conveyor system for $36,000, which will
reduce sawmill transport costs by $12,000 per year. The payback period for this capital
investment is 3.0 years. If Alaskan only has sufficient funds to invest in one of these projects,
and if it were only using the payback method as the basis for its investment decision, it would
buy the conveyor system, since it has a shorter payback period.

What Is the Discounted Payback Period

The discounted payback period is a capital budgeting procedure used to determine the
profitability of a project. A discounted payback period gives the number of years it takes to break
even from undertaking the initial expenditure, by discounting future cash flows and recognizing
the time value of money. The metric is used to evaluate the feasibility and profitability of a given
project.
The more simplified payback period formula, which simply divides the total cash outlay for the
project by the average annual cash flows, doesn't provide as accurate of an answer to the
question of whether or not to take on a project because it assumes only one, upfront investment,
and does not factor in the time value of money.

Net present value

Cash flows are discounted at the cost of capital to give the net present value (NPV) added to the
firm. Unless capital is constrained, or there are dependencies between projects, in order to
maximize the value added to the firm, the firm would accept all projects with positive NPV. This
method accounts for the time value of money.

Mutually exclusive projects are a set of projects from which at most one will be accepted, for
example, a set of projects which accomplish the same task. Thus when choosing between
mutually exclusive projects, more than one of the projects may satisfy the capital budgeting
criterion, but only one project can be accepted.

The internal rate of return

The internal rate of return (IRR) is the discount rate that gives a net present value (NPV) of zero.
It is a widely used measure of investment efficiency. To maximize return, sort projects in order
of IRR.Many projects have a simple cash flow structure, with a negative cash flow at the start,
and subsequent cash flows are positive. In such a case, if the IRR is greater than the cost of
capital, the NPV is positive, so for non-mutually exclusive projects in an unconstrained
environment, applying this criterion will result in the same decision as the NPV method.

An example of a project with cash flows which do not conform to this pattern is a loan,
consisting of a positive cash flow at the beginning, followed by negative cash flows later. The
greater the IRR of the loan, the higher the rate the borrower must pay, so clearly, a lower IRR is
preferable in this case. Any such loan with IRR less than the cost of capital has a positive NPV.
Excluding such cases, for investment projects, where the pattern of cash flows is such that the
higher the IRR, the higher the NPV, for mutually exclusive projects, the decision rule of taking
the project with the highest IRR will maximize the return, but it may select a project with a lower
NPV.

In some cases, several solutions to the equation NPV = 0 may exist, meaning there is more than
one possible IRR. The IRR exists and is unique if one or more years of net investment (negative
cash flow) are followed by years of net revenues. But if the signs of the cash flows change more
than once, there may be several IRRs. The IRR equation generally cannot be solved analytically
but only via iterations.

IRR is the return on capital invested, over the sub-period it is invested. It may be impossible to
reinvest intermediate cash flows at the same rate as the IRR. Accordingly, a measure called
Modified Internal Rate of Return (MIRR) is designed to overcome this issue, by simulating
reinvestment of cash flows at a second rate of return.
Why Capital Budgeting?
Why Capital Budgeting

1. Long-term Implications of Capital Budgeting

A capital budgeting decision has its effect over a long time span and inevitably affects the
company’s future cost structure and growth. A wrong decision can prove disastrous for the long-
term survival of firm. On the other hand, lack of investment in asset would influence the
competitive position of the firm. So the capital budgeting decisions determine the future destiny
of the company.

2. Involvement of large amount of funds in Capital Budgeting

Capital budgeting decisions need substantial amount of capital outlay. This underlines the need
for thoughtful, wise and correct decisions as an incorrect decision would not only result in losses
but also prevent the firm from earning profit from other investments which could not be
undertaken.

3. Irreversible decisions in Capital Budgeting

Capital budgeting decisions in most of the cases are irreversible because it is difficult to find a
market for such assets. The only way out will be scrap the capital assets so acquired and incur
heavy losses.

4. Risk and uncertainty in Capital budgeting

Capital budgeting decision is surrounded by great number of uncertainties. Investment is present

5. Difficult to make decision in Capital budgeting

Capital budgeting decision making is a difficult and complicated exercise for the management.
These decisions require an over all assessment of future events which are uncertain. It is really a
marathon job to estimate the future benefits and cost correctly in quantitative terms subject to the
uncertainties caused by economic-political social and technological factors.

6. Large and Heavy Investment

The proper planning of investments is necessary since all the proposals are requiring large and
heavy investment. Most of the companies are taking decisions with great care because of finance
as key factor.

7. Permanent Commitments of Funds

The investment made in the project results in the permanent commitment of funds. The greater
risk is also involved because of permanent commitment of funds.

8. Long term Effect on Profitability

Capital expenditures have great impact on business profitability in the long run. If the
expenditures are incurred only after preparing capital budget properly, there is a possibility of
increasing profitability of the firm.

9. Complicacies of Investment Decisions

Generally, the long term investment proposals have more complicated in nature. Moreover,
purchase of fixed assets is a continuous process. Hence, the management should understand the
complexities connected with each projects.

10. Maximize the worth of Equity Shareholders

The value of equity shareholders is increased by the acquisition of fixed assets through capital
budgeting. A proper capital budget results in the optimum investment instead of over investment
and under investment in fixed assets. The management chooses only most profitable capital
project which can have much value. In this way, the capital budgeting maximize the worth of
equity shareholders.
11. Difficulties of Investment Decisions

The long term investments are difficult to be taken because decision extends several years
beyond the current account period, uncertainties of future and higher degree of risk.

12. Irreversible Nature

Whenever a project is selected and made investments as in the form of fixed assets, such
investments is irreversible in nature. If the management wants to dispose of these assets, there is
a heavy monetary loss.

13. National Importance

The selection of any project results in the employment opportunity, economic growth and
increase per capita income. These are the ordinary positive impact of any project selection made
by any company.
How to Apply Capital Budgeting?
How to Apply Capital Budgeting?

Capital Budgeting Techniques

To assist the organization in selecting the best investment there are various techniques available
based on the comparison of cash inflows and outflows?

These techniques are:

1. Payback period method

In this technique, the entity calculates the time period required to earn the initial investment of
the project or investment. The project or investment with the shortest duration is opted for.

2. Net Present value

The net present value is calculated by taking the difference between the present value of cash
inflows and the present value of cash outflows over a period of time. The investment with a
positive NPV will be considered. In case there are multiple projects, the project with a higher
NPV is more likely to be selected.

3. Accounting Rate of Return

In this technique, the total net income of the investment is divided by the initial or average
investment to derive at the most profitable investment.

4. Internal Rate of Return (IRR)

For NPV computation a discount rate is used. IRR is the rate at which the NPV becomes zero.
The project with higher IRR is usually selected.

5. Profitability Index

Profitability Index is the ratio of the present value of future cash flows of the project to the initial
investment required for the project.
Each technique comes with inherent advantages and disadvantages. An organization needs to use
the best-suited technique to assist it in budgeting. It can also select different techniques and
compare the results to derive at the best profitable projects.

Conclusion

Capital budgeting is a predominant function of management. Right decisions taken can lead the
business to great heights. However, a single wrong decision can inch the business closer to shut
down due to the number of funds involved and the tenure of these projects.
Where to Apply Capital Budgeting?
Where to Apply Capital Budgeting?

Capital budgeting techniques are related to investment in fixed assets. Fixed assets are that
portion of balance sheets which are long term in nature. On the other hand current assets are
short term by nature. We may also said that capital budgeting is technique employed to
determine the value of project and investment in fixed assets.

Capital budgeting is very important area of financial management on the basis of a number of
reasons. First of all is that the fixed assets like machinery & equipment etc depreciate with the
passage of time. After a number of years those assets must be replaced with the new ones which
definitely involve investment in fixed assets. Secondly when a new project is under consideration
by a company, then it must apply capital budgeting & capital techniques in order to ascertain the
financial soundness of the new project. In this way the company can effectively determine that
whether the new project should be started or not.
When Capital Budgeting Required?
When Capital Budgeting Required?

The Capital budgeting process is an important tool to make decision When a new investments or
new projects are considered weather to proceed ahead with or not. Also a toll could be used to
prioritize investments based on their returns (increase owner equity)

In most of the times, the project’s returns, life time, cash flows in & cash flows out are used to
determine if the project’s returns are acceptable or even better than management min. accepted
returns (based on market benchmark).

Why we need Capital Budgeting:

 In case we want to introduce new product to our products family.

 If we are planning to increase production by adding new machine.

 Incase we are planning to enter new markets.

 If we are planning to replace old machinery with new automatic machinery.

 In case we want to our source parts of components.

Ideally, all business units would be attracted to any market opportunity or projects which will
increase the owner’s equity. However, due to limitations of the “ new projects “ available capital
in adjacent time, managers needs to use capital budgeting techniques to find out which projects
will achieve the best return over an applicable period of time