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.

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.

Features of Capital Budgeting

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.

Understanding Capital Budgeting

While companies would like to take up all the projects that maximize the
benefits of the shareholders, they also understand that there is a limitation on
the money that they can employ for those projects. Therefore, they utilize
capital budgeting strategies to assess which initiatives will provide the best
returns across a given period. Owing to its culpability and quantifying abilities,
capital budgeting is a preferred way of establishing if a project will yield
results.

Investment and financial commitments are part of capital budgeting. In taking on a

project, the company involves itself in a financial commitment and does so on a
long-term basis, which may affect future projects.

To measure the longer-term monetary and fiscal profit margins of any option
contract, companies can use the capital-budgeting process. Capital budgeting
projects are accepted or rejected according to different valuation methods
used by different businesses. Under certain conditions, the internal rate of
return (IRR) and payback period (PB) methods are sometimes used instead of
net present value (NPV) which is the most preferred method. If all three
approaches point in the same direction, managers can be most confident in
their analysis.

How Capital Budgeting Works

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:

1. Payback Period (PB)

2. Internal Rate of Return (IRR) and
3. 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.

Techniques/Methods of Capital Budgeting

In addition to the many capital budgeting methods available, the following list
outlines a few by which companies can decide which projects to explore:

#1 Payback Period Method

It refers to the time taken by a proposed project to generate enough income

to cover the initial investment. The project with the quickest payback is
chosen by the company.

Formula:

Initial Cash Investment

Payback Period
= Annual Cash Flow

Example of Payback Period Method:

An enterprise plans to invest $100,000 to enhance its manufacturing process.

It has two mutually independent options in front: Product A and Product B.
Product A exhibits a contribution of $25 and Product B of $15. The expansion
plan is projected to increase the output by 500 units for Product A and 1,000
units for Product B.

Here, the incremental cash flow will be calculated as:

(25*500) = 12,500 for Product A

(15*1000) = 15,000 for Product B

The Payback Period for Product A is calculated as:

2 Initial Cash Investment $100,000

3 Incremental Cash Flow $12,500

4 Payback Period of Product A (Years) 8

Product A = 100,000 / 12,500 = 8 years

Now, the Payback Period for Product B is calculated as:

2 Initial Cash Investment $100,000

3 Incremental Cash Flow $15,000

4 Payback Period of Product A (Years) 6.7

Product B = 100,000 / 15,000 = 6.7 years

This brings the enterprise to conclude that Product B has a shorter payback
period and therefore, it will invest in Product B.

Despite being an easy and time-efficient method, the Payback Period cannot
be called optimum as it does not consider the time value of money. The cash
flows at the earlier stages are better than the ones coming in at later stages.
The company may encounter two projections with the same payback period,
where one depicts higher cash flows in the earlier stages/years. In such as
case, the Payback Period may not be appropriate.

A similar consideration is that of a longer period, potentially bringing in

greater cash flows during a payback period. In such a case, if the company
selects the projects based solely on the payback period and without
considering the cash flows, then this could prove detrimental for the financial
prospects of the company.

#2 Net Present Value Method (NPV)

Evaluating capital investment projects is what the NPV method helps the
companies with. There may be inconsistencies in the cash flows created over
time. The cost of capital is used to discount it. An evaluation is done based on
the investment made. Whether a project is accepted or rejected depends on
the value of inflows over current outflows.

This method considers the time value of money and attributes it to the
company's objective, which is to maximize profits for its owners. The capital
cost factors in the cash flow during the entire lifespan of the product and the
risks associated with such a cash flow. Then, the capital cost is calculated with
the help of an estimate.

Formula:

Net Present Value (NPV)

=

t = time of cash flow

i = discount rate
R = net cash flow
t

Example of Net Present Value (with 9% Discount Rate ):

For a company, let’s assume the following conditions:

Capital investment = $10,000

Expected Inflow in First Year = $1,000

Expected Inflow in Second Year = $2,500

Expected Inflow in Third Year = $3,500

Expected Inflow in Fourth Year = $2,650

Expected Inflow in Fifth Year = $4,150

Discount Rate = 9%

Calculation
Year Flow Present Value

0 -$10,000 -$10,000 -

1 1,000 9,174 1,000/(1.09) 1

2 2,500 2,104 2,500/(1.09) 2

3 3,500 2,692 3,500/(1.09) 3

4 2,650 1,892 2,600/(1.09) 4

5 4,150 2,767 4,000/(1.09) 5

Total $18,629

Net Present Value achieved at the end of the calculation is:

With 9% Discount Rate = $18,629

This indicates that if the NPV comes out to be positive and indicates profit.
Therefore, the company shall move ahead with the project.

#3 Internal Rate of Return (IRR)

IRR refers to the method where the NPV is zero. In such as condition, the cash
inflow rate equals the cash outflow rate. Although it considers the time value
of money, it is one of the complicated methods.
 It follows the rule that if the IRR is more than the average cost of the capital,
then the company accepts the project, or else it rejects the project. If the
company faces a situation with multiple projects, then the project offering the
highest IRR is selected by them.

DiscountInternal
rate thatRate
makes
of NPV=0;
Return=
implies discounted cash inflows are equal to discounted cash
outflows

turn Rule = Accept investments if IRR greater than Threshold Rate of Return, else
reject.

Example:

We shall assume the possibilities exhibited in the table here for a company
that has 2 projects: Project A and Project B.

Project B
Year Project A

0 -$10,000 -$10,000

1 $2,500 $3,000

2 $2,500 $3,000

3 $2,500 $3,000

4 $2,500 $3,000

5 $2,500 $3,000

Total $12,500 $15,000

IRR 7.9% 15.2%

Here, The IRR of Project A is 7.9% which is above the Threshold Rate of Return
(We assume it is 7% in this case.) So, the company will accept the project.
However, if the Threshold Rate of Return would be 10%, then it would be
rejected as the IRR would be lower. In that case, the company will choose
Project B which shows a higher IRR as compared to the Threshold Rate of
Return.

#4 Profitability Index
This method provides the ratio of the present value of future cash inflows to
the initial investment. A Profitability Index that presents a value lower than
1.0 is indicative of lower cash inflows than the initial cost of investment.
Aligned with this, a profitability index great than 1.0 presents better cash
inflows and therefore, the project will be accepted.

Formula:

Present value of Cash

Profitability Index Inflows
=
Initial Investment

Example:

Assuming the values given in the table, we shall calculate the profitability
index for a discount rate of 10%.

Year Cash Flows 10% Discount

0 -$10,000 -$10,000

1 $3,000 $2,727

2 $5,000 $4,132

3 $2,000 $1,538

4 $6,000 $4,285

5 $5,000 $3,125

Total $15,807

So, Profitability Index with 10% discount = $15,807/$10,000 = 1.5807

As per the rule of the method, the profitability index is positive for the 10%
discount rate, and therefore, it will be selected.

Process of 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.

Implementation

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.

Performance Review

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.

Factors Affecting Capital Budgeting

So far in the article, we have observed how measurability and accountability
are two primary aspects that achieve the center stage through capital
budgeting. However, while on the path to accomplish a competent capital
budgeting process, you may come across various factors that may affect it.
Let us move on to observing the factors that affect the capital budgeting
process.

Factors Affecting Capital Budgeting

Capital Return

Accounting Methods

Structure of Capital

Availability of Funds

Management decisions

Government Policies

Working Capital

Need of the project

Lending terms of financial

institutions

Earnings

Taxation Policies

The economic value of the project

Objectives of Capital Budgeting
The following points present the objectives of the capital budgeting:

 Capital Expenditure Control: Organizations need to estimate the

cost of investment as it allows them to control and manage the
required capital expenditures.
 Selecting Profitable Projects: The company will have to select the
most appropriate project from the multiple possibilities in front of it.
 Identification of Source of funds: The businesses need to locate
and select the most viable and apt source of funds for long-
term capital investment. It needs to compare the various costs
like the costs of borrowing and the cost of expected profits.

Limitations of Capital Budgeting

Although capital budgeting provides a lot of insight into the future prospects
of a business, it cannot be termed a flawless method after all. In this section,
we learn about some of the limitations of capital budgeting.

LIMITATIONS OF CAPITAL
BUDGETING
 Cash Flows

Time Horizon

Time Value

Discount Rates
Cash Flow

It is a simple technique that determines if an enhanced value of a project

justifies the required investment. The primary reason to implement capital
budgeting is to achieve forecasting revenue a project may possibly generate.
The problem could be the estimate itself. All the upfront costs or the future
revenue are all only estimates at this point. An overestimation or an
underestimation could ultimately be detrimental to the performance of the
business.

Time Horizon

Usually, capital budgeting as a process works across for long spans of years.
While the shorter duration forecasts may be estimated, the longer ones are
bound to be miscalculated. Therefore, an expanded time horizon could be a
potential problem while computing figures with capital budgeting.

Besides, there could be additional factors such as competition or legal or

technological innovations that could be problematic.

Time Value

The payback period method of capital budgeting holds a lot of relevance,

especially for small businesses. It is a simple method that only requires the
business to repay in the predecided timeframe. However, the problem it
poses is that it does not count in the time value of money. This is to say that
equal amounts (of money) have different values at different points in time.

Discount Rates

The accounting for the time value of money is done either by borrowing
money, paying interest, or using one’s own money. The knowledge of
discount rates is essential. The proper estimation and calculation of which
could be a cumbersome task.

Even if this is achieved, there are other fluctuations like the varying interest
rates that could hamper future cash flows. Therefore, this is a factor that adds
up to the list of limitations of capital budgeting.

Generation Basis Sources for Funds

The way of classifying the sources of funds is whether the funds are
generated from within the organization or from external sources of
the organization. Internal sources of funds are those that are
generated inside the business. A business, for example, can generate
funds internally by speeding collection of receivables, disposing of
surplus inventories and increasing its profit. The internal sources of
funds can fulfil only limited needs of the business.

Whereas, External sources of funds are the sources that lie outside
an organization, such as suppliers, lenders, and investors. When a
large amount of money is needed to be raised, it is generally done
through the external sources. External funds may be costly as
compared to those raised through internal sources.

Preparation of projected financial statements:

Projection of the financial statement means to estimate the statements like
Income statement, Balance sheet, and statement of cash flow. The
projection of financial statements emphasizes the current trends and
expectations to arrive at the perfect financial picture that management
wants to attain in the future.

Projected financial statements show the summary of the statement of

income, balance sheet, and cash flow statement which helps the managers
to take future decisions accordingly. It plays a big role in the business
planning process as it forecasts the future financial position of the
company.

Projected statements are also known as "pro forma financial statements"

which means "as a matter of form"

The financial projection is all related to the assumptions taken for

forecasting the data of financial statements. Mostly, assumptions are made
based on past data and knowledge.

Types of projections

Short term projections

Short term projections mainly cover one year and breaks into monthly
projections. This type of projection is mostly useful for small businesses
where the only plans related to increasing sales and revenue are
considered.

Long term projections

Long term projections cover mainly the next three to five years and is used
in large businesses for creating strategic plans for expansion and
development are made. It also attracts investors so that they invest a large
amount in their business.

Importance of projected financial statements

 It helps to find out the additional requirement, which is there for assets to support
increased revenue and also create a positive impact on the financial statement.
 It helps in predicting the future outcomes of any business
 It supports the business planning process.
 Business growth becomes easy as financial projections help to measure how much
debt or equity will be required for the business in the future.
 Businesses never run out of cash as it generates additional cash and revenue whenever
required.
 For applying for a loan from banks or any other institution, Projected financial
statements are very much important.
 As well as creditors also ask for projected statements to know the capability of the
business to reimburse the debts.
Important data and statements required for financial
projections:

 Historical financial data

 The balance sheet of previous years
 The income statement of previous years
 Cash flow statement of previous years
 Market conditions and possible changes
 Projected fixed assets

The sequence of projecting financial statements

 Income statement
 Balance sheet
 Cash flow statement

Projecting Income Statement Line Items

Projecting work begins from an income statement in which past values are compared with
the present values and then, future values are forecasted. The statement of income is
projected to analyse the net income and make future business plans accordingly.

The mainline items to forecasts are as below:

 Sales revenue
 Cost of goods sold
 Direct expenses
 Depreciation expense
 Interest expense
 Tax expense

These items are important for preparing the income statement and will help to project the net
income of the company.

Balance Sheet Line Items

The financial forecast of balance sheet items is done simultaneously with the items of the
income statement. This will be helpful to project the financial items one by one and forecast
each of the items properly to complete the forecasting of financials completely.

The mainline items to forecasts are as below:

Current Assets
  Inventory
 Account’s receivables
 Other current assets

Non-Current Assets

 Investments
 Property, plant, and equipment
 Other long-term assets

Current Liabilities

 Creditors
 Account’s receivables
 Other current liabilities

Non-Current Liabilities

 Long-term debts
 Deferred tax liabilities
 Bonds payable

Equity

 Shareholder's capital
 Retained earnings
 Dividend distribution