Top Capital Budgeting Methods
Capital budgeting methods are used to aid the decision-making process in Capital Budgeting. They can be used as non-discounted cash flow methods, including the Payback period, etc., and the discounted cash flow methods, including the Present Net Value, profitability index, and Internal Rate of Return.
Top Capital budgeting methods include –
- Payback PeriodPayback PeriodThe payback period refers to the time that a project or investment takes to compensate for its total initial cost. In other words, it is the duration an investment or project requires to attain the break-even point.
- NPVNPVNet Present Value (NPV) estimates the profitability of a project and is the difference between the present value of cash inflows and the present value of cash outflows over the project’s time period. If the difference is positive, the project is profitable; otherwise, it is not.
- Internal Rate of Return MethodInternal Rate Of Return MethodInternal rate of return (IRR) is the discount rate that sets the net present value of all future cash flow from a project to zero. It compares and selects the best project, wherein a project with an IRR over and above the minimum acceptable return (hurdle rate) is selected.
- Profitability IndexProfitability IndexThe profitability index shows the relationship between the company projects future cash flows and initial investment by calculating the ratio and analyzing the project viability. One plus dividing the present value of cash flows by initial investment is estimated. It is also known as the profit investment ratio as it analyses the project's profit.
Table of contents
- Capital budgeting methods are helpful in decision-making concerning capital budgeting procedures. In addition, they can be used as non-discounted cash flow methods and discounted cash flow methods.
- The top capital budgeting methods are the payback period method, net present value method, internal rate of return (IRR), and profitability index.
- It is a helpful method in the decision-making process related to long-term investments and may also be used to evaluate a capital investment’s economic feasibility.
- These methods are critical for an organization to make informed decisions about long-term investments.
#1 – Payback Period Method
It refers to the period in which the proposed project generates enough cash to recover the initial investment. The project with a shorter payback period is selected.
The formula of payback period is represented as below,
ABC Ltd has $200,000 additional capital to invest in its Production activity. Options available are Product A and Product B, which are mutually exclusiveMutually ExclusiveMutually exclusive refers to those statistical events which cannot take place at the same time. Thus, these events are entirely independent of one another, i.e., one event's outcome has no impact on the other event's result.. The contribution per unit is $50, and Product B is $30. The expansion plan will increase output by 1,000 units for Product A and 2,000 units for Product B.
Thus the Incremental cash flowIncremental Cash FlowIncremental cash Flow is the additional cash inflow that a business might receive by acquiring a particular project. In other words, it is basically the resulting increase in cash flow from operations due to the acceptance of new capital investment or a project. will be (50 * 1000) $50,000 for Product A and (30 * 2000) $60,000 for Product B.
The payback period of product A is calculated as follows,
Product A = 200000 / 50000 = 4 Years
The payback period of product B is calculated as follows,
Product B = 200000 / 60000 = 3.3 Years
Hence ABC Ltd will invest in Product B as the payback period is shorter.
It is the most simple method. Hence it takes very little time and effort to arrive at a decision.
The time value of moneyTime Value Of MoneyThe Time Value of Money (TVM) principle states that money received in the present is of higher worth than money received in the future because money received now can be invested and used to generate cash flows to the enterprise in the future in the form of interest or from future investment appreciation and reinvestment. is not considered in the payback method. Generally, Cash flows generated at the initial stage are better than cash flows received later. There might be two projects with the same payback period, but one generates more cash flow in the early years. Hence the decision taken by this method in this particular scenario will not be the most optimum one.
Similarly, projects might have a longer payback period but generate larger cash flows after the payback period. In this scenario, selecting a project based on a shorter payback period without considering the cash flows generated after the payback period by the other project is detrimental to the company.
The rate of return from the amount invested is not considered in the payback method. So if the actual return is less than the cost of capital, then the decision arrived through a shorter payback period will be detrimental to the company.
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#2 – Net Present Value Method (NPV)
Most companies use this NPV method for evaluating capital investmentCapital InvestmentCapital Investment refers to any investments made into the business with the objective of enhancing the operations. It could be long term acquisition by the business such as real estates, machinery, industries, etc. proposals. There might be uneven cash flows generated during different periods. It is discounted at the cost of capital for the company. It is compared with the initial investment made. If the present value of inflows is more than the outflow, then the project is accepted or otherwise rejected.
The time value of money is considered in this method and attributes to the company’s objective: maximizing profits for the owners.
Also, it considers the cash flow during the entire tenure of the product and the risks of such cash flow through the cost of capital. It requires the use of an estimate to calculate the cost of capital.
The formula of NPV in excelFormula Of NPV In ExcelThe NPV (Net Present Value) of an investment is calculated as the difference between the present cash inflow and cash outflow. It is an Excel function and a financial formula that takes rate value for inflow and outflow as input. is represented as below,
When there are two projects with a positive NPV, select the project with a higher NPV.
XYZ Ltd wants to open a retail outlet with an investment of $ 1 Million. Either the company can open it in Mumbai or Bangalore. For Mumbai, the present value of cash flow is $150,000 per annum for ten years at a discount rate of XX percent is $1.2M. After subtracting the initial outlay of $1 Million, NPV is $0.2 Million. For Bangalore, the present value of cash flow is $175,000 per annum for six years at a discount rate of XX percent is $1.3M. After subtracting the initial outlay of $1 Million, NPV is $0.3 Million.
Hence the company would select Bangalore for opening the retail outlet as it has a higher NPV.
#3 – Internal Rate of Return (IRR)
IRR is defined as the rate at which NPV is zero. At this rate, the present value of cash inflow is equal to the cash outflow. The time value of money is also considered. It is the most complex method.
If IRR is greater than the weighted average cost of capitalWeighted Average Cost Of CapitalThe weighted average cost of capital (WACC) is the average rate of return a company is expected to pay to all shareholders, including debt holders, equity shareholders, and preferred equity shareholders. WACC Formula = [Cost of Equity * % of Equity] + [Cost of Debt * % of Debt * (1-Tax Rate)], then the project is accepted; otherwise, it is rejected. In the case of more than one project, then the project with the highest IRR is selected.
ABC Ltd has two proposals in hand with an IRR of 14 percent and 18 percent, respectively. If the company’s capital cost is 15 percent, then the second proposal is selected. The first proposal will not be selected as IRR is less than the WACC.IRR considers the cash flow during the entire product tenure and risks of such cash flows through the cost of capital.
But the decision arrived by IRR may not be accurate in the following scenarios.
- For mutually exclusive projectsMutually Exclusive ProjectsMutually Exclusive Projects is a term that is commonly used in the capital budgeting process where companies choose a single project based on certain parameters from a set of projects where acceptance of one project results in rejection of the other projects.;
- When there is capital rationingCapital RationingCapital Rationing is a process or a method applied to select and allocate a combination of project mix in a manner made of the shareholder’s wealth with limited initial investment amount available for investing in several projects under consideration.;
Also, IRR cannot be used if the sign of cash flows changes during the project’s life.
There is no single formula by which you can arrive at IRR. The trial and error method is the only way to arrive at IRR. However, Excel can be used to arrive at IRR automatically.
#4 – Profitability Index
Profitability IndexProfitability IndexThe profitability index shows the relationship between the company projects future cash flows and initial investment by calculating the ratio and analyzing the project viability. One plus dividing the present value of cash flows by initial investment is estimated. It is also known as the profit investment ratio as it analyses the project's profit. is the present value of future cash inflows discounted at the required rate of return to the cash outflow at the investment stage.
The formula of Profitability IndexFormula Of Profitability IndexThe Profitability Index is calculated by dividing the present value of all the project's future cash flows by the initial investment in the project. Profitability Index = PV of future cash flows / Initial investment is represented as follows,
A profitability index lower than 1.0 indicates that the present value of cash inflows is lower than the initial investment cost. Similarly, the profitability index greater than 1.0 means that the project is worthy and accepted.
NPV Method is the most optimum method for capital budgeting.
- Consider the cash flow during the entire product tenure and the risks of such cash flow through the cost of capital.
- It is consistent with maximizing the value to the company, which is not the case in the IRR and profitability index.
- In the NPV method, it is assumed that cash inflows will be reinvested at the cost of capital. The IRR method assumes that it is reinvested at IRR, which is not accurate.
Capital Budgeting refers to the decision-making process related to long term investmentsLong Term InvestmentsLong Term Investments are financial instruments such as stocks, bonds, cash, or real estate assets that a company intends to hold for more than 365 days in order to maximize profits and are reported on the asset side of the balance sheet under the heading non-current assets.. Different capital budgeting methods include the Payback Period, the accounting rate of return, the net present value, the discounted cash flow, the profitability Index, and the Internal Rate of Return method.
Frequently Asked Questions (FAQs)
NPV Method is the most preferred method for capital budgeting because it considers the cash flow in the tenure and the cash flow uncertainties through the cost of capital. Moreover, it constantly boosts the company’s value, which is void in the IRR and profitability index.
All the methods focus on cash flow, as these methods are concerned with the analysis of long-term investments that generate future cash flows. However, the extent to which they rely on cash flows can vary.
The choice of capital budgeting method depends on the organization’s goals, risk tolerance, and the nature of the investment. Therefore, it is advised to consider all the relevant factors when selecting these methods.
This article has been a guide to Capital Budgeting Methods. Here we provide the top 4 methods along with the examples and explanations. You may learn more about Corporate Finance from the following articles –