Capital Budgeting refers to the decision-making process related to long term investments where different capital budgeting methods include the Payback period method, the accounting rate of return method, the net present value method, the discounted cash flow method, the profitability Index method, and the Internal Rate of Return method.
Top Capital Budgeting Methods
Capital budgeting methods are used to aid the decision-making process in Capital Budgeting and can be as non-discount cash flow methods which include the Payback period etc and the discounted cash flow methods which includes the Net Present Value, profitability index and Internal Rate of Return.
Top Capital budgeting methods include –
Top 4 Capital Budgeting Methods
Let us discuss each one of them in detail –
#1 – Payback Period Method
It refers to the period in which the proposed project generates enough cash so that the initial investment is recovered. The project with the 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 exclusive. Contribution per unit of Product A is $50 and Product B is $30. The expansion plan will increase output by 1,000 units for Product A and by 2,000 units for Product B.
Thus the Incremental cash flow 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.
This is the most simple method of capital budgeting. Hence it takes very less time and effort is involved in arriving at a decision.
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Time value of money is not considered in the payback method. Generally, Cash flows generated at the initial stage is better than cash flows received at the later stage. There might be two projects with the same payback period, but one project 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, there might be projects which might have a longer payback period but generates 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.
#2 – Net Present Value Method (NPV)
Most companies use this NPV method for evaluating capital investment proposals. There might be uneven cash flows generated during different periods of time. This is discounted at the cost of capital to the company. This 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.
Time value of money is considered in this method and attributes to the company’s objective which is maximizing profits for the owners.
Also, it considers the cash flow during the entire tenure of the product and risks of such cash flows through the cost of capital. It requires the use of an estimate to calculate the cost of capital.
The formula of Net Present Value (NPV) is represented as below,
When there are two projects with the positive NPV, then select the project with 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 10 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 6 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 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. Time value of money is also considered. This is the most complex method used in Capital budgeting.
If IRR is greater than the weighted average cost of capital then the project is accepted otherwise it is rejected. In case of more than one projects, 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 cost of capital to the company 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 tenure of the product 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 projects.
- When there is capital rationing.
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. 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 Index is the ratio of 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 Index is represented as follows,
A profitability index lower than 1.0 indicates that the present value of cash inflows is lower than the cost of the initial investment. Similarly, the profitability index greater than 1.0 means that the project is worthy and will be accepted.
NPV Method is the most optimum method for capital budgeting.
- Considers the cash flow during the entire tenure of the product and risks of such cash flows through the cost of capital.
- It is consistent with the objective of 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. In the IRR method, it is assumed that it is reinvested at IRR which is not accurate.
This has been a guide to Capital Budgeting Methods. Here we provide the top 4 methods of Capital Budgeting along with the examples and explanation. You may learn more about Corporate Finance from the following articles –