Capital Budgeting Methods

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 include the Net Present Value, profitability index, and Internal Rate of Return.

Top Capital budgeting methods include –

  1. 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.read more
  2. 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.read more
  3. Internal Rate of Return Method
  4. Profitability Index
Capital Budgeting Methods

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Source: Capital Budgeting Methods (wallstreetmojo.com)

#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,

Example

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.read more. 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 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.read more 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,

Capital Budgeting Methods Example 1

Product A = 200000 / 50000 = 4 Years

The payback period of product B is calculated as follows,

Capital Budgeting Methods Example 1.1jpg

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 less time, and effort is involved in arriving 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.read more 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 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.read more proposals. There might be uneven cash flows generated during different periods of time. 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, 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 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.read more is represented as below,

Net Present Value (NPV) = Present value (PV) of Inflows – Present value (PV) of outflows

When there are two projects with a positive NPV, then select the project with a higher NPV.

Example

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 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 capital, 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.

Example

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.

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 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 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 read more is represented as follows,

Profitability Index = Present Value of cash inflows / Initial investment.

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.

Conclusion

NPV Method is the most optimum method for capital budgeting.

Reasons:

  • 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.

Conclusion

Capital Budgeting refers to the decision-making process related to long term investments where 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.

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This article has been a guide to Capital Budgeting Methods. Here we provide the top 4 methods along with the examples and explanation. You may learn more about Corporate Finance from the following articles –

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