Capital Budgeting

What is a Capital Budgeting?

Capital Budgeting refers to the planning process which is used for decision making of the long term investment that whether the projects are fruitful for the business and will provide the required returns in the future years or not and it is important because capital expenditure requires huge amount of funds so before doing such expenditure in capital, the companies need to assure themselves that the spending will bring profits in the business.

Explanation

Capital Budgeting is a decision-making process where a company plans and determines any long term Capex whose returns in terms of cash flows are expected to be received beyond a year. Investment decisions may include any of the below:

  • Expansion
  • Acquisition
  • Replacement
  • New Product
  • R&D
  • Major Advertisement Campaign
  • Welfare investment

The capital budgeting decision making remains in understanding whether the projects and investment areas are worth the funding of cash through the capitalization structure of the company debt, equity, retained earnings – or not.

Capital Budgeting

How to Take Capital Budgeting Decisions?

Capital Budgeting Decisions

There are 5 major techniques used for capital budgeting decision analysis in order to select the viable investment are as below:

#1 – Payback Period

Payback Period is the number of years it takes to recover the initial cost – the cash outflow – of the investment. The shorter the payback period, the better it is.

Features:
  • Provides a crude measure of liquidity
  • Provides some information on the risk of the investment
  • Simple to calculate

#2-Discounted Payback Period

Features:

#3-Net Present Value Method

NPV is the sum of the present values of all the expected cash flows in case a project is undertaken.

NPV = CF0 + CF1/(1+k)1+ . . . + CFn/(1+k)n

where,

The required rate of return is usually the Weighted Average Cost of Capital (WACC) – which includes the rate of both debt and equity as the total capital

Features:
  • It considers the time value of money
  • Considers all the cash flows of the project
  • Considers the risk involved in the project cash flows by using the cost of capital
  • Indicates whether the investment will increase the project’s or the company’s value

#4- Internal Rate of Return (IRR)

IRR is the discount rate when the present value of the expected incremental cash inflows equals the initial cost of the project.

i.e. when PV(Inflows) = PV(Outflows)

Features:
  • It considers the time value of money
  • Considers all the cash flows of the project
  • Considers the risk involved in the project cash flows by using the cost of capital
  • Indicates whether the investment will increase the project’s or the company’s value

#5- Profitability Index

Profitability Index is the Present Value of a Project’s future cash flows divided by the initial cash outlay

PI = PV of Future Cash Flow / CF0

Where,

CF0 is the initial investment

This ratio is also known as Profit Investment Ratio (PIR) or Value Investment Ratio (VIR).

Features:
  • It considers the time value of money
  • Considers all the cash flows of the project
  • Considers the risk involved in the project cash flows by using the cost of capital
  • Indicates whether the investment will increase the project’s or the company’s value
  • Useful in ranking and selecting projects when capital is rationed

Examples

Example #1

A company is considering 2 projects to select anyone. The projected cash flows are as follows

Capital Budgeting1

WACC for the company is 10 %.

Solution:

Let us calculate and see which project should be selected over the other, using the more common capital budgeting decision tools.

NPV For Project A –

CB Example 1-2

The NPV For Project A = $1.27

NPV For Project B-

CB Example 1-3

NPV For Project B = $1.30

Internal Rate of Return For Project A-

CB Example 1-4

The Internal Rate of Return For Project A = 14.5%

Internal Rate of Return For Project B-

CB Example 1-5

Internal Rate of Return For Project B = 13.1%

The net present value for both the projects is very close, and therefore taking a decision here is very difficult.

Therefore, we pick the next method to calculate the rate of return from the investments if done in each of the 2 projects. This now provides an insight that Project A would yield better returns (14.5%) as compared to the 2nd project, which is generating good but lesser than Project A.

Hence, Project A gets selected over Project B.

Example #2

In case of selecting a project based on the Payback period, we need to check for the inflows each year and check in which year the outflow gets covered by the inflows.

Now, there are 2 methods to calculate the payback period based on the cash inflows – which can be even or different.

Capital Budgeting 2

Payback Period for Project A-

CB Example 2-1

10 years, the inflow remains the same as $100 mn always

Project A depicts a constant cash flow; hence the payback period, in this case, is calculated as Initial Investment / Net Cash Inflow. Therefore, for project A, in order to meet the initial investment, it would take approximately 10 years.

Payback Period for Project B-

CB Example 2-2

Adding the inflows, the investment of $1000 mn is covered in 4 years

On the other hand, Project B has uneven cash flows. In this case, if you add up the yearly inflows – you can easily identify in which year would the investment and returns are close. So, for project B, the initial investment requirement is met in the 4th year.

On comparing, Project A is taking more time to generate any benefits for the entire business, and therefore project B should be selected over project A.

Example #3

Consider a project where the initial investment is $10000. Using the Discounted Payback period method, we can check if the project selection is worthwhile or not.

This is an extended form of payback period, where it considers the time value of the money factor, hence used the discounted cash flows to arrive at the number of years required to meet the initial investment.

Given the below observations:

Capital Budgeting 3

There are certain cash inflows over the years under the same project. Using the time value of money, we calculate the discounted cash flows at a predetermined discount rate. In column C above are the discounted cash flows, and column D identifies the initial outflow that is covered each year by the expected discount cash inflows.

The payback period would lie somewhere between years 5 & 6. Now, since the life of the project is seen to be 6 years, and the project gives returns in a lesser period, we can infer that this project has a better NPV. Therefore, it will be a good decision to pick this project which can be foreseen to add value to the business.

Example #4

Using the budgeting method of the Profitability index to select between two projects, which are the options tentative with a given business. Below are the cash inflows expected from the two projects :

Capital Budgeting 4

Profitability Index for Project A-

CB Example 4.1

The Profitability Index for Project A =$1.16

Profitability Index for Project B-

Capital Budgeting4.2

Profitability Index for Project B = $0.90

The profitability index as well involves converting the regular estimated future cash inflows using a discount rate, which is mostly the WACC % for the business. The sum of these present values of the future cash inflows is compared with the initial investment, and thus, the profitability index is obtained.

If the Profitability index is > 1, it is acceptable, which would mean that inflows are more favorable than the outflows.

In this case, Project A has an index of $1.16 as compared to Project B, which has the Index of $0.90, which is clearly that Project A is a better option than Project B, hence, selected.

Advantages of Capital Budgeting

  • Helps in making decisions in the investments opportunities
  • Adequate control over expenditures of the company
  • Promotes understanding of risks and its effects on the business
  • Increase shareholders’ wealth and improve market holding
  • Abstain from Over or Under Investment

Limitations

  • Decisions are for a long term and therefore, not reversible in most of the cases
  • Introspective in nature due to the subjective risk and discounting factor
  • Few techniques or calculations are based on assumptions – uncertainty might lead to incorrect application

Conclusion

Capital budgeting is an integral and very important process for a company to choose between projects for a long term perspective. It is a necessary procedure to be followed before investing in any long-term project or business. It gives the management methods to adequately calculate the returns on investment and make a calculated judgment always to understand whether the selection would be beneficial for improving the company’s value in the long term or not.

Recommended Articles

This has been a guide to what is Capital Budgeting and its definition. Here we will discuss how to make capital budgeting decisions using practical examples and explanations. We also discuss its advantages & disadvantages. You may learn more about Corporate Finance from the following articles –

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