What is a Capital Budgeting?

Explanation

Capital Budgeting is a decision-making process where a company plans and determines any long-term CapexCapexCapex or Capital Expenditure is the expense of the company’s total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year.read more whose returns in terms of cash flows are expected to be received beyond a year. Investment decisions may include any of the below:

  • ExpansionAcquisitionAcquisitionAcquisition refers to the strategic move of one company buying another company by acquiring major stakes of the firm. Usually, companies acquire an existing business to share its customer base, operations and market presence. It is one of the popular ways of business expansion.read moreReplacementNew ProductR&DMajor Advertisement CampaignWelfare 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 earningsRetained EarningsRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company.read more – or not.

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How to Take Capital Budgeting Decisions?

There are five major techniques used for capital budgetingTechniques Used For Capital BudgetingCapital Budgeting refers to a Company’s procedure for analyzing investment or project-related decisions by considering the investment to be made & expenses to be incurred. Its techniques include Net Present Value, Internal Rate of Return, Accounting Rate of Return, Profitability Index, Discounted Cash Flows, & Payback Period, etc. read more decision analysis to select the viable investment are as below:

#1 – Payback Period

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

  • Provides a crude measure of liquidityProvides some information on the risk of the investmentSimple to calculate

#2-Discounted Payback Period

  • It considers 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 moreConsiders the risk involved in the project cash flows by using the cost of capitalCost Of CapitalThe cost of capital formula calculates the weighted average costs of raising funds from the debt and equity holders and is the total of three separate calculations – weightage of debt multiplied by the cost of debt, weightage of preference shares multiplied by the cost of preference shares, and weightage of equity multiplied by the cost of equity.read more

#3-Net Present Value Method

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

where,

  • CF0 = Initial InvestmentCFn = AfterTax Cash FlowK = Required Rate of ReturnRequired Rate Of ReturnRequired Rate of Return (RRR), also known as Hurdle Rate, is the minimum capital amount or return that an investor expects to receive from an investment. It is determined by, Required Rate of Return = (Expected Dividend Payment/Existing Stock Price) + Dividend Growth Rateread more

The required rate of return is usually 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)]read more (WACC) – which includes the rate of both debt and equity as the total capital

  • It considers the time value of moneyConsiders all the cash flows of the projectConsiders the risk involved in the project cash flows by using the cost of capitalIndicates whether the investment will increase the project’s or the company’s value

#4- Internal Rate of Return (IRR)

IRRIRRInternal 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.read more is the discount rate when the present value of the expected incremental cash inflows equals the project’s initial cost.

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

#5- 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.read more is the Present Value of a Project’s future cash flows divided by the initial cash outlay.

Where,

CF0 is the initial investment

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

  • It considers the time value of moneyConsiders all the cash flows of the projectConsiders the risk involved in the project cash flows by using the cost of capitalIndicates whether the investment will increase the project’s or the company’s valueUseful in ranking and selecting projects when capital is rationedCapital Is RationedCapital 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.read more

Examples

Example #1

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

WACC for the company is 10 %.

Solution:

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

NPV For Project A –

The NPV For Project A = $1.27

NPV For Project B-

NPV For Project B = $1.30

Internal Rate of Return For Project A-

The Internal Rate of Return For Project A = 14.5%

Internal Rate of Return For Project B-

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 two projects. It now provides an insight that Project A would yield better returns (14.5%) than the 2nd project, which is generating good but lesser than Project A.

Hence, Project A gets selected over Project B.

Example #2

In selecting a project based on the Payback period, we need to check for the inflows each year and which year the inflows cover the outflow.

There are two methods to calculate the payback period based on the cash inflows – which can be even or different.

Payback Period for Project A-

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 to meet the initial investment, it would take approximately ten years.

Payback Period for Project B-

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 the investment and returns would close. So, the initial investment requirement for project B is met in the 4th year.

In comparison, 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 periodDiscounted Payback PeriodThe discounted payback period is when the investment cash flow paybacks the initial investment, based on the time value of money. It determines the expected return from a proposed capital investment opportunity. It adds discounting to the primary payback period determination, significantly enhancing the result accuracy.read more method, we can check if the project selection is worthwhile or not.

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

Given the below observations:

There are certain cash inflows over the years under the same project. Using the time value of money, we calculate the discounted cash flowsDiscounted Cash FlowsDiscounted cash flow analysis is a method of analyzing the present value of a company, investment, or cash flow by adjusting future cash flows to the time value of money. This analysis assesses the present fair value of assets, projects, or companies by taking into account many factors such as inflation, risk, and cost of capital, as well as analyzing the company’s future performance.read more 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 project’s life is seen to be six 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 that can 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:

Profitability Index for Project A-

The Profitability Index for Project A =$1.16

Profitability Index for Project B-

Profitability Index for Project B = $0.90

The profitability index also 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 outflows.

In this case, Project A has an index of $1.16 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 opportunitiesAdequate control over expenditures of the companyPromotes understanding of risks and its effects on the businessIncrease shareholders’ wealth and improve market holdingAbstain from Over or Under Investment

Limitations

  • Therefore, decisions are for the long term and not reversible in most cases.Reflective in nature due to the subjective risk and discounting factorDiscounting FactorDiscount Factor is a weighing factor most often used to find the present value of future cash flows, i.e., to calculate the Net Present Value (NPV). It is determined by,
  • 1 / {1 * (1 + Discount Rate) Period Number}read moreFew techniques or calculations are based on assumptions – uncertainty might lead to incorrect application

Conclusion

Capital budgeting is a necessary and very important process for a company to choose between projects from a long-term perspective. 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. It is necessary to follow before investing in any long-term project or business.

This has been a guide to what is Capital Budgeting and its definition. Here we will discuss making 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 –

  • Examples of BudgetingNominal Rate of ReturnProcess of Capital Budgeting Examples of Capital Budgeting