What is capital budgeting techniques of capital budgeting?

Capital budgeting is made up of two words ‘capital’ and ‘budgeting.’ In this context, capital expenditure is the spending of funds for large expenditures like purchasing fixed assets and equipment, repairs to fixed assets or equipment, research and development, expansion and the like. Budgeting is setting targets for projects to ensure maximum profitability.

Capital budgeting is a process of evaluating investments and huge expenses in order to obtain the best returns on investment.

An organization is often faced with the challenges of selecting between two projects/investments or the buy vs replace decision. Ideally, an organization would like to invest in all profitable projects but due to the limitation on the availability of capital an organization has to choose between different projects/investments. Capital budgeting as a concept affects our daily lives.

Let’s look at an example- Your mobile phone has stopped working! Now, you have two choices: Either buy a new one or get the same mobile repaired. Here, you may conclude that the costs of repairing the mobile increases the life of the phone. However, there could be a possibility that the cost to buy a new cell phone would be lesser than its repair costs. So, you decide to replace your cell phone and you proceed to look at different phones that fit your budget!

What are the objectives of Capital budgeting?

Capital expenditures are huge and have a long-term effect. Therefore, while performing a capital budgeting analysis an organization must keep the following objectives in mind:

Selecting profitable projects

An organization comes across various profitable projects frequently. But due to capital restrictions, an organization needs to select the right mix of profitable projects that will increase its shareholders’ wealth.

Capital expenditure control

Selecting the most profitable investment is the main objective of capital budgeting. However, controlling capital costs is also an important objective. Forecasting capital expenditure requirements and budgeting for it, and ensuring no investment opportunities are lost is the crux of budgeting.

Finding the right sources for funds

Determining the quantum of funds and the sources for procuring them is another important objective of capital budgeting. Finding the balance between the cost of borrowing and returns on investment is an important goal of Capital Budgeting.

Capital Budgeting Process

The process of capital budgeting is as follows:

Identifying investment opportunities

An organization needs to first identify an investment opportunity. An investment opportunity can be anything from a new business line to product expansion to purchasing a new asset. For example, a company finds two new products that they can add to their product line.

Evaluating investment proposals

Once an investment opportunity has been recognized an organization needs to evaluate its options for investment. That is to say, once it is decided that new product/products should be added to the product line, the next step would be deciding on how to acquire these products. There might be multiple ways of acquiring them. Some of these products could be:

Manufactured In-house
Manufactured by Outsourcing manufacturing the process, or
Purchased from the market

Once the investment opportunities are identified and all proposals are evaluated an organization needs to decide the most profitable investment and select it. While selecting a particular project an organization may have to use the technique of capital rationing to rank the projects as per returns and select the best option available. In our example, the company here has to decide what is more profitable for them. Manufacturing or purchasing one or both of the products or scrapping the idea of acquiring both.

Capital Budgeting and Apportionment

After the project is selected an organization needs to fund this project. To fund the project it needs to identify the sources of funds and allocate it accordingly. The sources of these funds could be reserves, investments, loans or any other available channel.

Performance Review

The last step in the process of capital budgeting is reviewing the investment. Initially, the organization had selected a particular investment for a predicted return. So now, they will compare the investments expected performance to the actual performance.

In our example, when the screening for the most profitable investment happened, an expected return would have been worked out. Once the investment is made, the products are released in the market, the profits earned from its sales should be compared to the set expected returns. This will help in the performance review.

Capital Budgeting Techniques

To assist the organization in selecting the best investment there are various techniques available based on the comparison of cash inflows and outflows. These techniques are:

Payback period method

In this technique, the entity calculates the time period required to earn the initial investment of the project or investment. The project or investment with the shortest duration is opted for.

Net Present value

The net present value is calculated by taking the difference between the present value of cash inflows and the present value of cash outflows over a period of time. The investment with a positive NPV will be considered. In case there are multiple projects, the project with a higher NPV is more likely to be selected.

Accounting Rate of Return

In this technique, the total net income of the investment is divided by the initial or average investment to derive at the most profitable investment.

Internal Rate of Return (IRR)

For NPV computation a discount rate is used. IRR is the rate at which the NPV becomes zero. The project with higher IRR is usually selected.

Profitability Index

Profitability Index is the ratio of the present value of future cash flows of the project to the initial investment required for the project. Each technique comes with inherent advantages and disadvantages. An organization needs to use the best-suited technique to assist it in budgeting. It can also select different techniques and compare the results to derive at the best profitable projects.

Conclusion

Capital budgeting is a predominant function of management. Right decisions taken can lead the business to great heights. However, a single wrong decision can inch the business closer to shut down due to the number of funds involved and the tenure of these projects.

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Capital budgeting technique is the company’s process of analyzing the decision of investment/projects by taking into account the investment to be made and expenditure to be incurred and maximizing the profit by considering following factors like availability of funds, the economic value of the project, taxation, capital return, and accounting methods.

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Source: Capital Budgeting Techniques (wallstreetmojo.com)

Let us discuss this one by one in detail along with examples –

#1 – Profitability Index

Profitability Index is one of the essential techniques, and it signifies a relationship between the investment of the project and the payoff of the project.

The formula 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 given by:-

Profitability Index = PV of future cash flows / PV of initial investment

Where PV is the present value.

It is mainly used for ranking projects. According to the rank of the project, a suitable project is chosen for investment.

#2 – Payback Period

This method of capital budgeting helps to find a profitable project. The payback period is calculated by dividing the initial investment by the annual cash flows. But the main drawback is it ignores the time value of money. By the time 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, we mean that money is more today than the same amount in the future. So if we payback to an investor tomorrow, it includes an opportunity costThe difference between the chosen plan of action and the next best plan is known as the opportunity cost. It's essentially the cost of the next best alternative that has been forgiven.read more. As already mentioned, the payback period disregards the time value of money.

It is calculated by how many years it is required to recover the amount of investment done. Shorter paybacks are more attractive than more extended payback periods. Let’s calculate the payback period for the below investment:-

Example

For example, there is an initial investment of ₹1000 in a project, and it generates a cash flow of ₹ 300 for the next five years.

Therefore the payback period is calculated as below:

Payback period = no. of years – (cumulative cash flow/cash flow)
Payback period = 5- (500/300)
= 3.33 years

Therefore it will take 3.33 years to recover the investment.

#3 – Net Present Value

Net Present ValueNet 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 difference between the present value of incoming cash flow and the outgoing cash flow over a particular time. It is used to analyze the profitability of a project.

The formula for the calculation of NPV is as below:-

NPV = [Cash Flow / (1+i)n ] – Initial Investment

Here i is the discount rate, and n is the number of years.

Example

Let us see an example to discuss it.

Let us assume the discount rate is 10%

NPV = -1000 + 200/(1+0.1)^1 + 300/(1+0.1)^2+400/(1+0.1)^3+600/(1+0.1)^4+ 700/(1+0.1)^5
= 574.731

We can also calculate it by basic excel formulasThe term "basic excel formula" refers to the general functions used in Microsoft Excel to do simple calculations such as addition, average, and comparison. SUM, COUNT, COUNTA, COUNTBLANK, AVERAGE, MIN Excel, MAX Excel, LEN Excel, TRIM Excel, IF Excel are the top ten excel formulas and functions.read more.

There is an in-built excel formula of “NPV” which can be used. The discounting rate and the series of cash flows from the 1st year to the last year are considered arguments. We should not include the year zero cash flow in the formula. We should later subtract it.

= NPV (Discount rate, cash flow of 1st year: cash flow of 5th year) + (-Initial investment)
= NPV (10%, 200:700) – 1000
= 574.731

As NPV is positive, it is recommended to go ahead with the project. But not only NPV but IRR is also used for determining the profitability of the project.

#4 – Internal rate of return

The Internal rate of return is also among the top techniques that are used to determine whether the firm should take up the investment or not. It is used together with NPV to determine the profitability of the project.

IRR is the discount rate when all the NPV of all the cash flows is equal to zero.

NPV = [Cash Flow / (1+i)n ] – Initial Investment =0

Here we need to find “i” which is the discount rate.

Example

Now we shall discuss an example to understand the internal rate of returnInternal 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 in a better way.

While calculating, we need to find out the rate at which NPV is zero. This is usually done by error and trial method else we can use excel for the same.

Let us assume the discount rate to be 10%.

NPV at a 10 % discount is ₹ 574.730.

So we need to increase the discount percentage to make NPV as 0.

So if we increase the discount rate to 26.22 %, the NPV is 0.5, which is almost zero.

There is an in-built excel formula of “IRR,” which can be used. The series of cash flows is taken as arguments.

=IRR (Cash flow from 0 to 5th year)
= 26 %

Therefore in both ways, we get 26 % as the internal rate of return.

#5 – Modified Internal Rate of return

The main drawback of the internal rate of return that it assumes that the amount will be reinvested at the IRR itself, which is not the case. MIRRMIRR or Modified Internal Rate of Return refers to the financial metric used to assess precisely the value and profitability of a potential investment or project. It enables companies and investors to pick the best project or investment based on expected returns. It is nothing but the modified form of the Internal Rate of Return (IRR).read more solves this problem and reflects the profitability in a more accurate manner.

The formula is as below:-

MIRR= (FV (Positive cash flows* Cost of capital)/ PV(Initial outlays * Financing cost))1/n −1

Where,

Example

We can calculate MIRR for the below example:

Let us assume the cost 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 at 12%. In MIRR, we need to consider the reinvested rate, which we assume as 14%. In Excel, we can calculate as the below formulae

MIRR= (cash flows from year 0 to 4th year, cost of capital rate, reinvestment rate)
MIRR= (-1000: 600, 12%, 14%)
MIRR= 22%

A MIRR in excelMIRR or (modified internal rate of return) in excel is an in-build financial function to calculate the MIRR for the cash flows supplied with a period. It takes the initial investment, interest rate and the interest earned from the earned amount and returns the MIRR.read more is a better estimation than an internal rate of return.

Conclusion

Therefore capital budgeting methods help us to decide the profitability of investments that need to be done in a firm. There are different techniques to decide the return of investment.