Running a business is complex and it takes a lot of planning and decision-making to keep it survive in the competitive landscape. Most importantly, the manager of the company has to plan for expenditures and the benefits a business achieves through its investment decisions. Here, the investment decisions depend on the long-term assets that are expected to provide benefits for more than one year. The capital budgeting process involves all the evaluation forms. So, what is capital budgeting?
In this blog, let us learn about capital budgeting in detail —
What is Capital Budgeting?
Capital budgeting is crucial for businesses as it involves the process of making investment decisions about long-term assets. The main motive is to decide whether or not to invest in a particular project. Because most investment decisions are not always rewarding. The manager has the task of choosing a project that gives a high return on investment more than the cost allotted to the particular project. Hence, the manager must review projects based on cost and benefit.
Let us take other examples, assessing the need for funding before approval or rejection by management is a common practice for initiatives such as establishing a new facility or acquiring a significant share in an external venture, which falls under the realm of capital budgeting.
Within the context of capital budgeting, an organization may analyze the anticipated long-term cash inflows and outflows of a potential project. This analysis aims to ascertain if the projected returns align with a predefined target benchmark deemed satisfactory. Capital Budgeting can also be called investment appraisal.
Given below is the list of projects that can be analysed using a capital budgeting process −
- Decisions regarding buying new machinery.
- Business expansion in new geographical zones.
- Obsolete equipment replacement.
- Launching new products, innovation or market development etc.
Why is capital budgeting a significant task for the business? The first thing to know is that capital budgeting is undertaken by a financial manager. Its importance is listed below —
- It is responsible for the purchase of long-term assets and the decision regarding its purchase influences the future success of the company.
- Decisions regarding these investments maximise the shareholders’ value.
- The principles that are relevant to the capital budgeting process are equally applicable to other corporate choices, such as the management of working capital.
How does Capital Budgeting work?
Businesses have to take up projects and grab opportunities that will help in maximising shareholder value and revenue. Usually, the capital for pursuing new projects is limited which is why the company applies capital budgeting techniques to analyse which project will yield the highest rate of return in an applicable period.
Process of Capital Budgeting
As learned earlier capital budgeting is a process about the identification of the capital investment needs of a particular firm. Enumerated below are the steps of the capital budgeting process.
1. Generating investment ideas
The primary requirement of capital budgeting is to generate good capital investment ideas. Many investment ideas can be acquired from many sources such as senior management, managers, any department or outside sources.
2. Examine individual proposals
The managers must collect information to forecast cashflows for each project to determine the expected revenue. And to accept or reject a capital investment depends on the expected cash flow received through future investments.
3. Capital budget planning
An organization should prioritize profitable projects based on factors such as project cash flow timing, the company’s available resources, and its overarching strategic objectives. Some projects which look promising individually will be strategically undesirable. Due to financial and other resource issues, prioritizing and scheduling projects is vital.
4. Supervising and Performing a post-audit
Managers must track and follow capital budgeting decisions. They have to analyse the performance by comparing the actual with projected results and should state reasons as to why the results didn’t match up with the performance. To make capital budgeting effective, conduct a post-audit to identify errors in the forecasting process. This will enhance business operations.
Also Read : Capital Account: What It Is and How It Works
Methods of Capital Budgeting
There are many capital budgeting methods and the seven most common methods are enumerated below :
1. Discounted cash flow analysis
The discounted cash flow (DCF) method examines the initial cash flow required for project funding, the blend of cash flows in the form of profit and the outflows in the form of maintenance and other costs which is likely to occur in the future. So, all these cash flows excluding the initial outflows are discounted back to the current date. The number resulting from the discounting cash flow is referred to as the Net present value NPV.
Discounting of cash flows is implemented because the concept of present value is based on the notion that a specific sum of money holds greater value today compared to an equivalent amount in the future, accounting for inflationary effects.
Opportunity costs occur in every project decision. Opportunity cost means the return a company would have received if it pursued a different project. To simplify, it means that the cash inflows or the profits received from the project have to account for the costs which are initial and ongoing. And it should also exceed any opportunity costs.
The reason for discounting future cash flows using the risk-free rate, also known as the discount rate, is that the project must generate returns equal to or surpass this rate. Failing to do so would render the project unviable as an endeavour.
Furthermore, sometimes a company will have to borrow money for the project. So through the project, the company should earn revenue which will at least cover the financing costs which is also known as the cost of capital.
Publicly traded corporations may opt for a blend of debt components like bonds or bank credit lines, alongside equity expansion through the issuance of additional shares of stock. The main objective here is to compute the minimum amount which the project is required to earn from its cash inflows or cover the costs. Before proceeding with the project, the company expects that its rate of return exceeds the hurdle rate.
The discounted cash flow model is used by project managers to ensure that a particular project is worth pursuing.
2. Pay Back Period Method
This method is the simplified form of capital budgeting analysis. The major drawback is that it is the least accurate technique. The payback period method is used by the majority of managers as it gives quick results regarding the real value proposed to a project. It means that it refers to the total number of years it takes to retrieve the initial cost of investment. As such, it serves as an indicator of a company’s liquidity. So, if a company is facing any liquidity issues, it will be a better option to shorten the payback period.
Payback period = Full years until recovery + (unrecovered cost at the beginning of the last year)/ Cash flow during the last year
In this formula, full years until recovery means it occurs when the cumulative net cash flow equals zero. The cumulative net cash flow represents the ongoing sum of cash flows after each successive time interval.
3. Average Rate of Return Method (ARR)
In this method, by dividing average income after taxes by average investment, the revenue of an investment proposal can be determined. This forms the average book value after depreciation.
Hence, ARR can be computed using the following formula :
ARR = Average Net Income After Taxes/Average Investment x 100
Where, Average Income After Taxes = Total Income After Taxes/Total Number of Years
Average Investment = Total Investment/2
In this method, a company can choose projects that possess an Accounting Rate of Return (ARR) exceeding the company’s predefined minimum rate. Further, the company can reject projects with low ARR.
4. Net Present Value NPV Method
The net present value method NPV is calculated by summing the present values of anticipated incremental cash flows from a project, discounted at a rate of return which is lower than the present value of the initial investment cost.
In simpler terms, NPV is the distinction between the present value of cash inflows of the project and the initial cost of the project. This technique allows the company to choose projects whose net present value is positive or above zero. In contrast, if the NPV value of the project is negative or less than zero, it is rejected. Suppose, if there is more than one project with a positive NPV, the project with the highest NPV will be chosen by the business.
NPV = CF1/(1 + k)1 + ……….. CFn/ (1 + k)n + CF0
where, CF0 = Initial Investment Outlay (Negative Cash flow)
CFt = After-tax cash flow at time t
k = required rate of return
5. Internal Rate of Return IRR
Internal rate of return is a method of capital budgeting. It refers to the discount rate which will drive the present value of expected after-tax inflows equal to the initial cost of the project. In simpler terms, the internal rate of return IRR is the rate of discount at which the present values of projected cash inflows from a project align with the present value of the project’s anticipated cash outflows.
If the internal rate of return is higher than the expected value, the project is selected. The project will be rejected if the IRR value is less.
PV (inflows) = PV (outflows)
NPV = 0 = CF0 + CF1/(1 + IRR)1 + ……….. CFn/ (1 + IRR)n + CF0
6. Throughput Analysis
Throughput analysis is the most complicated method of capital budgeting. This is the most accurate method for the managers helping them to decide on the projects which yield higher revenue. If the company is under this method of capital budgeting, it is regarded as a single profit-generating system. Throughput is quantified as the volume of material moving through the system.
This method presumes that most of the costs are operating expenses. And a company must maximise its throughput to pay for the expenses. Further, the best way to increase revenue is to maximise throughput passing through the bottleneck operation. A bottleneck is an element within the system that necessitates the most extensive time during operations.
The managers should prioritise the projects that maximise throughput or flow passing through the bottleneck.
7. Profitability Index
It can be referred to as the current value of a project’s future cashflows which is then divided by initial cash outlay. This method slightly resembles the net present value method. As learned earlier, we know that net present value is the difference between the current value of future cash flows and the initial cash outlay.
In this, PI is the ratio of the present value of future cash flows and initial cash outlay.
PI = PV of future cash flows/CF0 = 1 + NPV/CF0
Here, if the net present value of a company is positive, then the PI is greater than 1. Select the project if the PI is greater than 1, or else reject it.
Importance and the Need for Capital Budgeting
A company’s financial manager is responsible for choosing the most profitable capital expenditure proposal. Let us look at the some of importance of capital budgeting.
1. Long-lasting effect on profitability
A long-term vision is crucial for the business to grow and succeed. A slightly wrong decision will impact the company negatively in the long run affecting capital budgeting. Further, it also influences the company’s costs, profitability and growth. Hence, if the expenditures are done based on the budget plan, definitely the profitability of the business will increase.
2. Big investments
A company should make wise decisions regarding the investment it makes for the company to grow. If there are limited resources, depending on the available resources capital budgeting should be planned. A bad investment or wrong decision will impact the sustainability of the business. Plus, it impacts the purchase of an asset, rebuilding or replacing the existing equipment.
3. Decisions initiated cannot be undone
Capital investment decisions are vast and are not irreversible. It is difficult most of the time to find a suitable market for capital budgeting. The only thing that can be done is to scrap the assets and bear the losses.
4. Expenditure Control
Research and development for the investment project has to be done. Capital budgeting lays more focus on expenditure. A good project has to be regularly monitored and the expenditure has to be under control or it will turn bad for the business if the expenditure exceeds.
5. Data Flow
The inception of a project begins as a concept, and its acceptance or rejection hinges on factors such as levels of authority and prevailing circumstances. Information is shared with the decision-makers without any barriers which will enable them to make better decisions for the growth of the business.
6. Aids investment decisions
Long-term investments may cause risk to the company if they fail. Any decision taken for the long term has to be carefully considered when accepting the proposal. When making an investment decision, management sacrifices its flexibility and available funds. So, capital budgeting decisions have to be carefully examined before making a decision.
7. Maximise the wealth of your company
All the project investments have to be well-planned before it is pursued, and then the shareholders also take an interest in your company. This will contribute to the growth of the organisation. Any organisational expansion is linked to growth, sales, profitability and assets regarding capital budgeting.
Conclusion
Capital budgeting is a strategic blueprint detailing the financial requirements associated with an investment, expansion, or significant acquisition over an extended period. Unlike an operational budget, which monitors income and costs, a capital budget necessitates preparation to assess the prospective profitability of a long-term undertaking. The NPV, IRR, discounted rate method, payback period etc. are some of the techniques applied to analyse capital budgeting. ERP software is also an expert tool to help with the capital budgeting process efficiently.
