Capital Budgeting and Its Techniques

Meaning Of Capital Budgeting

Capital budgeting is the process that a company goes through in order to evaluate potential major projects or investments. Building a new plant or investing heavily in a new venture are two examples of projects that would require capital budgeting before they could be approved or rejected by the appropriate authorities. As part of its capital budgeting process, a company might examine the lifetime cash inflows and outflows of a prospective project to determine whether the potential returns that would be generated are sufficient in comparison to a target benchmark. The process of developing a capital budget is also referred to as investment appraisal.


Importance of Capital Budgeting

As a tool, capital budgeting is beneficial because it provides a means of evaluating and measuring the value of a project throughout its entire life cycle. In order to evaluate and rank the value of projects or investments that require a significant amount of capital investment, you must first determine their worth. For example, investors can use capital budgeting to analyze investment options and determine which ones are worth their time and money to pursue.

When it comes to projects that are expected to last a year or longer and require a significant amount of capital investment, capital budgeting assists financial decision-makers in making informed financial decisions. Projects of this nature can include:

  • Upgrading and maintaining existing equipment and technological infrastructure

  • New equipment, technology, and buildings are being invested in.

  • Construction of new buildings and completion of renovation projects on existing structures

  • Increasing the size of their workforce

  • Inventing and developing new products

  • Expansion into new geographies and markets

Limitation Of Capital Budgeting

  • All capital budgeting techniques are based on the assumption that the various investment proposals under consideration are mutually exclusive, which may not be the case in some specific circumstances.

  • Capital budgeting techniques necessitate the forecasting of future cash inflows and outflows, which is a time-consuming process. The future is always unpredictable, and the information gathered for the future may not be accurate. Unaware of this, the results based on incorrect data may not be favorable.

  • There are some factors, such as employee morale and the goodwill of the company, that cannot be accurately quantified but which nevertheless have a significant impact on the capital decision.

  • Another limitation in the evaluation of capital investment decisions is the need to act quickly.

  • Uncertainty and risk are the most significant constraints on the application of capital budgeting techniques.



5 Techniques of Capital Budgeting

Payback Period

The payback period method is the most straightforward method of planning a new project's budget. It is a measure of the amount of time it will take for your project to generate enough cash inflows to cover the amount of money you have invested. When using this method, a project with a shorter payback period is more appealing because it means you will recover your investment costs in a shorter period of time, making it more appealing. A common application of the payback period method is for people who have a limited amount of funds to invest in a project and who need to recover their initial investment cost before they can begin working on another project.


Net present value (NPV)

The net present value capital budgeting method estimates how profitable a project will be in the future. A positive net present value is acceptable when using this method, whereas a negative net present value is unacceptable when using this method. In capital budgeting, the net present value (NPV) method is one of the most popular options because it allows you to select the most profitable projects or investments.

You can use the net present value method to choose only one project or investment to make, or you can use it to select a number of projects to make at the same time. If a company is considering three different projects but only has the financial resources to invest in one of them, this is an example. To determine which project is most likely to be profitable, they can use the net present value method to make their selection.

Additionally, an investor who is considering eight investment portfolio options but only has enough capital to fund three of the options may use the net present value method in order to determine which of the three investment portfolio options is likely to yield the highest profits.


Internal rate of return (IRR)

The internal rate of return method calculates the percentage of return you can expect to receive from a specific project based on its internal rate of return. With this method, the greater the percentage by which the rate of return exceeds the project's initial capital investment, the more appealing the project appears to be in terms of profitability. In order to choose between two or more competing project options, it is common for businesses to employ the IRR method.

In order to compare the internal rate of return of expanding operations in an existing facility to the internal rate of return of expanding operations by building and opening a new facility, a company can use this method, for example. Because the company only requires one site to expand operations, the two project options are diametrically opposed to one another. Accordingly, the company would select the project with a higher IRR percentage that exceeds the cost of investment percentage. a.


Profitability Index

The Profitability Index is one of the most important techniques because it represents a relationship between the amount of money invested in a project and the amount of money earned from the project.

The profitability index formula provided by is as follows:

Profitability Index = PV of future cash flows / PV of initial investment Where PV is the present value.

It is primarily employed in the ranking of projects. A suitable project for investment is selected based on the project's ranking in the ranking system.


Discounted cash flow method

The discounted cash flow technique estimates the cash inflows and outflows that will occur over the asset's useful life. After that, a discounting factor is applied to reduce the price. The discounted cash inflows and outflows are then compared to determine which is more favorable. This method takes into consideration the interest factor as well as the return after the payback period.


Conclusion

Each of the capital budgeting methods described above has its own set of advantages and disadvantages to consider. The Payback Period is straightforward and demonstrates the investment's liquidity. This method, however, does not take into consideration the value of time or the value of cash flows received after the payback period. The Discounted Payback Period takes into account the time value of money, but it does not take into account any cash flows received after the payback period has ended. The Net Present Value analysis provides a present value return on the investment in the form of dollars denominated present value.

However, when comparing investments of varying sizes, it is of little use to the investor. It is a variation on the Net Present Value analysis that shows the cash return on each dollar invested, which is useful for comparing projects when comparing cash flows. Many analysts, on the other hand, prefer to see a percentage return on their investment. The Internal Rate of Return (IRR) can be calculated in this case. It's possible, however, that the company will be unable to reinvest its internal cash flows at the Internal Rate of Return. Consequently, the Modified Internal Rate of Return analysis may be employed.