Capital budgeting is how a business evaluates investments in potential projects or other business ventures that could help the company maximize shareholders’ wealth.
As part of capital budgeting, a business may assess a potential project’s cash outflows and inflows during its lifetime to determine whether the returns projected to be generated by the projects meet the target benchmark.
The capital budgeting process consists of five steps:
- Proposal generation
- Review and analysis
- Decision making
- Performance review
The first step of capital budgeting involves generating a proposal for potential investments. In other words, businesses at this stage of capital budgeting identify investment opportunities as well as generate proposals for them. An investment opportunity could be anything from launching a new product line to purchasing new tools and equipment.
Review and Analysis
The next step of capital budgeting involves an entity analyzing and reviewing all its investment proposals. For example, an entity prepares a proposal for launching a new product in the market. At this stage, the entity would analyze the pros and cons of launching a new product as well as whether it would help the company in maximizing shareholders’ wealth.
After all potential opportunities for investment have been identified and evaluated, an entity is then required to select the most profitable investment proposal(s) that will help in maximizing shareholders’ wealth. Usually, entities rank all investment projects on the basis of returns and then select the most profitable project(s).
Next, an entity is required to implement the selected project(s) within a given time frame and budget by assigning duties and responsibilities to relevant personnel so that to avoid unnecessary delays and cost overruns.
At this stage of the process, an entity reviews the performance of the implemented project(s) by comparing the actual results with the budget. Usually, businesses compare the actual return generated by a project with the return that was expected from the project before it was implemented.
Capital Budgeting Techniques
There a number of capital budgeting methods and techniques which businesses use to determine the economic feasibility of a specific investment project. Below we will discuss some of the most commonly used capital budgeting techniques in detail:
a) Payback Period
This method helps the companies in calculating the time period in which the initial investment of the project will be recovered. The payback period method is usually used when a company has limited funds to invest in a project and therefore wants to know how quickly it can recover its investment. For example, a company is planning on investing $10,000 in a project that is expected to generate cash flows of $2,000 per year for the next eight years. This means that the company would recover its initial investment in the project in 5 years’ time ($10,000/$2000).
b) Discounted Payback Period Method
The payback period method does not take into account the concept known as the time value of money (TVM). TVM is a concept as per which money you have now is worth more than the identical sum in the future due to its earning capacity.
In order to address this deficiency, discounted payback period method was developed. This method helps in discounting a project’s future cash flows to their present values and then comparing the discounted cash flows with the project’s initial investment amount. The time that a project takes for the present value of future cash flows to equal the initial investment cost indicates an entity of when the project in which it is considering to invest will break even. A general rule when using this method is to accept investment projects having a shorter payback period than the target timeframe.
c) Net Present Value
The net present value (NPV) of a project is computed by comparing the present value of all cash inflows with the present value of all cash outflows over the life of the project. Only, the investment project that has a positive NPV is considered for selection. In case, there are multiple investment projects, the project with the highest NPV is normally selected.
In this method, a project’s cash flows are discounted to their present values through the use of a discount rate/ factor. The discount rate is an integral component of the analysis. It may represent different approaches for a business using this method. For example, it may represent the cost of capital such as cost of using internal funds or the cost of borrowing funds from a third party. The discount rate may also represent the threshold rate of return (TRR) which a business requires from a specific project before it decides to select that project. Selecting an appropriate discount factor is critical for an accurate NPV analysis.
d) Accounting Rate of Return
Accounting rate of return (ARR) is basically a formula that is used for calculating the rate of return expected of an asset or investment project by taking into consideration its initial investment cost.
In this technique, the average net income expected of an asset or investment project is divided by the expected average investment cost to calculate the expected return.
The ARR formula is as follows:
ARR= Average net profit/ Average initial investment
e) Internal Rate of Return
Another technique used for analyzing capital investments is the Internal Rate of Return (IRR). This method is used in financial analysis to assess the profitability of potential investment projects. IRR can be defined as the rate of return at which NPV becomes zero. IRR is usually used together with NPV analysis to assess whether investment projects should move forward or not. The formula used for calculating IRR is as follows:
0 (NPV) = P0 + P1/(1+IRR) + P2/(1+IRR)2 + P3/(1+IRR)3 +…….+ Pn/(1+IRR)n
- P0 equals the initial investment
- P1, P2, P3, and so on equals the cash flows in periods 1, 2, 3, etc.
- NPV refers to the project’s net present value
- IRR is the project’s internal rate of return
- N refers to the number of holding periods
f) Profitability Index
Another measure that is used for determining the acceptability of a capital investment project is the Profitability Index. This index is calculated by dividing the present value of cash flows of the project under review by the present value of cash flows of the same project. Usually, a capital investment project having a profitability index of greater than one is accepted. If it is less than one then the project having such an index is rejected. The formula of the profitability index is as follows:
Profitability index = Present value of cash inflows/ Present value of cash outflows.