Capital budgeting refers to the process of evaluating potential risks and expected returns of a project. It helps businesses to establish a quantitative view of every proposed investment, which enables them to make rational decisions. Typically, such investments pertain to long-term assets that can potentially increase an organization’s profitability.
Before knowing the different capital budgeting techniques, let’s take a look at this accounting concept in more detail.
Understanding the Meaning of Capital Budgeting
An organization, irrespective of its size, is often caught in the dilemma of choosing between two or more projects. Ideally, a business would want to invest in every profitable project. But that is not possible owing to the limited availability of capital. Accordingly, businesses have to do a project that would provide the best return on investment.
Individuals are often caught up in similar situations as well. Here’s an example:
Let’s say Mr. Singh’s laptop is malfunctioning. He can repair it, or he can buy a new laptop. Although the cost of repairing his laptop would increase the device’s lifespan, there might be a possibility that the cost of a new laptop would be lower than the cost of repair.
Hence, Mr. Singh would want to check out different laptops that would fit his budget. After weighing the pros and cons of different models, he would choose the most suitable option. This can be done via the process of capital budgeting.
In simple terms, capital budgeting is an accounting concept that businesses can utilize to decide which project they should pursue.
Here are some categories of projects that businesses can evaluate using capital budgeting techniques:
- Purchase of a new long-term (fixed) asset, for example, plant and machinery, land and building, etc.
- Replacement of any equipment that is obsolete
- Launch of a new product in a market
- Expansion of operations in different geographical areas, etc.
Keep in mind that principles concerning capital budgeting are applicable for other business-related decisions, for example, working capital management.
Importance of Capital Budgeting
Given below are a few reasons why capital budgeting is crucial for any business:
Identifying the Right Fund Sources:
Identifying the correct sources and quantum of funds is a vital objective of capital budgeting. Businesses can use this concept to find the ideal balance between returns on investment and the cost of borrowing.
For example, let’s say that a business requires funds worth Rs. 20,00,000 to finance the expenses of a project and the estimated returns form 21%. The manager can assess each of the financing options (business loans, loan against property, etc.) and pick the one which has the lowest cost of borrowing.
Impacts Future Success:
Businesses utilize capital budgeting techniques to decide which long-term assets to purchase. Accordingly, this accounting principle impacts the future success of an organization.
Controlling Capital Costs:
Before approving a certain project, managers can utilize capital budgeting to make a budget for the project’s costs., They can predict a timeline for the project’s ROI and decide if the potential value of that project justifies the required investment of capital. Once the project is underway, businesses can use capital budgeting to evaluate the progress and the efficacy of the investment decisions.
Lastly, through efficient capital budgeting, companies can maximize shareholders’ value.
Capital Budgeting Process
The capital budgeting process involves these steps:
Step 1: Generation of New Investment Ideas
The most crucial step concerning the capital budgeting process is formulating new investment ideas that can boost earnings. Such ideas may come from various sources, such as a senior member of the management team, any particular department of the organization, consultants, etc.
Step 2: Evaluation of Investment Proposals
Businesses must accumulate adequate information to predict cash flow from each of the investment proposals. This would enable them to determine which project is the best in terms of profitability.
Step 3: Selection of the Most Profitable Project
An organization will choose the most profitable project based on projected future cash flows.
Step 4: Planning of Capital Budget and Allocation of funds
After the selection of the most profitable investment proposal, the business has to fund it. To finance the expenses related to the project, an organization has to efficiently identify the right sources of funds and allocate the required amount accordingly. Examples of such sources of funds include loans, reserves, etc.
Step 5: Tracking and Evaluation
For managers, it is vital to monitor all decisions related to capital budgeting. They must compare actual results with the projected figures and find out what caused deviations (if any). An evaluation is necessary to identify any systematic error in the projection process. This would enable the managers to make changes and improve the business’s operations.
Capital Budgeting Techniques
There are various capital budgeting techniques that businesses can utilize to decide which projects they can accept. Let’s check out each of these techniques in detail.
Payback Period
The payback period technique involves calculating the duration required to recover the amount invested initially. It serves as a measure of liquidity for business organizations. If a company has issues concerning liquidity, the shorter the payback period of a project, the better.
Given below is the formula for calculating the payback period:
Payback period = Cost of Initial Investment ÷ Net Annual Cash Flow
Average Rate of Return (ARR)
To find out the most profitable project using the ARR technique, one has to divide the overall net income of any project by average investment.
ARR formula is given below:
ARR = Total Net Income of a Project ÷ Average Investment
If a business opts for this capital budgeting technique, it should consider projects that have a higher ARR than the minimum expected rate of return.
Net Present Value (NPV)
To calculate the net present value or NPV of any project, one has to find out the difference between the present value of cash outflows and inflows over a time period. According to the NPV rule, managers should only consider those projects that have a positive NPV. In case there is more than one project with a positive NPV, it is likely that a manager will select the one having the highest NPV.
Internal Rate of Return
Internal rate of return or IRR is a discount rate due to which the present value of any project’s projected cash inflows (after-tax) becomes equal to the present value of the projected cash outflows. As per the IRR rule, if IRR is higher than the required rate of return (RRR), which is typically the cost of capital, managers can accept a project.
Profitability Index (PI)
The profitability index refers to the ratio of a project’s present value of future cash flows and the initial cost of investment. There’s a close relation between NPV and PI. In case the NPV of any project is positive, its PI will be greater than 1. Accordingly, when PI is more than 1, managers may consider accepting the project.
Discounted Cash Flows
The Discounted cash flow technique is also referred to as a time-adjusted technique. This method takes into account the time value of money while assessing the benefits and expenses of a project. This valuation technique is utilized to get an estimate of the value of a project on the basis of its projected future cash flows.
Final Word
Typically, investments in long-term assets involve a substantial amount of funds. If the project turns out to be a failure, it could lead to the bankruptcy of a company. On the other hand, selecting the right investment proposals can take a business to greater heights. Accordingly, it is essential that managers use capital budgeting techniques efficiently to choose the most profitable project.