Every organization prepares budget to achieve its short term and long term goals. Budgeting is a process to create a plan to spend the money available with the organization. Some of such plans are short term plans and some are long term plans. To achieve the short term goals of the organization, annual plans or short term plans are made but for achieving long term objectives, such as investing in a project, purchase of land and other properties, long term planning is needed which is also called capital budgeting. We will learn more about “capital budgeting’ in this article.

What is Capital Budgeting?

Capital Budgeting is the process of spending your money in acquiring land, properties, other fixed assets like machinery, vehicles, etc. Making investment decisions in the projects also come under capital budgeting. Capital budgeting is necessary for strategic purposes, to achieve long term objectives and for the sustainability & growth of the organization. Capital budgeting help us to decide which fixed assets or the projects are worth investing for the benefit of the organization.

Features of the Capital Budgeting

There are following features of the capital budgeting:

(1) Capital budgeting involves large capital to handle.

(2) It is for long duration.

(3) It is aimed to achieve strategic objectives, long term goals and/or large profits.

(4) It is a fixed investment.

(5) Capital budgeting involves high risk.

(6) The investment is usually arranged from the external sources rather than the internal ones.

Methods Used for Capital Budgeting

To successfully accomplish the capital budgeting, it is crucial to know whether the project or the fixed asset, the company is considering for investment, is profitable or not. There are various methods to determine this, which are discussed below in detail. It is important to note that the companies should cross check their final budget with other methods available, so that any shortcoming in the budget due to a particular method may be rectified.

Traditional Methods

Traditional methods consider the useful life of the project or asset and the expected returns, however, these methods do not take into account the ‘time value of money’, an important concept which should be consider to determine the profitability of a project. Following traditional methods are used for capital budgeting:

(i) Pay Back Period Method

Payback period is the number of years in which the initial cost of investment will be recovered. For e.g., if a capital budgeting keeps provision of investing USD 10 million in a project, then the payback period will give you the number of years by which, the initial investment (i.e. USD 10 million) will be recovered. Obviously, a shorter the payback period, more desirable will be the project because it means that the project would pay for itself in a shorter span of time.

Let us understand this with the following example:

In the above example, we can easily see that the payback period will fall somewhere between year 3 and year 4 as within this period, the initial investment will be recovered.

The payback method is useful for the firms facing liquidity issue. The firms having limited funds invest in one project at a time and they choose the project having less payback period so that they may recover their initial investment quickly and invest it in another project.

There are some drawbacks of payback period also. First, the payback period does not take into account time value of money, which is a major factor to be considered in estimating the profitability of the project. This drawback can easily be rectified if we adopt the more refined version of this method, i.e., discounted payback period method.

Second, the payback period ignores the cash flow occurring at the end, such as salvage value. Thus, the payback method is not a direct measure of profitability.

(ii) Average Rate of Return Method

This method is based on determining average rate of return, which is calculated using the following formula:

Average rate of return= 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

The criteria for selection of the projects using this method is that the projects having average rate of return more than the expected rate of return are chosen and the other projects are rejected.

Discounted Cash Flow Methods

(i) Net Present Value(NPV) Method

Net Present Value is the difference between present value of all cash inflows and present value of all cash outflows during a certain period of time. The present value of all the future payments is calculated using the discount rate and compared with the present value of all the cash inflows. The difference between the two gives NPV of a project or investment.

      Where:

Cash flow1, cash flow 2 ,…………..cash flow n are the cash flows in period (say year) 1, 2,………….n.

r= Discount rate

n= number of periods

Example: Find the NPV of the project having the following data:

Discount rate= 8%

Solution: To determine the NPV of the project, we will have to calculate the present values of all cash flows first, using the following formula:

Then the present values of all cash flows will be added together to get the NPV of the project. It is important to note that the initial investment, it any, will be subtracted from this because it represents cash outflow.

(ii) Internal Rate of Return (IRR) Method

Internal Rate of Return (IRR) is a financial parameter which is used to determine the profitability of an investment, project or the business proposal. In other words, it is the discount rate that makes the net present value (NPV) of a project zero. You can also say that it is the expected annual rate of return, that has to earned from an investment or a project.

In this method, the IRR of the project or investment is calculated using the formula, as mentioned below. It is then compared with the cost of capital or the interest rate.

If the IRR is greater than or equal to the cost of capital, it means that the proposal is worth accepting and will be profitable.

In the IRR is less than the cost of capital, it means that it is now wise to go ahead with the proposal.

Internal Rate of Return of a project is calculated using the following formula:

Example: The internal rates of two projects are given below:

Let the threshold rate of return is 6.5% in this case. The project A is acceptable since its IRR is more than the threshold rate of return. However, if the threshold rate of return would be 9%, then the project A would not be acceptable because its IRR is less than the threshold rate of return. Project B would be more acceptable in this case because its IRR is more than the threshold rate of return.

(iii) Profitability Index (PI)

Profitability index (PI) is the ratio of the present value of all the cash inflows to the initial investment.

It may have following scenarios:

Example:

Calculate the profitability index of the project having the following series of cash flows having a discount rate of 8%:

Solution: We will first calculate the present values of all future cash flows and add them. The profitability index will be obtained by dividing the sum of present values of all cash flows with the initial investment. The present value of all the cash flows shall be calculated either by using the following formula or by the excel sheet.

You can see that the profitability index of above project is 1.0794, hence the project is profitable.

Conclusion

The capital budgeting is an important process for the companies from strategic point of view as well as to achieve the long term objectives of the organization. There are certain merits as well as demerits of all the methods employed for capital budgeting. The payback period method is simple and easy but it ignores the time value of money. The Net Present Value method does not consider the size of the project. A single method therefore cannot be relied upon for finalization of the capital budget. The companies must analyze the capital budget using more than methods to make it more effective.

Also read: Using the Time Value of Money Concept in Business Decisions