Capital Budgeting

What is Capital Budgeting?
Capital Budgeting is defined as the process by which a business determines which fixed asset
purchases or project investments are acceptable and which are not. Using this approach, each
proposed investment is given a quantitative analysis, allowing rational judgment to be made by
the business owners.
Capital asset management requires a lot of money; therefore, before making such investments,
they must do capital budgeting to ensure that the investment will procure profits for the
company. The companies must undertake initiatives that will lead to a growth in their
profitability and also boost their shareholder’s or investor’s wealth.
Features of Capital Budgeting
Capital Budgeting is characterized by the following features:
 There is a long duration between the initial investments and the expected returns.
 The organizations usually estimate large profits.
 The process involves high risks.
 It is a fixed investment over the long run.
 Investments made in a project determine the future financial condition of an organization.
 All projects require significant amounts of funding.
 The amount of investment made in the project determines the profitability of a company.
How Capital Budgeting Works
It is of prime importance for a company when dealing with capital budgeting
decisions that it determines whether or not the project will be profitable.
Although we shall learn all the capital budgeting methods, the most common
methods of selecting projects are:
1. Payback Period (PB)

2. Net Present Value (NPV)
3. Internal Rate of Return (IRR)
It might seem like an ideal capital budgeting approach would be one that
would result in positive answers for all three metrics, but often these
approaches will produce contradictory results. Some approaches will be
preferred over others based on the requirement of the business and the
selection criteria of the management. Despite this, these widely used
valuation methods have both benefits and drawbacks.
Investing in capital assets is determined by how they will affect cash flow in
the future, which is what capital budgeting is supposed to do. The capital
investment consumes less cash in the future while increasing the amount of
cash that enters the business later is preferable.
Keeping track of the timing is equally important. It is always better to

generate cash sooner than later if you consider the time value of money.
Other factors to consider include scale. To have a visible impact on a
company's final performance, it may be necessary for a large company to
focus its resources on assets that can generate large amounts of cash.
In smaller businesses, a project that has the potential to deliver rapid and
sizable cash flow may have to be rejected because the investment required
would exceed the company's capabilities.
The amount of work and time invested in capital budgeting will vary based
on the risk associated with a bad decision along with its potential benefits.
Therefore, a modest investment could be a wiser option if the company fears
the risk of bankruptcy in case the decisions go wrong.
Sunk costs are not considered in capital budgeting. The process focuses on
future cash flows rather than past expenses.
Techniques/Methods of Capital Budgeting

In addition to the many capital budgeting methods available, the following
list outlines a few by which companies can decide which projects to explore:
#1 Payback Period Method
It refers to the time taken by a proposed project to generate enough income

to cover the initial investment. The project with the quickest payback is
chosen by the company.
Formula:
#2 Net Present Value Method (NPV)
Evaluating capital investment projects is what the NPV method helps the
companies with. There may be inconsistencies in the cash flows created over
time. The cost of capital is used to discount it. An evaluation is done based
on the investment made. Whether a project is accepted or rejected depends
on the value of inflows over current outflows.
This method considers the time value of money and attributes it to the
company's objective, which is to maximize profits for its owners. The capital
cost factors in the cash flow during the entire lifespan of the product and the
risks associated with such a cash flow. Then, the capital cost is calculated
with the help of an estimate.
Formula:
#3 Internal Rate of Return (IRR)

IRR refers to the method where the NPV is zero. In such as condition, the
cash inflow rate equals the cash outflow rate. Although it considers the time
value of money, it is one of the complicated methods.
It follows the rule that if the IRR is more than the average cost of the capital,
then the company accepts the project, or else it rejects the project. If the
company faces a situation with multiple projects, then the project offering
the highest IRR is selected by them.
Examples:
Example of Payback Period Method:
An enterprise plans to invest $100,000 to enhance its manufacturing
process. It has two mutually independent options in front: Product A and
Product B. Product A exhibits a contribution of $25 and Product B of $15. The
expansion plan is projected to increase the output by 500 units for Product A
and 1,000 units for Product B.
Here, the incremental cash flow will be calculated as:
(25*500) = 12,500 for Product A
(15*1000) = 15,000 for Product B
The Payback Period for Product A is calculated as:

Product B = 100,000 / 15,000 = 6.7 years
This brings the enterprise to conclude that Product B has a shorter payback
period and therefore, it will invest in Product B.
Despite being an easy and time-efficient method, the Payback Period cannot
be called optimum as it does not consider the time value of money. The cash
flows at the earlier stages are better than the ones coming in at later stages.
The company may encounter two projections with the same payback period,
where one depicts higher cash flows in the earlier stages/years. In such as
case, the Payback Period may not be appropriate.
A similar consideration is that of a longer period, potentially bringing in

greater cash flows during a payback period. In such a case, if the company
selects the projects based solely on the payback period and without
considering the cash flows, then this could prove detrimental for the financial
prospects of the company.
Example of Net Present Value (NPR):

For a company, let’s assume the following conditions:
Capital investment = $10,000, Expected Inflow in First Year = $1,000
Expected Inflow in Second Year = $2,500; Expected Inflow in Third Year = $3,500
Expected Inflow in Fourth Year = $2,650; Expected Inflow in Fifth Year = $4,150
Discount Rate = 9%
Solution:
Net Present Value achieved at the end of the calculation is= (With 9%
Discount Rate ) $18,629
This indicates that if the NPV comes out to be positive and indicates profit.
Therefore, the company shall move ahead with the project.
Example of Internal Rate of Return (IRR):

Here, The IRR of Project A is 7.9% which is above the Threshold Rate of
Return (We assume it is 7% in this case.) So, the company will accept the
project. However, if the Threshold Rate of Return would be 10%, then it
would be rejected as the IRR would be lower. In that case, the company will
choose Project B which shows a higher IRR as compared to the Threshold
Rate of Return.

Capital Budgeting

Uploaded by

Copyright:

Available Formats

Capital Budgeting

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Capital Budgeting

Uploaded by

Copyright:

Available Formats

What is Capital Budgeting?

Features of Capital Budgeting

Capital Budgeting is characterized by the following features:

1. Payback Period (PB)

Keeping track of the timing is equally important. It is always better to

Techniques/Methods of Capital Budgeting

#1 Payback Period Method

It refers to the time taken by a proposed project to generate enough income

#2 Net Present Value Method (NPV)

#3 Internal Rate of Return (IRR)

Here, the incremental cash flow will be calculated as:

(25*500) = 12,500 for Product A

(15*1000) = 15,000 for Product B

The Payback Period for Product A is calculated as:

A similar consideration is that of a longer period, potentially bringing in

Example of Net Present Value (NPR):

Capital investment = $10,000, Expected Inflow in First Year = $1,000

Example of Internal Rate of Return (IRR):

You might also like