Principles of Capital Budgeting: Methods and Formulas
Capital budgeting is the process of analyzing investment opportunities and deciding which ones to accept. Capital budgeting is very important for companies. Because, companies determine which investments need to be prioritized. Also, it enables companies allocate their financial resources more effectively and maximize its value.
Capital budgeting involves generation of investment proposals, the valuation of cash flows for the proposals, evaluation of cash flows, selection of projects based on an acceptance criterion, and the continuous reevaluation of projects after their acceptance.
Investment projects can be grouped into three categories:
- New products and expansion of existing products
- Replacement of equipment and buildings
- Research and Development projects
Capital budgeting process is also known by the term investment appraisal which involves technical evaluation, financial evaluation, and economic evaluation.
Technical Evaluation
Technical appraisal of investment projects involves the analysis and decision making regarding the following issues:
- Determination of the technical specifications and quality standards of output
- The choice of optimum production capacity
- Breakdown of the investment by years
- Determination of the total cost of the fixed investment
- Location selection
- Determining the need for technical assistance, patent, know-how and their cost
- Selection of the technical specifications of the machinery and equipment
- Controlling the adequacy of the available infra-structure
- Evaluation of the availability of raw materials and the flexibility regarding the number and choice of suppliers
Financial Evaluation
In the financial appraisal of investment projects , cash flows expected over the life of the project are estimated and the riskiness of cash flows is determined . The discount rate appropriate for the project’s risk level is used to discount the cash flows and estimate the profitability of the investment alternatives.
Financial evaluation involves:
- Estimation of working capital and initial investment needs
- Breakdown of the investment by years
- Estimation of production costs, operating costs,and other operating cash outflows
- Estimation of operating cash inflows
- Determining the financing need and sources
- Estimation of the discount rate for the Project
- Formation of projected income statements over the life of the Project
- Evaluating the profitability of the investment proposals
Basic inputs to financial analysis:
- Cash flow Schedule
-
- The amount of initial outlay to acquire Project
- The amount of cash that will be released when the investment is liquidated at the end of its economic life (Terminal value)
- The stream of cash flows that will generate over the life of the investment
-
- The times at which the cash inflows and outflows are expected to occur
- The expected productive life of the investment
- The rate of return (hurdle rate which reflects the project’s riskiness) at which this investment be evaluated
Economic Evaluation
Economic evaluation of the projects involves the following steps:
- Evaluation of the consistency of the investment with the development policy. ( five-year targets, objectives of development, annual targets)
- Effects on national income:
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- Determining the value added of the investment
- Determining Capital/ Output ratio
- Effects on Capital /Employment ratio
- Social profitability estimation
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- Effects on the Balance of Payments:
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- Foreign exchange earnings of the Project
- Marginal productivity of foreign Exchange
- Foreign Exchange output- capital relations
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Capital Budgeting Methods: Discounting and Nondiscounting
Discounting Methods
The discounted cash flow methods weigh the time value of money and focus on cash inflows and outflows rather than net income.
Assumptions of discounted cash flows:
- Required rate of return on the project is constant
- Cash flows are certain
- Cash flows are independent
- Initial amount that can be borrowed or loaned at the specified discount rate
1. Net Present Value (NPV) Method
With net present value method , all cash flows are discounted to present, using the required rate of return.
n
NPV= ∑ At / (1+k)t
t=1
If NPV is equal to or greater than zero, the proposal is acceptable.If not, it is rejected. When NPV is positive, the firm is taking on a project with a return greater than that necessary to leave the market price of the stock unchanged.
2. Internal Rate of Return (IRR) Method
Internal rate of return is the discount rate that equates the present value of the expected cash outflows with the present value of the expected cash inflows.
n
∑ At / (1+r)t =0
t=0
where At is the cash flow for period t whether it be a net cash outflow or inflow and n is the last period in which a cash flow is expected.If cash flows are even, then initial outlay is divided by cash flows and the corresponding interest rate is found.
3. Profitability Index
Profitability index of a project is the present value of future net cash flows over the initial outlay.
n
PI = ∑ At / (1+k)t/ A0
t=1
As long as profitability index (PI) is equal to greater than one, the investment is acceptable.
Comparison of the Discounting Methods
NPV method only produces optimal solutions under conditions of certainty and perfect knowledge. The valuation based on NPV assumes that all net cash flows from a project are paid out as dividends and that cash flows are known with certainty.By accepting all projects which have a positive NPV, we ensure that V0 is maximized since we assume the value of the firm is the total present value of cash dividends from its projects. Thus ignoring uncertainty, value of the firm depends on the size of its dividend stream and discount rate. Under uncertainty, the use of NPV may not be optimal. So, NPV models should be adjusted for uncertainty.
NPV and IRR have different reinvestment assumptions. These methods have different assumptions with respect to the marginal reinvestment rate on funds released from the projects.The IRR implies that the funds are reinvested at the internal rate of return over the remaining life of the proposal. NPV assumes a reinvestment rate equal to the required rate of return.
NPV always provides correct rankings of mutually exclusive projects whereas IRR sometimes does not.IRR asumes a high reinvestment rate for projects with high IRR and vice versa.With the NPV method, the reinvestment rate is the same for each proposal.
Nondiscounting Methods
1. Payback Period Method
Payback period is the time projects have to run before their original investment is returned. The decision rule is to accept any project having equal or shorter payback than the target period.
Advantages:
- Payback method makes use of incremental cash flows.It is a popular method because:
- It has applications to industries subject to rapid changes
- When used with a low payback, it is referred to as a dynamic policy where the firm restricts itself to high standards
- Payback period helps to assess the risks of a time nature. However, even if two projects have the same payback, they may have different cash flows and payback does not consider the flow of benefits within the payback.
Shortcomings of the method:
- Payback method ignores profitability.A project can have a high payback but low discounted yield
- Payback method ignores the time value of money
- Payback method does not consider cash flows beyond the payback period
2. Average Rate of Return Method
The average rate of return is an accounting method and represents the ratio of the average annual profits after taxes to the initial nvestment.
Average rate of return (ARR) = Average Net Profit / Initial investment
The advantages of the methos is that the method is simple to use. It rests on accounting data, rather than cash flows , which is easier to obtain.
The disadvantages of the method is that it disregards the pattern of cash flows and their timing.
The Bottom Line
Capital budgeting is an essential tool for companies to achieve long-term growth. It helps companies to plan their future investments. Companies analyze alternative projects and decide which ones to accept through capital budgeting process.
With proper capital budgeting methods, companies use their limited financial resources more effectively, reduce the risk of investing, and maximize their value in the long-term.
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