What is Capital Budgeting?

Capital budgeting is a decision-making process whereby long-term investments is evaluated and selected based on whether such investment is worth pursuing in future or not. It plays an important role in financial decision-making as it impacts the profitability of the business in the long term. The benefits of capital budgeting may be in the form of increased revenue or reduction in cost. The capital budgeting decisions include replacing or rebuilding of the fixed assets, addition of an asset. These long-term investment decisions involve a large number of funds and are irreversible because the market for the second-hand asset may be difficult to find and will have an effect over long-time spam. A right decision can yield favorable returns on the other hand a wrong decision may have an effect on the sustainability of the firm. Capital budgeting helps businesses to understand risks that are involved in undertaking capital investment. It also enables them to choose the option which generates the best return by applying the various capital budgeting techniques.

Capital budgeting should be done only after the firm’s corporate strategy is determined. The capital budgeting process is interchangeably called investment appraisal which involves stages such as identifying and screening the project, selecting the project, implement it and after implementation review the performance. Apart from all this, capital budgeting is also affected by various factors such as working capital, accounting methods, accounting policies, decision of the management, and many more.

The three types of capital budgeting decision are as:

• Accept or reject decision
• Mutually exclusive project decision
• Capital rationing decision.

Capital Budgeting Techniques

Average rate of return (ARR): ARR is also known as accounting rate of return and it measures the return that is expected from an investment. The proposed capital expenditure evaluated is not based on cash flows but on accounting information. The formula for calculating average rate of return is

$\text{ARR}=\left(\frac{\text{ Average annual profit after taxes}}{\text{Average investment over the life of the project}}\right)\times 100$

EXAMPLE

Solution

$\text{Average income of machines A and B}=\frac{\$35,000}{5}=\$7,000$

$\begin{array}{c}\text{Average investment of machine A and B}=\text{Salvage value}+\left[\frac{1}{2}\times \left(\text{Cost of machines}–\text{Salvage value}\right)\right]\\ =\$3,000+\left[\frac{1}{2}\times \left(\$56,000-\$3,000\right)\right]=\$29,500\end{array}$

$\begin{array}{c}\text{ARR }\left(\text{For both machines X and Y}\right)=\left(\frac{\text{Average income}}{\text{Average investment}}\right)\times 100\\ =\left(\frac{\$7,000}{\$29,500}\right)\times 100=\text{23}\text{.7}3\%\end{array}$

Another approach for calculating ARR is in which the original cost is used in place of average cost. So, in this case, ARR for machines X and Y:

Therefore, after determining the ARR, the decision can be taken on whether to accept or reject the investment. It can be done by comparing it to a set target. Taking the above example, if the target is set to be 15% then the project would be selected under the first method and rejected under the second approach. If the actual ARR is higher than the minimum required rate of return, a project is qualified to be accepted.

Payback Method

This method is used to determine the years it will take to recover the original cost of investment. The shorter payback period is considered a better payback period because it indicates the recovery of the investment amount is faster. There is two approach of calculating payback period. The first method is when the stream of cash inflows for each year is equal. The formula for calculation of payback period is

Payback period = (Initial cost of investment/ constant annual cash flows).

EXAMPLE

An investment in a machine cost $1,000,000 and is expected to generate cash flow after tax (CFAT) of $500,000 for 5 years.

Solution – Payback period = $2,000,000/$400,000 = 5years.

Time – adjusted technique – In this technique, it involves consideration of time value and money. All methods under this require the future cash flow to be discounted at a given rate.

Present value method (PV)- PV method is used to determine the current value of future expected cash inflows. It shows that, the value of the money that is received today is worth more than the value of the money that is received in the future. The formula for calculating the present value method is:

$\text{Present Value (PV)}=\text{Future Value ×}{\left(\frac{\text{1}}{\text{1+r}}\right)}^{\text{n}}$

Where,

 r= rate of return

n= number of periods.

(1/1+r${)}^n$ = present value factor.

Example calculate the present value of the given cash flow after tax for the following five years. Market interest rate is 10%. Initial outlay is $50,000.

The present value of cash flow is more than cash outflow therefore this investment

Proposal is acceptable.

Net present value method (NPV) – This method is used to determine the present value of future cash flows. If NPV is positive project is accepted but if it is negative the project is rejected. The following are the formula to calculate NPV:

$\text{Net present value }\left(\text{NPV}\right)=\frac{\text{Cash flows}}{{\text{(1+i)}}^{\text{t}}}-\text{Initial investment}$

Where,

i= discount rate

t= number of times period.

Interest rate of return (IRR) method: In this method, the time value of money is considered by discounting the cash flows and it calculates the discount rate in which NPV should be equal to zero. The IRR is calculated by using the formula given below:

$\text{Initial investment}=\frac{\text{Cash flow}}{{\text{(1+r)}}^{\text{n}}}$

Where,

r= discount rate

n= time period

$\text{Internal rate of return }\left(\text{IRR}\right)=\text{r}\times \frac{\text{PB}-{\text{DF}}_{\text{r}}}{{\text{DF}}_{\text{rL}}-{\text{DF}}_{\text{rH}}}$$$

Where,

PB    = payback period

D$F_r$ = discount factor for interest rate r

D$F_{rL}$ = Discount factor for higher interest rate

D$F_{rH}$ = Discount factor for highest interest rate

Profitability Index (PI): This method is used to understand the profitability of capital invested. The criterion on which the project will be accepted if profitability index is greater than one and rejected if it is lesser than one. The formula for calculating profitability index is:

Profitability index = present value of Cash inflows / present value of cash outflow

Example

Let’s example of 4 initial outlays is $50,000 and cash inflows is $65,215.

Profitability index = $65,215 / $50000 = 1.30.

Context and Applications  

This topic is significant in the professional exams for both undergraduate and graduate courses, especially for

• B.B.A in Finance  
• M.B.A in Finance