Capital budgeting is a bookkeeping or accounting principle that businesses use to figure out projects that add value to them. With the help of different capital budgeting techniques, you can understand the decision-making process used by investors and companies.
Companies use capital budgeting to assess key projects and investments like new plants or hardware. The capital budgeting cycle includes analyzing cash inflows and outflows of a project to decide if the expected return would meet the set benchmark. Some of the common methods used in capital budgeting decisions incorporate payback, discounted cash flow, throughput analyses, etc.
What is Capital Budgeting?
Definition: Capital budgeting is defined as the process that businesses embrace to assess potential major projects or investments. It includes picking projects that increase the value of your business.
It is associated with the decision-making process that businesses use to understand which capital-intensive projects they should opt for. It is important because it creates accountability and measurability.
Why is Capital Budgeting Important?
It helps in evaluating and measuring the value of a project throughout its life cycle. Investors might use capital budgeting for analyzing investment options and determining which ones are worth to invest.
It also assists financial decision-makers to make informed financial decisions for a wide variety of projects like investing in new buildings, technology, equipment, etc, expanding into new markets, developing new products, improving existing technology, equipment, expanding workforce, etc.
Capital budgeting assists in creating a budget for the costs of the project along with estimating the timeline for the ROI of the project and analyzing the potential value of the project. After starting a project, the capital budgeting process is also used for measuring the progress and effectiveness of the project and investment decisions.
Capital Budgeting Methods
Two popular capital budgeting techniques that can assist businesses in selecting the best investment are based on the comparison of cash inflows and outflows. Let us have a look at these techniques-
A – Traditional Method
1. Payback Period
This method is the least difficult method for making a budget for the new projects. It estimates how much time it will take to earn sufficient cash inflows from a project for recovering your investments.
This technique is used for calculating the time period required for earning the initial investment of the project or investment. It suggests that the investment or project with the shortest duration should be opted for.
2. Average Rate of Return (ARR)
The ARR technique suggests that the total net income of the investment is divided by the initial or average investment for deriving the most profitable investment.
B- Discounted Cash Flow Methods
This method is also called “time-adjusted techniques” as such methods consider the time value of money while assessing the expenses and advantages of projects.
In it, the cash flows associated with the project are discounted at the cost of capital. Let us have a look at the two types of these methods-
1. Net present value (NPV)
This method is used for measuring how profitable you can expect a project to be.
While utilizing NPV, any project having a positive net present value will be considered acceptable while projects with a negative net present value will not be OK.
As one of the most well-known capital budgeting strategies, NPV assists you with picking the most productive projects or investments.
The NPV is calculated by considering the difference between the present value of cash inflows and the present value of cash outflows over a given time span. The investments with the positive Net Present Value are supposed to be considered. And when there are multiple projects, the projects having the higher NPVs will be more likely to be selected.
2. Internal rate of return (IRR)
The IRR method estimates the return rate you can hope to get from a particular project.
When you use this method, you need to understand that the more the rate of return rate exceeds the initial capital investment percentage of the project, the more favorable will be the project.
It is quite normal for businesses to utilize the internal rate of return method to pick between available project options.
IRR can be understood as the rate at which the NPV becomes zero. The projects having higher IRR are generally selected.
3. Profitability index (PI)
It is again one of the key capital budgeting methods.
It is also called “profit investment ratio (PIR),” “value investment ratio (VIR), and “benefit-cost ratio (BCR)”.
It suggests a relationship between the investment and the payoff of the project, and it is primarily used for ranking projects.
It can be understood as the ratio of the present value of future cash flows of the project to the initial investment required for these projects.
Each of these capital budgeting techniques includes inherent upsides and downsides.
Therefore, companies or businesses need to use the best-suited technique for assisting them in budgeting. Businesses might also opt for different techniques and compare the results for finalizing the best profitable projects.
Objectives of Capital Budgeting Methods
Some of the objectives of capital budgeting methods are-
- Determining profitable projects
- Ensuring capital expenditure control
- Determining the quantum of funds
- Finding the right sources for funds
Capital Budgeting Process
Different steps involved in the capital budgeting processes are-
1. Recognizing investment opportunities
Finding out the investment opportunities is one of the first steps of capital budgeting. These opportunities can be anything like product expansion, or new business line or purchasing new assets, etc.
2. Assessing investment proposals
The next step revolves around assessing different options for investment purposes. It will help you in deciding how to acquire new products or assets.
3. Choosing a profitable investment
After identifying investment opportunities and evaluating or assessing them, you need to finalize the most profitable investment and select it.
4. Capital Budgeting and Apportionment
In this step, sources of funds and their allocation are decided as per the specific needs of the chosen opportunities. Sources of such funds can be investments, reserves, loans, or any other possible channels.
5. Performance Review
This step suggests a revision of the investment. In this, the comparison will take place between the expected performance of the investments and their actual performance.
Best Practices in Capital Budgeting
Some of the key practices for effective capital budgeting are
1. Decisions based on actual cash flows
You need to understand here that just incremental cash flows are applicable to the capital budgeting process. The sunk costs ought to be ignored during the process.
2. Cash flow timing
Cash flows that are received earlier in the life of projects are considered worthier than future cash flows received later. In simple words, cash flows that take place earlier have a bigger time horizon.
3. Cash flows are based on opportunity costs
Evaluation of projects is done on the incremental cash flows that they bring in far beyond the amount that they might generate in their next best alternative use. This practice is followed for quantifying how much better one project is over another project.
4. Cash flows are computed on an after-tax basis
As taxes, interest payments, depreciation, amortization, etc are costs that take place independently of a project, they ought not to be considered while analyzing the profitability of a project.
5. Financing costs are ignored from calculations of operating cash flows
Financing costs are reflected in the expected rate of return from such an investment project, so cash flows are not adapted to these expenses. The expenses are generally harmonious with the company’s Weighted Average Cost of Capital (WACC) that addresses the expense the company incurs to run its current capital design. During the valuations of the project, discount rates used are frequently the WACC of the company. Consequently, this is one more constant that can be ignored also.
As a final observation, it can be said that capital budgeting is one of the key functions of effective financial management.
The process of making the right financial decisions get alleviated by capital budgeting that can lead businesses to greater heights. While choosing budgeting methods, making a single wrong decision might inch the business closer to shut down.
So, these capital budgeting methods should be analyzed adeptly to let businesses choose the best-suited methods to optimize financial success.