Capital Budgeting and its Techniques:

 Capital Budgeting

Meaning of Capital Budgeting

Capital budgeting is the process where the need of fixed assets is assessed and it is checked which project for fixed assets is need to accepted and which project is to be rejected. In this process, a quantitative analysis is done for the proposed investment is done and then decision is taken after proper analysis.

Features of Capital Budgeting

1.      Capital budgeting is concerned with long term decision making as it is related to fixed investments which are for long term in an organization.

2.      It involves huge risks as there can be the huge negative difference between initial investments and expected return.

3.      This process involves huge amount of funding as it is concern with long term sources of funds.

4.      Investments made in the projects decide the future of a company.

5.      Payback Period, Net Present Value Method, Internal Rate of Return, and Profitability Index are the methods to carry out capital budgeting.

6.      The process of capital budgeting involves the  following steps

                                i.            Identifying the potential projects,

                              ii.            Evaluating them,

                            iii.            Selecting and implementing the projects,

                            iv.            Then finally reviewing the performance for future considerations.

Techniques of Capital Budgeting

The most common methods of capital budgeting are as follows:

1. Payback Period (PB)
2. Internal Rate of Return (IRR)
3. Net Present Value (NPV) and
4. Profitability Index(PI)

1.      Payback  Period Method

This method involves assessing the proposed project on the basis of time taken in generating the initial capital invested in the beginning. On the basis of this method, the project which is taking least time to generate the enough capital what was invested in the beginning is chosen by the company.

Formula for calculating payback period under this method:

Example for this method     

Suppose an enterprise has with it Rs. 100 lac which it is seeking for making fixed investments and for which there are two options available with the company:

1.      Project A which is having the initial investment 100 lac and will contribute fixed 10% of investment annually.

2.      Project B which is also having the initial investment of 100 lac but will contribute uneven cash inflow annually in this way:

                                   i.            First year : 20 lac

                                 ii.            Second year: 30 lac

                               iii.            Third year : 10 lac

                               iv.            Fourth year : 60 lac

Thus, payback period for the first project would be:

Payback period= Initial investment/Net annual cash inflows

Initial investment = 100 lac,

Net annual cash flow = 100 lac/10%of 100 lac

=100 lac/10 lac = 10 years 

→Payback period for Project B (as there is uneven inflow, we have to calculate the payback period by calculating the cumulative flow for each year for project B.

It will be calculated this way:

How to choose payback period for uneven cash flow:

Step 1: We have to choose the year in which the flow was last negative (3rd year) → 3

Step2: Then divide the cumulative flow of last negative year by total flow of first positive year (fourth year) →40/60 = 0.6

Step 3: At last add the values calculated in first two steps.

It will be calculated for the above example in this way

3+4/6 = 3+ 0.6 = 3.6 are approx. 4 years.

So we will choose 4th year.  So it will take 4 years to cover the outflows

Project A or B?

Obviously as the payback period is less which is 4 years in project B. So company must choose Project B.

Advantages of Payback Period method:

        i.             It is the most easiest and simplest method even in uneven cash flows

      ii.            It is the best method for small business especially where the investment is done for shorter span of time.

Limitations of payback period method:

        i.            Time value of money is not considered.

      ii.            And this method doesn’t calculate the flows post return. Some projects may generate high profits.

1.      Net Present Value Method (NPV) Method:

This method is also known as “Discounted cash flow method” and while computing the net present value, it considers the time value of money. The decision of dropping or accepting the project is based on the net present value of the investment. Net present value is calculated by deducting the present value of cash outflows from the present value of cash inflows and that decides the decision to drop or accept the project. Net present value can be positive (when inflows are more than outflows), zero (outflows and inflows are equal) or negative (outflows are more than inflows).

Formula for calculating Net present value under this method:

Example for NPV method:

Suppose a project requires initial investment of 10 lac and cash inflow for 4 years:

                                   i.            First year : 2 lac

                                 ii.            Second year: 3 lac

                               iii.            Third year : 4 lac

                               iv.            Fourth year : 6 lac

                                 v.            Addition: 12% is the discount rate.

Net present value calculation:

As the net present value is positive, the project seems attractive, company may go for it.

Advantages of NPV method:

        i.            It involves Time value of money.

      ii.            It is the easy method as compared to IRR method.

Limitations of Net Present value method:

        i.            It is complex method as compared to other methods.

      ii.            It assumes that there is immediate reinvestment of cash inflows. But this assumption doesn’t settle down sometimes.

1.      Internal Rate of Return (IRR):

IRR method works on one basic assumption that NPV is Zero (the inflows are equal to outflows). It is the most complicated method as it also involves calculation of time value of money.

A project is accepted when IRR is more than average cost of capital  which is basically calculated on the basis of present value of future inflows and if IRR is less than average cost of capital, the project is canceled. In the cases where there are many projects to choose from, then the project with highest IRR is accepted.

Formula for Internal rate of return under this method:

0 = C₁/(1+r) + C₂/(1+r)₂ + C₃/(1+r)₃+ ....+ C_n/(1+r)_n - initial investment

Internal Rate of Return Rule = Accept investments if IRR greater than Threshold Rate of Return, else reject.

Example for IRR method:

Let suppose there are two projects for the company named project A and Project B.

Both the projects require initial investment of 100 lac and cash inflow for 4 years:

As we have assumed the threshold rate of return to be 12% but Product A , at 12% IRR , it is having positive net flow , this continues till 15 % and as at 16%, it will start giving negative net flow. So in conclusion we can say the IRR for Project A would be 15%.

Similarly, let us check IRR for project B

There is constant inflow of 40 lac in all the 5 years for project B and talking about the assumed IRR that was 12%, Project B can hold for more than that and as we can see through the sheet that there is positive flow till the IRR is 21% and it started getting negative when it was increased to 22%. So, we can say that IRR for project B is 22% which is even greater than IRR of Project A which was 15% that tells us that a company must go with Project B.

Advantages of IRR method:

        i.            It involves the calculation of present value of inflows which means it considers time value of money.

      ii.            It gives the limit of IRR.

Limitations of Internal rate of return method:

        i.            It is the most complicated method as involves time value of value

      ii.            It is a hit and trial method, it becomes difficult to calculate the exact IRR of a project.

 

1.      Profitability Index

This method is particularly used for calculation of ratio of present value of future cash flows to initial investment. for analyzing the projects on the basis of profitability Index, it is assumed that if the relation between present value of future inflows to initial investment is less than 1.00 which basically means the initial investment is more than the net inflows, then the project would be rejected otherwise if the ratio between the two is more than 1   which means there are more cash inflows than the initial investment that indicates that the project should be accepted.

Formula for this method:

Example for PI method:

Suppose a project named XYZ requires initial investment of 10 lac and cash inflow for 4 years:

                                   i.            First year : 20 lac

                                 ii.            Second year: 30 lac

                               iii.            Third year : 40 lac

                               iv.            Fourth year : 60 lac

                                 v.            Addition: 12% is the discount rate

Now let us calculate the exact cash flow for Project XYZ

So, Profitability Index of Project XYZ with 12% discount = NPV of Inflow + Initial Investment

                                                                   Initial Investment

                                                                                             = 10840000/10000000 =1.08

As per the assumption of the method, the profitability index is positive and more than 1.00 for the 12% discount rate, and therefore, the proposed project will be selected.

Advantages of Profitability Index method:

        i.            Its main advantage is that it is mathematically supports the decision for individual projects as NPV.

Limitations of Profitability Index method:

        i.             There can be huge differences in the cash inflows and while using this method, PI ranking can be conflicting when will come to NPV ranking.

Conclusion:

 As there are some limitations in every method of capital budgeting. Which method is to be used depends on the circumstances and type of business.

• For example: For small businesses where the investments are made generally for shorter span of time, payback period would be acceptable as it doesn’t include time value of money, it would be quite simple for a small business.
• Talking about when there is longer time span of investment, rest of the methods would be considered good based on the complexity and number of projects which are proposed and also depends on the requirement of investment.