Capital budgeting refers to the method used by businesses to determine as well as evaluate the major potential investments or expenses. These investments and expenditures include projects like a new plant or building or investments in a long-term enterprise. The long-term monetary outflows and inflows of a prospective project are often assessed for determining whether a proper benchmark, also referred to as “investment appraisal”, is met by potential returns.
Methods of Capital Budgeting
Businesses need to ideally pursue all chances and projects that improve the value of shareholders. However, given the fact that there is limited capital amount is available for new projects at any specific time, capital budgeting methods have to be used by the management for determining which projects would be the most profitable over a specific time period.
There are different Capital Budgeting methods, which can include:
- Accounting rate of return method (ARR)
- Throughput analysis
- Net present value (NPV)
- Internal rate of return (IRR)
- Discounted cash flow (DCF)
- Payback period
There are famous techniques to determine which projects have to get investment funds over other projects. These include the following:
Accounting rate of return method (ARR)
This technique assists in overcoming the cons of the method of Payback period. It expresses the return rate as a percentage of the investment earnings in a specific project. It works on the important criteria that any type of project with ARR that is greater than the minimum rate specified by the management would be accepted while those under the rate would be rejected.
ARR takes the whole economic life of a project into account, and offers a better method of comparison. It also uses the Net Earnings concept to ensure full compensation of projects that are expected to generate profits. But the technique has a drawback in the sense that it ignores the time worth of money and fails to consider the entire lifespan of projects. It is also inconsistent with the aim of a business to maximize the market worth of its shares.
It is measured in the form of how much material is passing through a specific system. It is the most complex type of capital budgeting analysis, although it is the most precise in assisting managers determine the kind of projects to focus on. In this technique, the whole corporation is regarded as a single system that generates profit.
This analysis supposes that almost all the system expenses are operating costs. A company has to optimize the throughput of the whole system for paying the entire expenses. It is assumed that maximizing the throughput that goes through a bottleneck operation is the method to earn optimal profits. A bottleneck is a system resource that needs the most time during the operations. This indicates that managers always need to put more emphasis on capital budgeting projects impacting and increasing throughput that pass through bottlenecks.
The name itself is an indication that the technique is all about the period where the proposal generates enough cash for recovering the initial investment. It focuses mainly on the cash inflows, the investment that is made in the project and the economic life of the same project, without considering the worth of money in terms of time.
In this technique, a proposal is chosen based on how much a project can earn. The project can be chosen or rejected with basic calculations, and the results can help determine the risks that are included. However, this technique is founded on thumb rule. The associated aspects of profitability and the importance of the worth of money in time are not considered.
Net present Value (NPV)
The technique happens to be one that is used most widely, for the evaluation of the proposals of capital investment. The inflow of cash, in this method, expected at various time periods gets a specific rate of discount.
The current cash inflow values are compared to the investment amount that is originally put in. It is accepted in case of a positive (+) difference and rejected in case there is a negative (-) difference. The process takes the time value of money in consideration and it is consistent with the aim of profit maximization for owners. However, it is not easy to understand the concept of capital cost.
DCF (Discounted Cash Flow) Analysis
It is the same as NPV analysis or at least similar, in the sense that is focuses on the initial cash outflow required for financing a project, various types of costs, future outflows as maintenance, mix of cash inflows as revenue. Other than the initial outflow, such counts are discounted to the current date. The NPV is the resultant number of the DCF analysis. Projects that come with the most NPV have to be ranked higher than others, unless either or other is exclusive mutually.
The technique of DCF (Discounted Cash Flow) computes the cash outflow and inflow through an asset’s life. Then, a discounting factor is used to discount them and the discounted cash outflows and inflows are compared. The method takes the interest factor as well as the return after the period of payback in consideration.
Internal Rate of Return (IRR)
It means the rate which an investment’s net present worth amounts to zero. The discounted cash inflow equals the discounted cash outflow. The technique also takes the time worth of money in consideration. It attempts to arrive at an interest rate in which funds that are invested in a project can be paid again from the money that flows in. However, calculating IRR happens to be a long drawn and laborious process.
It is referred to as Internal Rate, as it completely depends in the outlay and the project proceeds, and not on any rate that is determined externally to the investment.
This is the simplest type of capital budgeting analysis, and happens to be least precise as a result. But this technique is still in use as it is fast and provides managers with a clearer view of how effective a project or cluster of projects happens to be. The analysis helps calculate the amount of time will be needed for recouping a project investment. The period for payback is identified by using the average annual cash inflow to divide the initial investment.
Why Capital Budgeting is Important?
Capital budgeting is important for the following reasons:
- Capital expenditures happen to be long term investments, and these include more financial risks. Naturally, it is important to use capital budgeting for a proper planning.
- Capital expenditures are huge investments but the funds are restricted. It is important to plan properly. Capital investment decisions also happen to be irreversible in form. In other words, once there is purchase of a permanent asset, losses shall be incurred on its disposal.
- Capital budgeting also helps lower the expenses and brings some changes in the company profitability. The use of this process can help companies to under-invest or over-invest. With proper project planning and analysis, there can be gains over the long term.
Capital budgeting is an important financial management tool. It provides financial managers with a wide scope for the evaluation of various projects according to their investment viability.