What is Capital Budgeting? Principles, Process, Techniques

What is Capital Budgeting?

Capital Budgeting play a vital role in the future profitability of a concern. The process of decisions to invest a sum of money when the expected results will flow after the lapse of a period of more than one year is called Capital Budgeting. It also includes the process of decision regarding disinvestment, i.e., a decision to sell off an undertaking or a part of it. Normally, however, specially in these days, it is the former type of decision which predominates.

It is a most important decision to make since afterwards, after money has been irrevocably committed, it may not be possible to do much in improving results. A capital investment decision entails a mostly permanent commitment of money, which is usually fraught with risk. Such decisions have longterm implications for an organisation’s sustainability and flexibility. Accepting non-viable plans drains an organisation’s capital and can potentially lead to bankruptcy.

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Capital Budgeting (Investment Appraisal)

Capital budgeting can be described as the mechanism by which businesses determine the purchasing of major fixed assets such as machinery, equipment, and buildings, as well as the acquisition of other businesses, either through the purchase of equity shares or a group of assets, to conduct ongoing operations. Capital budgeting is a structured preparation mechanism for the acquisition and investment of capital that results in a capital budget, or it can be understood as firm’s formal strategic outlay for fixed asset acquisition.

Principles of Capital Budgeting

Capital budgeting typically adopts the following principles:

• Cash flows are used to make decisions rather than accounting measures like net profits.
  
  
• The pacing of cash flows is extremely important.
  
  
• Opportunity costs are used to calculate cash flows. The incremental cash flows that occur with an investment are compared to the cash flows that occur without the investment.
  
  
• The borrowing costs are not taken into account. Since financing costs are already accounted for in the appropriate discounting rate, including that in the cash flows and discount rate will lead to double counting.
  
  
• Cash flows in capital budgeting are not the same as the net profits in accounting.

Process of Capital Budgeting

Capital budgeting is a decision-making mechanism by which businesses assess the acquisition of large fixed assets such as buildings, machinery, and equipment. It also includes decisions to buy other companies, either through the acquisition of their common stock or a collection of assets that can be used to run a company.

The capital budgeting process consists of five steps:

• Proposal for project: Proposals for new investment programmes are made at all levels of a company and reviewed by finance personnel and key management bodies.
  
  
• Review and analysis of projects: Financial administrators, including main management bodies, conduct formal reviews, and analyses to evaluate investment ideas’ merits and demerits.
  
  
• Decision making about proposals: Capital expenditure decision-making is usually dependent on capital availability and limits.
  
  
• Selection and implementation: Expenditures are made, and programmes are initiated after identification, analysis, selection, and approval.
  
  
• Follow-up and review process: Outcomes are tracked and real costs and benefits are compared to what was predicted. If actual results vary from those predicted, action may be taken.

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Basics of Capital Budgeting Techniques

A project’s cash flows are calculated using discounted and non-discounted cash flows methods. Followings are some basics techniques of capital budgeting.

Discounted Cash Flows

Discounted cash flow, or DCF, methods account for the time value of money when determining the viability of projects. The shift in thepurchasing power of the dollar over time is represented by this time value. DCF methods often show the opportunity cost, or the cost of foregoing other investments to make the chosen investment. Net present value, internal rate of return, and profitability index are the three most popular DCF methods.

Net Present Value

The difference between an investment’s present value of cash inflows and present value of cash outflows is known as the net present value or NPV. The cash flow forecasts are based on a market-based discount rate, also known as a hurdle rate, that takes into account the time value of money. In dollar terms, net present value (NPV) expresses the effect of an investment on wealth creation.

Allow capital investments with positive cash flows and dismiss those with negative cash flows as a rule of thumb. This is because a positive net present value (NPV) indicates that the investment’s cash flow would be adequate to cover its expenses, borrowing costs, and underlying cash flow risks.

Internal Rate of Return

The internal rate of return, or IRR, is the average rate of return on an investment over the course of its useful life. The IRR is the discount rate that causes the NPV to become zero. This is the discount rate at which the current value of cash outflows equals the present value of cash inflows, or anything similar. Accept a capital expenditure if the IRR exceeds the cost of capital; deny it if the IRR falls below the cost of capital.

Profitability Index

The profitability index, or PI, is the ratio of an investment’s net present value to its cost of capital. The present value of cash inflows divided by the present value of cash outflows is shown. This method simplifies investment ranking, especially when dealing with mutually exclusive investments or limited capital resources. When PI is greater than 1, accept the capital investment; and when PI is less than 1, deny it.

Non discounted Cash Flows

Non-DCF strategies ignore the time value of currency, assuming that the dollar’s value will remain constant over the economic life of a capital investment. The only non-DCF approach that uses cash flow estimations is the payback period or PBP. PBP is the time it takes to recoup an investment’s initial capital. Shorter PBP investments are favoured over longer PBP investments. However, since it does not reveal the timing of cash flows or the time value of money, this approach has significant flaws.

Risk Analysis

The process of assessing the existence and extent of anticipated and unforeseen setbacks that may derail the achievement of investment goals is known as risk analysis. The probability of a long-term investment failing to produce the anticipated cash flows is referred to as a capital budgeting risk.

Such risks occur as a result of flaws in potential cash flow forecasts, exposing the company to the risk of making capital investments that aren’t profitable. It is important to assess those potential risks and apply the necessary risk premiums, or the rate of return you can expect in exchange for taking on the additional risks.