Techniques used in Capital Budgeting: With Examples

What is Capital Budgeting?

Capital Budgeting is an investment viability assessment exercise that the company undertakes to determine its investment decisions. Every company must invest in new projects and keep upgrading the existing facilities to keep up the growth momentum and when looking at various available options for expansion by way of investment into plant and machinery, Research and other long-term assets capital budgeting exercise gives actionable insights. Available options need to be analysed in terms of their ability to generate return in excess of cost involved in taking up the projects for completion to cover cost of capital and create value for its shareholders. This money can be from internal accruals or a borrowed money from financials institutions and from shareholders, everything has a cost attached to it one needs to consider the WACC to get the cost of capital for doing a Capital Budgeting analysis. Projects which don’t fetch returns more than company’s WACC not to be taken up for further considerations as they are going to become liability for the company and don’t have positive cash flow maximize shareholder value.

 

Capital budgeting essentially measures the time value of money by way of discounting the future cash flows to arrive at a net present value of anticipated cash flows from projects under evaluation. It helps finance professionals to evenly leverage its available resources for growth plans and not to remain over or under invested in opportunities. In other words, for the project to stand viable project IRR shall surpass hurdle rate.

 

Best Techniques used in Capital Budgeting

To arrive at a viable investment decision the below methods can be used as stand appropriate depending on planned outplay, company size, economic situation and industry prospects:

 

IRR:

Most common method to understand the real returns the projects can generate without attaching it to cost of capital. Internal Rate of Return exercise considers cash outflow and cash flow year on year and where net present value in zero. Higher the IRR it can be considered good and needs to be adjusted to uncertainties in the project duration. Every capital budgeting exercise assumes future cash flows and it involves high risks, IRR method can be helpful to evaluate projects rate of return and manually adjustable to various possibilities.

 

Application of IRR in Capital Budgeting:

In Capital Budgeting If the IRR is more than Cost of Capital its Acceptable.

If the IRR is less than the Cost of Capital, then it’s not desirable and hence rejected.

 

NPV:

Under Net Present Value or NPV method in capital budgeting the net outflow is deducted from Discounted Cash inflows from the project. The outcome should be positive to consider the project as good. Here applying a appropriate Discount Rate is key a rate which not only involves the Cost of Capital but also which carries minimum desirable returns for shareholders. In other words, the NPV should be more than zero to stand as viable for investment.

 

Application of NPV in Capital Budgeting:

 

If Current Value of Cash Inflows are more and Current Value of Cash Outflows the Projects is considered positive for investment.

 

If the Present value of Cash Inflows are less than the Current Value of Cash Outflows the project is considered as negative for investment.

 

Profitability Index:

Under PI method of Capital Budgeting the Present value (PV) of future cash inflows is divided on Initial Cash Outflows or Total Investment during the project life cycle. This is used to rank projects based on profitability index ratio, the higher the profitability index of project the better returns are visible and projects with high PI can be taken up for investment compared to projects which indicate lower PI.

 

Factors attached to Capital Budgeting Decisions:

Not only the method used in determining the project viability affect capital budgeting of companies there are several other factors which needs to be considered while doing a through capital budgeting exercise:

 

Economic Situation: Anticipated cash flows from any projects are in line with economic situation of the country in which the projects are planned and the analysis of economic situation and government policies affecting the sector needs to be taken into account while applying a discounting rate for future cash flows.

 

Funds Availability: This is crucial to the while capital budgeting exercise as availability of funds and their cost needs to be pre-examined to arrive at WACC. All available options of funding including Internal Accruals, Loans from lending institutions or shareholders capital infusion. The continuous flow of planned cash to complete the project without affecting the working capita cycle is crucial to manage present operations without the burden of future expansion.  Each project needs to be evaluated in proportions to its ability to self-sustain and generate positive cash flows if possible synergy and not dependence on existing business assets.

 

Future: Any capital outlay and capital budgeting should give second thought to its future plans and vision of the company not all good investment decision is great if they are not in line with company core business model, as these are long term and large investments.

Management decisions: Every decision on large investment must get management nod to see light of the sun. Vision of management and its decision among key decision makers influence the final call taken to implement projects. This is crucial, and key is how well the professionals and projects evaluators can convey the message to the management which is insightful and actionable.

 

 

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