Capital Budgeting

Capital Budgeting

• Capital Budgeting is a project selection exercise performed by the business enterprise.

• Capital budgeting uses the concept of present value to select the projects.

• Capital budgeting uses tools such as pay back period, net present value, internal rate of return,     profitability index to select projects.

Capital Budgeting Techniques

I. Profitability Index:

II. Discounted Payback Period

III. Internal Rate of Return

IV. Payback Period

V. Net Present Value

I. Profitability Index:

Profitability index (PI) is the ratio of investment to payoff of a suggested project. It is a useful capital budgeting technique for grading projects because it measures the value created by per unit of investment made by the investor.

This technique is also known as profit investment ratio (PIR), benefit-cost ratio and value investment ratio (VIR).

The ratio is calculated as follows:

Profitability Index = Present Value of Future Cash Flows / Initial Investment

If project has positive NPV, then the PV of future cash flows must be higher than the initial investment. Thus the Profitability Index for a project with positive NPV is greater than 1 and less than 1 for a project with negative NPV. This technique may be useful when available capital is limited and we can allocate funds to projects with the highest PIs.

Decision Rule:

Rules for the selection or rejection of a proposed project:

If Profit Index is greater than 1, then project should be accepted.

If Profit Index is less than 1, then reject the project.

II. Discounted Payback Period

One of the limitations in using payback period is that it does not take into account the time value of money. Thus, future cash inflows are not discounted or adjusted for debt/equity used to undertake the project , inflation, etc. However, the discounted payback period solves this problem. It considers the time value of money, it shows the breakeven after covering such costs. This technique is somewhat similar to payback period except that the expected future cash flows are discounted for computing payback period.

Discounted payback period is how long an investment’s cash flows, discounted at project’s cost of capital, will take to cover the initial cost of the project. In this approach, the PV of future cash inflows are cumulated up to time they cover the initial cost of the project. Discounted payback period is generally higher than payback period because it is money you will get in the future and will be less valuable than money today.

For example, assume a company purchased a machine for $10000 which yields cash inflows of $8000, $2000, and $1000 in year 1, 2 and 3 respectively. The cost of capital is 15%. The regular payback period for this project is exactly 2 year. But the discounted payback period will be more than 2 years because the first 2 years cumulative discounted cash flow of $8695.66 is not sufficient to cover the initial investment of $10000. The discounted payback period is 3 years.

Decision Rule of Discounted Payback:

If discounted payback period is smaller than some pre-determined number of years then an investment is worth undertaking.

III. Internal Rate of Return

Internal Rate of Return is another important technique used in Capital Budgeting Analysis to access the viability of an investment proposal. This is considered to be most important alternative to Net Present Value (NPV). IRR is “The Discount rate at which the costs of investment equal to the benefits of the investment. Or in other words IRR is the Required Rate that equates the NPV of an investment zero.

NPV and IRR methods will always result identical accept/reject decisions for independent projects. The reason is that whenever NPV is positive , IRR must exceed Cost of Capital. However this is not true in case of mutually exclusive projects.

The problem with IRR come about when Cash Flows are non-conventional or when we are looking for two projects which are mutually exclusive. Under such circumstances IRR can be misleading.

Suppose we have to evaluate two mutually exclusive projects. One of the project requires a higher initial investment than the second project; the first project may have a lower IRR value, but a higher NPV and should thus be accepted over the second project (assuming no capital rationing constraint).

Decision Rule of Internal Rate of Return:

If Internal Rate of Return exceeds the required rate of Return, the investment should be accepted or should be rejected otherwise.

IV. Payback Period

Payback period is the first formal and basic capital budgeting technique used to assess the viability of the project. It is defined as the time period required for the investment’s returns to cover its cost. Payback period is easy to apply and easy to understand technique; therefore, widely used by investors.

For example, an investment of $5000 which returns $1000 per year will have a five year payback period. Shorter payback periods are more desirable for the investors than longer payback periods.

It is considered as a method of analysis with serious limitations and qualifications for its use. Because it does not properly account for the time value of money, risk and other important considerations such as opportunity cost.

V. Net Present Value

Net Present Value measures the difference between present value of future cash inflows generated by a project and cash outflows during a specific period of time. With a help of net present value we can figure out an investment that is expected to generate positive cash flows.

In order to calculate net present value (NPV), we first estimate the expected future cash flows from a project under consideration. The next step is to calculate the present value of these cash flows by applying the discounted cash flow (DCF) valuation procedures. Once we have the estimated figures then we will estimate NPV as the difference between present value of cash inflows and the cost of investment.

NPV Formula:

NPV=Present Value of Future Cash Inflows – Cash Outflows (Investment Cost)

 In addition to this formula, there are various tools available to calculate the net present value e.g. by using tables and spreadsheets such as Microsoft Excel.

Decision Rule:

A prospective investment should be accepted if its Net Present Value is positive and rejected if it is negative.