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.
