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Meaning of Capital Budgeting
Capital Budgeting is a process used for evaluating the long term investments that are of capital nature. It helps in finding out potential investments and expenditures that will provide a better return to business. Capital budgeting is also known as investment appraisal process as it aims at increasing the return of business by choosing the most profitable project.
It analyses and finds out whether it is worth to fund through the firm capitalization structure the long term investments like purchase or replacement of machinery, new plants and products and project related to research development. It is an important process which helps managers in deciding out the most profitable capital projects by comparing all cash inflows and cash outflows of the project.
It makes the choice clear that which project should be accepted and which should be declined. Capital budgeting process involves: Identification of investment opportunities, then evaluating and choosing the most profitable investment, now capital budgeting and apportionment and at last review of the performance.
The different techniques of capital budgeting used by business are: Net present value, Payback period method, Internal rate of return, accounting rate of return and Profitability index. Capital budgeting is termed as predominant function of management. Different methods/techniques used in capital budgeting process are discussed below:
Techniques of Capital Budgeting
Payback Period
Payback period is the most common and easiest technique of capital budgeting process. This method measures how long will a project take to generate cash to recover the initial investment value. It does not consider the time value of money and cash flow are not discounted in this method.
Payback period method gives preference to the project having a shorter payback period means the one which is able to recover the initial investment made in short time. It pays to focus on cash flows, the investment made and economic life of the project to find out the best earning capacity project. If the project undertaken generates constant return, then the payback period can be simply computed by dividing total cash outflow by annual cash inflow of project.
Payback period = Cash outlay (Investment)/Annual cash inflow
Net Present Value Method
Net present value method of capital budgeting considers the time value of money. It discounts all cash inflows and cash outflows of the project using the cost of capital as the discounting factor. It compares the presented value of all cash inflows and cash outflows of the project and where the difference is maximum in the positive sense that the project is given preference.
Higher the present cash inflows from cash outflows higher will be NPV which means the project is profitable. The difficult task in this method is understanding the concept of a firm’s cost of capital used as a discounting factor. Net Present value is simply calculated as –
Net present value = Present value of inflow – Present value of outflow
Accounting Rate of Return Method
Accounting rate of return method uses the information provided by financial statements in judging the profitability of the investment proposal. It is simply a financial ratio which evaluates the profit potential of a proposal.
It judges the profitability of the project by dividing the total net income of the project with its average or initial investment. It does not consider the time value of money nor does it focus on the length of life of the project. Accounting rate of return is calculated by the following formula:
Accounting rate of return = Average income/ Average investment
Internal rate of return
Internal rate of return method is one of the most complex methods of capital budgeting involving various computations. This method equates the discounted cash inflow value with discounted cash outflow value of an investment. It aims to arrive at a rate of interest at which the Net present value of the investment is zero. It is termed as an internal rate because it does not depend on any rate determined outside the investment but only with the outlay and proceeds associated with the project.
Calculation of IRR involves the following step – Finding out positive net present value, finding out the negative net present value and finding out the internal rate of return.
Internal rate of return = [Lower rate + (Positive NPV / Diff. in positive & negative NPV)] × DP
DP refers to the difference in the percentage of positive and negative NPV
Lower rate is the rate at which NPV is greater than Zero or NPV is positive
Profitability Index
It is a method in which NPV is used as a basis of calculation and calculations are expressed in percentage. Profitability index method is also known as a value investment ratio or profit investment ratio. This method analyses the project by evaluating the relationship between the costs associated with the project and its future anticipated benefits.
It is simply the ratio between the present value of cash inflows and the present value of cash outflows. If the profitability index is lower than 1.0 than it means that the present value of cash inflows is lower than the initial investment cost. Whereas if it is more than 1.0 than the project is considered as worthy and acceptable.
Profitability Index = Present value of cash inflow / Initial Investment