Question

What do you incorporate into a capital budget?

Answer 1

Capital Budgeting

Capital investments are long-term investments in which the assets involved have useful lives of multiple years. Capital budgeting is a method of estimating the financial viability of a capital investment over the life of the investment.
Capital budgeting focuses on cash flows rather than profits. Capital budgeting involves identifying the cash in flows and cash out flows rather than accounting revenues and expenses flowing from the investment.

Below are the steps involved in capital budgeting.

1. Identify long-term goals of the individual or business.
2. Identify potential investment proposals for meeting the long-term goals identified in Step 1.
3. Estimate and analyze the relevant cash flows of the investment proposal identified in Step 2.
4. Determine financial feasibility of each of the investment proposals in Step 3 by using the capital budgeting methods outlined below.
5. Choose the projects to implement from among the investment proposals outlined in Step 4.
6. Implement the projects chosen in Step 5.
7. Monitor the projects implemented in Step 6 as to how they meet the capital budgeting projections and make adjustments where needed.

There are several capital budgeting analysis methods that can be used to determine the economic feasibility of a capital investment. They include the Payback Period, Discounted Payback Period, Net Present Value, Profitability Index, Internal Rate of Return, and Modified Internal Rate of Return.

Payback Period

It represents the amount of time required for the cash flows generated by the investment to repay the cost of the original investment. For example, assume that an investment of $500 will generate annual cash flows of $100 per year for 10 years. The number of years required to recoup the investment is five years.

Discounted Payback Period

The Payback Period analysis does not take into account the time value of money. To correct for this deficiency, the Discounted Payback Period method was created. This method discounts the future cash flows back to their present value so the investment and the stream of cash flows can be compared at the same time period. Each of the cash flows is discounted over the number of years from the time of the cash flow payment to the time of the original investment.

Net Present Value

The Net Present Value (NPV) method involves discounting a stream of future cash flows back to present value. The cash flows can be either positive (cash received) or negative (cash paid). The present value of the initial investment is its full face value because the investment is made at the beginning of the time period. The ending cash flow includes any monetary sale value or remaining value of the capital asset at the end of the analysis period, if any. The cash inflows and outflows over the life of the investment are then discounted back to their present values.

The Net Present Value is the amount by which the present value of the cash inflows exceeds the present value of the cash outflows. Conversely, if the present value of the cash outflows exceeds the present value of the cash inflows, the Net Present Value is negative.

Profitability Index

Another measure to determine the acceptability of a capital investment is the Profitability Index (PI). The Profitability Index is computed by dividing the present value of cash inflows of the capital investment by the present value of cash outflows of the capital investment. If the Profitability Index is greater than one, the capital investment is accepted. If it is less than one, the capital investment is rejected.

Internal Rate of Return

Another method of analyzing capital investments is the Internal Rate of Return (IRR). The Internal Rate of Return is the rate of return from the capital investment. In other words, the Internal Rate of Return is the discount rate that makes the Net Present Value equal to zero.

Modified Internal Rate of Return

Another problem with the Internal Rate of Return method is that it assumes that cash flows during the analysis period will be reinvested at the Internal Rate of Return. If the Internal Rate of Return is substan­tially different than the rate at which the cash flows can be reinvested, the results will be skewed.