Question

All there is to know about Capital Budgeting.

Answer 1

Capital budgeting is a type of planning process that is used to determine whether an organization’s long term investments are worth pursuing. A correct decision taken on capital budgeting can help a company survive in long run.

>>>The whole process of capital budgeting includes a number of steps which are undertaken systematically in an order:

Identification and Generation of Project ---- > Screening and Evaluation --- > Selection of Project --- > Implementation of Project --- > Performance Reviews

One should start out by identifying and generating a project, where project proposals are generated. The next step involves screening and evaluation which requires selecting all the correct criteria to judge a project proposal which is aligned to the firm objective and also generates value. In this step, one needs to decide on an estimated cost and calculate the benefits. In the next step of Project selection, the most important project proposal is identified and selected along with exploring the different ways to raise fund. In the implementation step, the project is implemented and is checked for cost and schedule overruns. After all these, a performance review is conducted to compare the actual versus the standard results.

>>>There are certain factors that affect the capital budgeting decisions including: availability of funds, capital structure, working capital, management decisions, accounting methods, earnings, economic value of the project etc.

>>> Capital Budgeting Techniques:

1) Net Present Value (NPV): It is the difference between the present values of all the future cash inflows and the present values of the cash outflows.

NPV Rule: If NPV>0, accept the project

                   If NPV<0, reject the project

2) Payback Period Method: Payback period is the total time required to recover the cost of investment. One way is to select the project with the lowest payback period among all the projects. The other way is to decide on a cutoff time period and then select all the projects that have payback period within that time limit. For example, if the cutoff period is considered to be 2 years, then all those projects with payback period <= 2 years should be considered

3) Discounted payback Period: In this method, at first the cash flows of each period are discounted and then the discounted cash flows are considered for payback period calculation in a similar manner

4) Profitability Index (PI): It is the ratio of the summation of present values of all the future cash inflows divided by the amount of investment

Rule: if PI > 1, accept the project

          If PI < 1, reject the project

4) Internal Rate of Return (IRR): It is the discounting rate at which the net present value of an investment becomes zero.

Formula: [CF1/(1+IRR) + CF2/(1+IRR)^2 + CF3/(1+IRR)^3 + ……. + CFn/ (1+IRR)^n] – initial investment = 0

Here, CF = Cash Flow

IRR Rule: If IRR> discount rate, accept the project

                 If IRR< discount rate, reject the project

Disadvantages of IRR:

In case of mutually exclusive projects, there can be a possibility of NPV and IRR conflict caused due to either the size of the project or cash flow distribution. In this case this is advisable to consider NPV as it is an absolute measure providing the dollar value of the return. On the other hand, IRR is considered to be a relative measure, which is used to rank different projects by providing their rate of return.

Other disadvantages of IRR:

->It is unable to distinguish between investing and borrowing activities.

-> A project can have multiple IRR if there is a cash outflow even after the investment has been made at time 0.

>>> Capital Budgeting Decisions:

-> Independent Projects: generally all the independent projects are accepted. An independent project is the one whose acceptance/rejection decision does not depend on the acceptance/rejection of other projects taken up by the same company.

-> Mutually Exclusive Projects: It is a type of project where the acceptance/rejection decision of one project will affect the decision to accept/reject other projects. The one with higher NPV should be considered.

-> Capital Rationing: This situation occurs when the firm does not have enough capital to fund all the positive NPV projects. In this case, one should check for the profitability index and select the project with the highest PI.