Capital Budgeting

What is 'Capital Budgeting'

Capital budgeting is the process in which a business determines and evaluates potential
large expenses or investments. These expenditures and investments include projects
such as building a new plant or investing in a long-term venture. Often, a company
assesses a prospective project's lifetime cash inflows and outflows to determine
whether the potential returns generated meet a sufficient target benchmark, also known
as "investment appraisal."

In other words,Capital budgeting is the process that a business uses to determine

which proposed fixed asset purchases it should accept, and which should be
declined. This process is used to create a quantitative view of each proposed fixed
asset investment, thereby giving a rational basis for making a judgment.

Ideally, businesses should pursue all projects and opportunities that enhance
shareholder value. However, because the amount of capital available for new projects is
limited, management needs to use capital budgeting techniques to determine which
projects will yield the most return over an applicable period. Various methods of capital
budgeting can include throughout analysis, net present value, internal rate of return,
discounted cash flow and payback period.

The Importance of Capital Budgeting

The amount of cash involved in a fixed asset investment may be so large that it
could lead to the bankruptcy of a firm if the investment fails. Consequently, capital
budgeting is a mandatory activity for larger fixed asset proposals. This is less of an
issue for smaller investments; in these latter cases, it is better to streamline the
capital budgeting process substantially, so that the focus is more on getting the
investments made as expeditiously as possible; by doing so, the operations of profit
centers are not hindered by the analysis of their fixed asset proposals.
1) Long term investments involve risks:
Capital expenditures are long term investments which involve more financial risks. That
is why proper planning through capital budgeting is needed.
2) Huge investments and irreversible ones:
As the investments are huge but the funds are limited, proper planning through capital
expenditure is a pre-requisite. Also, the capital investment decisions are irreversible in
nature, i.e. once a permanent asset is purchased its disposal shall incur losses.
3) Long run in the business:
Capital budgeting reduces the costs as well as brings changes in the profitability of the
company. It helps avoid over or under investments. Proper planning and analysis of the
projects helps in the long run.

SIGNIFICANCE OF CAPITAL BUDGETING

 Capital budgeting is an essential tool in financial management
 Capital budgeting provides a wide scope for financial managers to evaluate
different projects in terms of their viability to be taken up for investments
 It helps in exposing the risk and uncertainty of different projects
 It helps in keeping a check on over or under investments
 The management is provided with an effective control on cost of capital
expenditure projects
 Ultimately the fate of a business is decided on how optimally the available
resources are used

Capital Budgeting: Techniques, tools, Methods

 There are different methods adopted for capital budgeting.

The traditional methods or non discount methods include:
Payback period and Accounting rate of return method. The
discounted cash flow method includes the NPV method,
profitability index method and IRR
Payback period method:

As the name suggests, this method refers to the period in which

the proposal will generate cash to recover the initial investment
made. It purely emphasizes on the cash inflows, economic life of
the project and the investment made in the project, with no
consideration to time value of money. Through this method
selection of a proposal is based on the earning capacity of the
project. With simple calculations, selection or rejection of the
project can be done, with results that will help gauge the risks
involved. However, as the method is based on thumb rule, it does
not consider the importance of time value of money and so the
relevant dimensions of profitability.
The payback period is the most basic and simple decision tool. With this method, you
are basically determining how long it will take to pay back the initial investment that is
required to undergo a project. In order to calculate this, you would take the total cost of
the project and divide it by how much cash inflow you expect to receive each year; this
will give you the total number of years or the payback period. For example, if you are
considering buying a gas station that is selling for $100,000 and that gas station
produces cash flows of $20,000 a year, the payback period is five years.

As you might surmise, the payback period is probably best served when dealing with
small and simple investment projects. This simplicity should not be interpreted as
ineffective, however. If the business is generating healthy levels of cash flow that allow
a project to recoup its investment in a few short years, the payback period can be a
highly effective and efficient way to evaluate a project. When dealing with mutually
exclusive projects, the project with the shorter payback period should be selected.

Payback period = Cash outlay (investment) / Annual cash

inflow

Example
Project Project
A B
Cost 1,00,000 1,00,000
 Expected future
cash flow
Year 1 50,000 1,00,000
Year 2 50,000 5,000
Year 3 1,10,000 5,000
Year 4 None None
TOTAL 2,10,000 1,10,000
Payback 2 years 1 year
Payback period of project B is shorter than A, but project A
provides higher returns. Hence, project A is superior to B.

Accounting rate of return method (ARR):

This method helps to overcome the disadvantages of the payback

period method. The rate of return is expressed as a percentage of
the earnings of the investment in a particular project. It works on
the criteria that any project having ARR higher than the minimum
rate established by the management will be considered and those
below the predetermined rate are rejected.
This method takes into account the entire economic life of a
project providing a better means of comparison. It also ensures
compensation of expected profitability of projects through the
concept of net earnings. However, this method also ignores time
value of money and doesn’t consider the length of life of the
projects. Also it is not consistent with the firm’s objective of
maximizing the market value of shares.
ARR= Average income/Average Investment
Discounted cash flow method:

The discounted cash flow technique calculates the cash inflow

and outflow through the life of an asset. These are then
discounted through a discounting factor. The discounted cash
inflows and outflows are then compared. This technique takes into
account the interest factor and the return after the payback
period.
Discounted cash flow (DCF) is a valuation method used to estimate the attractiveness
of an investment opportunity. DCF analyses use future free cash flow projections and
discounts them, using a required annual rate, to arrive at present value estimates. A
present value estimate is then used to evaluate the potential for investment. If the value
arrived at through DCF analysis is higher than the current cost of the investment, the
opportunity may be a good one.

Calculated as:

DCF = [CF1 / (1+r)1] + [CF2 / (1+r)2] + ... + [CFn / (1+r)n]

CF = Cash Flow

r= discount rate (WACC)

DCF is also known as the Discounted Cash Flows Model.

BREAKING DOWN 'Discounted Cash Flow (DCF)'

Several methods exist when it comes to assigning values to cash flows and the discount
rate in a DCF analysis. But while the calculations involved are complex, the purpose of
DCF analysis is simply to estimate the money an investor would receive from an
investment, adjusted for the time value of money.

The time value of money is the assumption that a dollar today is worth more than a
dollar tomorrow. For example, assuming 5% annual interest, $1.00 in a savings account
will be worth $1.05 in a year. Due to the symmetric property (if a=b, then b=a), we must
consider $1.05 a year from now to be worth $1.00 today. When it comes to assessing
the future value of investments, it is common to use the weighted average cost of
capital (WACC) as the discount rate.

For a hypothetical Company X, we would apply DCF analysis by first estimating the
firm's future cash flow growth. We would start by determining the company's trailing
twelve month (TTM) free cash flow (FCF), equal to that period's operating cash
flow minus capital expenditures.
Say that Company X's TTM FCF is $50m. We would compare this figure to previous
years' cash flows in order to estimate a rate of growth. It is also important to consider
the source of this growth. Are sales increasing? Are costs declining? These factors will
inform assessments of the growth rate's sustainability.

Say that you estimate that Company X's cash flow will grow by 10% in the first two
years, then 5% in the following three. After a few years, you may apply a long-term cash
flow growth rate, representing an assumption of annual growth from that point on. This
value should probably not exceed the long-term growth prospects of the overall
economy by too much; we will say that Company X's is 3%. You will then calculate a
WACC; say it comes out to 8%.

The terminal value, or long-term valuation the company's growth approaches, is

calculated using the Gordon Growth Model:

Terminal value = projected cash flow for final year (1 + long-term growth rate) /
(discount rate - long-term growth rate).

Now you can estimate the cash flow for each period, including the the terminal value:

Year 1 = 50 * 1.10 55

Year 2 = 55 * 1.10 60.5

Year 3 = 60.5 * 1.05 63.53

Year 4 = 63.53 * 1.05 66.70

Year 5 = 66.70 * 1.05 70.04

Terminal value = 70.04 (1.03) / (0.08 - 0.03) 1,442.75

Finally, to calculate Company X's discounted cash flow, you add each of these
projected cash flows, adjusting them for present value, using the WACC:

DCF of Company X = (55 / 1.081) + (60.5 / 1.082) + (63.53 / 1.083) + (66.70 / 1.084) +
(70.04 / 1.085) + (1,442.75 / 1.085)

DCF of Company X = 50.93 + 51.87 + 50.43 + 49.03 + 47.67 + 981.91

DCF of Company X = 1231.83

Our estimate of Company X's present enterprise value is $1.23 billion. If the company
has net debt, this needs to be subtracted, as equity holders' claims to a company's
assets are subordinate to bondholders'. The result is an estimate of the company's fair
equity value. If we divide that by the number of shares outstanding – say, 10 million –
we have a fair equity value per share of $123.18, which we can compare with the
market price of the stock. If our estimate is higher than the current stock price, we might
consider Company X a good investment.

Limitations of Discounted Cash Flow Model

Discounted cash flow models are powerful, but they are only as good as their inputs. As
the axiom goes, "garbage in, garbage out." Small changes in inputs can result in large
changes in the estimated value of a company, and every assumption has the potential
to erode the estimate's accuracy.

Read more: Discounted Cash Flow

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Net present Value (NPV) Method:

This is one of the widely used methods for evaluating capital

investment proposals. In this technique the cash inflow that is
expected at different periods of time is discounted at a particular
rate. The present values of the cash inflow are compared to the
original investment. If the difference between them is positive (+)
then it is accepted or otherwise rejected. This method considers
the time value of money and is consistent with the objective of
maximizing profits for the owners. However, understanding the
concept of cost of capital is not an easy task.
The term "present value" in NPV refers to the fact that cash flows earned in the future
are not worth as much as cash flows today. Discounting those future cash flows back to
the present creates an apples to apples comparison between the cash flows. The
difference provides you with the net present value.

The general rule of the NPV method is that independent projects are accepted when
NPV is positive and rejected when NPV is negative. In the case of mutually exclusive
projects, the project with the highest NPV should be accepted.

The equation for the net present value, assuming that all cash
outflows are made in the initial year (tg), will be:
Where A1, A2…. represent cash inflows, K is the firm’s cost of
capital, C is the cost of the investment proposal and n is the
expected life of the proposal. It should be noted that the cost of
capital, K, is assumed to be known, otherwise the net present,
value cannot be known.
NPV = PVB – PVC
where,
PVB = Present value of benefits
PVC = Present value of Costs

 Internal Rate of Return (IRR):

This is defined as the rate at which the net present value of the
investment is zero. The discounted cash inflow is equal to the
discounted cash outflow. This method also considers time value
of money. It tries to arrive to a rate of interest at which funds
invested in the project could be repaid out of the cash inflows.
However, computation of IRR is a tedious task.
It is called internal rate because it depends solely on the outlay
and proceeds associated with the project and not any rate
determined outside the investment.
The internal rate of return is a discount rate that is commonly used to determine how
much of a return an investor can expect to realize from a particular project. Strictly
defined, the internal rate of return is the discount rate that occurs when a project is
break even, or when the NPV equals 0. Here, the decision rule is simple: choose the
project where the IRR is higher than the cost of financing. In other words, if your cost of
capital is 5%, you don't accept projects unless the IRR is greater than 5%. The greater
the difference between the financing cost and the IRR, the more attractive the project
becomes.

The IRR decision rule is straightforward when it comes to independent projects;

however, the IRR rule in mutually-exclusive projects can be tricky. It's possible that two
mutually exclusive projects can have conflicting IRRs and NPVs, meaning that one
project has lower IRR but higher NPV than another project. These issues can arise
when initial investments between two projects are not equal. Despite the issues with
IRR, it is still a very useful metric utilized by businesses. Businesses often tend to value
percentages more than numbers (i.e., an IRR of 30% versus an NPV of $1,000,000
intuitively sounds much more meaningful and effective), as percentages are more
impactful in measuring investment success. Capital budgeting decision tools, like any
other business formula, are certainly not perfect barometers, but IRR is a highly-
effective concept that serves its purpose in the investment decision making process.

It can be determined by solving the following equation:

If IRR > WACC then the project is profitable.

If IRR > k = accept
If IR < k = reject

 Profitability Index (PI):

It is the ratio of the present value of future cash benefits, at the

required rate of return to the initial cash outflow of the investment.
It may be gross or net, net being simply gross minus one. The
formula to calculate profitability index (PI) or benefit cost (BC)
ratio is as follows.
Another technique of capital budgeting involves comparing the value of costs and the
value of the proposed project’s benefits. This is known as the profitability index, which is
calculated by dividing the initial investment by the current value of a project’s future
cash flows. If the profitability index is greater than 1.0, the profitability is positive and the
project is likely a good investment. If it is less than 1.0, the proposed project will lose
value. A profitability index equaling 1.0 indicates that the projects cash gains or losses
will be minimal.

In order to advise business owners properly regarding undertaking capital projects,

accountants must make use of a variety of budgeting methods. Knowing when to use
these techniques is an integral part of an their job. These and other capital budgeting
techniques are necessary functions that accountants can use to identify and
recommend profitable investments for organizations.

PI = PV cash inflows/Initial cash outlay A,

PI = NPV (benefits) / NPV (Costs)

All projects with PI > 1.0 is accepted.