Accounting And Finance

Overview of Capital Budgeting Decisions and Techniques

Capital budgeting is a critical process in financial management. that involves evaluating and selecting long-term investment projects to drive a company’s growth and profitability. It is the foundation for making informed decisions about where to allocate resources, as it helps firms assess the potential returns and risks associated with large-scale expenditures.

 This process is essential for ensuring that capital is invested in projects aligning with the company’s strategic goals, whether expanding operations, acquiring new assets, or entering new markets.

The importance of capital budgeting cannot be overstated, as it directly influences a company’s financial health and long-term success. By carefully analyzing cash flows, costs, and expected benefits, businesses can prioritize investments with the best potential for future returns. Effective capital budgeting optimizes resource allocation and helps companies mitigate risks by avoiding unprofitable or overly risky projects. In today’s competitive and ever-changing business environment, mastering the principles of capital budgeting is crucial for sustaining growth and maintaining a competitive edge.

Brief Understanding of Capital Budgeting

Capital budgeting is determining whether or not to invest money in a project. If there are two projects before you to choose and you can only invest in one project, capital budgeting helps you to make an informed choice.

Capital budgeting is a financial function. It more particularly comes under Corporate Finance.  Whenever a corporate body makes an investment decision, especially about investment in any project, there are two things to be considered: One, the technical feasibility of the project and two, the financial viability of that project.

If a project lacks technical feasibility, one should not consider checking the financial viability. If a project is technically feasible, one should check its financial viability through capital budgeting. There are certain metrics under which capital budgeting helps you check a project’s financial viability. They are as follows:

• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Profitability Index
• Payback period

Understand about Opportunity Cost and Cash Flow

Opportunity cost represents the value of the best alternative forgone, while cash flow tracks the movement of money in and out of a business. Both concepts are crucial in financial decision-making.

Opportunity Cost

Opportunity cost is the highest-valued alternative to your choice that you lose. For, e.g. if there are two investment options under which,

• In the Investment Option, I can incur a 10% interest
• In Investment Option 2, I can incur 12% of interest.
• If I erroneously chose Investment Option 1, then the Opportunity Cost for me was 12%. Why 12 but not 2? This is because there is no condition for investing just in one. Whenever we forgo another alternative while choosing one, the value lost with that alternative is the opportunity cost we suffer.

Cash Flow

Cash flow is the net cash and cash equivalents moving in and out of a company. There are two types of cash flow. Discounted and Non-discounted.

Discounted Cash flow

Discounted cash flow is a financial term for Opportunity Cost, also called the Cost of Capital or Opportunity Cost of Capital. It is considered when calculating the Net Present Value, Internal Rate of Return, and Profitability Index.

Non-discounted Cash flow

The interest rate, opportunity cost, or Discounted cash flow are not considered in non-discounted cash flow. They are taken into consideration when calculating the payback period.

Relationship between Future Value of money and Present Value of money. The formula can better understand the relationship,

FV = PV(1+K) ⁿ

Where,

FV= Future Value

PV= Present Value

K = Discounted Rate in %

n = Number of years

Let’s take an example:  

Suppose Rs. 100/- is invested in a bank today with an 8% of annual interest. Then let’s calculate, using the above formula, the value of the money in the 1st, 5th and 15th year.

Here,

PV= 100

K=8%

If n is taken as 1,

Then FV = 100(1+0.08)¹

               = 100 X 1.08

               = 108

If n is taken as 5

Then FV = 100(1+0.08)

               = 100 (1.4693)

   = 146.93

If n is taken as 15

Then FV = 100(1+0.08)¹⁵

               = 317.22

This means that the value 100 rupees has today will take 108 Rs. in the next year to match the value, 146.93 Rs. in the 5th year to match the present value, and 317.22 Rs. in the 15th year to match the present value. The more rupees are needed to match the present value, the more the value of the Rupee depreciates. The same can be examined by considering the inflation rate in % as the discount rate in %. This means that money depreciates over time.

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Understanding Capital Budgeting

To understand capital budgeting, let’s know each criterion individually.

Net Present Value

Net Present Value shows how much an investment is worth throughout its lifetime, discounted to today’s value. To calculate Net present value, one has to remove all the present value of cash outflows from the sum of all the present value of cash inflows.

Thus,

NPV=Present Value of all cash inflows-Present Value of all cash outflows

The criteria are,

If NPV is greater than 0, then the project should be accepted

If NPV is less than 0, then the project should be rejected

If NPV equals 0, the project should be accepted considering other non-tangible benefits.

The greater the NPV, the better the prospects.

Let’s consider an example:

If a sum of Rs. 4 lakhs is invested today in an IT project, the cash inflows in future for that project will be:

• 70,000 in the 1st year
• 120,000 in the 2nd year
• 1,40,000 in the 3rd year
• 1,40,000 in the 4th year
• 40,000 in the 5th year

The opportunity cost for the project is 8%. Thus, to determine whether this project should be accepted or rejected, the following steps have to be followed:

• Calculate the Present Value

PV= FV X         1       

          (1+K)ⁿ                    

If we use this formula and insert the future values given above as FV, K as 8% and n as the year for every value, respectively, then,

PV for 1st year = 64814.8

PV for 2nd year = 102880.7

PV for 3rd year = 111136.5

PV for 4th year = 102904.2

PV for 5th year = 27223.3

• Add all the Present value of cash inflow

If we add all these values, then the Present value of all cash inflows will be Rs. 408959.5/-

As given above, the Present value of all cash outflows will be 4 lakhs as it is being invested.

• Calculate the NPV

Then, the NPV will be,

PV of cash inflow – PV of cash outflow

That is, 408959 – 400000

Which equals to Rs. 8959/-

Since the NPV is more than 0, the project can be accepted.

Internal Rate of Return

IRR is the percentage of Rate of Return one is going to get on their investment. The discounted rate at which the NPV becomes zero is the IRR. It is important to remember that the NPV is dependent on a discounted rate. Both of them are inversely proportional. When the discounted rate increases, the NPV decreases. When the discounted rate decreases, the NPV increases. Thus, we need to increase or decrease the discounted rate so that the NPV becomes zero. That discounted rate will be the IRR.

For Example:

If at 8% discount rate, the NPV is 5000, and at 12% discount rate, the NPV is 0

Then 12% is the IRR

The criteria are,

1. If the IRR exceeds the Discounted rate, one must accept the project.
2. One must reject the project if the IRR exceeds the discount rate.
3. If the IRR equals the Discounted rate, a person may accept the project depending on other factors.
4. Relation between IRR, Discount rate and NPV
5. If IRR is greater than the Discount rate, NPV is always positive
6. If IRR is lesser than the Discount rate, NPV is always negative
7. If IRR is equal to the Discount rate, NPV is zero

As long as the NPV is positive, the project is financially viable.

Let’s consider an example.

The cost of a project is Rs. 1000. It has a time horizon of 5 years, and the expected year-wise incremental cash flows are:

• Year 1: Rs. 200
• Year 2: Rs. 300
• Year 3: Rs. 300
• Year 4: Rs. 400
• Year 5: Rs. 500

If the opportunity cost of Capital is 12%, let’s calculate the IRR and determine whether the project should be accepted.

The future values here are given before each year. (FV)

The cash outflow is Rs. 1000/- as mentioned above. (PV of all the cash outflow)

The discount rate is 12%

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What are the Steps to calculate the IRR?

Below are the steps to calculate the IRR:

Calculate the NPV with the given values

As mentioned above, we have all the values required to calculate PV. We have to calculate PV by following the steps mentioned earlier, and then, using the PV, we have to calculate the NPV.

The NPV is 169.18 if the discount rate is 12%. This means it is higher.

Increase or Decrease the Discount rate

To bring the NPV to zero, we need to increase the discount rate. It is pertinent to note that the discount rates should be increased or decreased considering the relation between the NPV and discount rate, which is inversely proportional. If the NPV had been negative, we would have had to reduce the discount rate to bring the NPV to zero. We have to use a trial-and-error method by inserting different values of the K to arrive at an NPV value of 0.

If 13% is taken as the value of K, still the NPV is 136.56

If we take 18% as K, the NPV is -7.59

If we take 17.7% as K, the NPV value reaches zero, i.e. 0.25.

Thus, in this case, the IRR is 17.7%

Since the IRR, i.e. 17.7%, is greater than the discount rate, i.e. 12%, this project can be accepted.

Profitability Index

The profitability index is for every rupee we spend and how much we return. It is calculated by dividing the sum of all the cash inflows by the sum of all the cash outflows.

Thus, PI = Sum of all cash inflows

                 The sum of all cash outflows

The criteria are,

If the PI is greater than 1, the project should be accepted.

If the PI is less than 1, the project should be rejected.

Let’s take an example:

If a sum of Rs.25,000 is invested today in a project, it gives rise to a series of cash flows as follows:

• Rs.5000 in the 1st year
• Rs. 9000 in the 2nd year
• Rs. 10,000 in the 3rd year
• Rs. 10,000 in the 4th year
• Rs. 3000 in the 5th year

The required rate of return is 12% annually. To get the value of PI, we have to:

• Add the cash inflow value for each year as given above.

The sum of which is 26814.29.

• Divide the sum of all the cash inflow by the cash outflow.

Thus, by dividing 26814.29 by 25000, we get 1.07. This is the PI.

Since the PI is greater than 1, the project can be accepted.

Payback Period

It is the time it takes to recover the money invested in the project. The criteria is that the project can be accepted when the payback period is less than the maximum or standard payback period set by the Industry or Senior Leadership. Regarding project ranking, the project with the shortest payback period is ranked highest. It is pertinent to note that, in general, the discounted cash flow is not considered for the payback period.

For example:

If the initial investment is Rs 25,000/-

The series of cash inflows that it gives rise to are:

• Rs.5000 in the 1st year
• Rs. 9000 in the 2nd year
• Rs. 10,000 in the 3rd year
• Rs. 10,000 in the 4th year
• Rs. 3000 in the 5th year

We must see each year’s cumulative cash flow to calculate the payback period.

In the first year, Rs.5000 will be recovered.

In the second year, Rs. The cash flow is Rs. 9000, so by the second year, Rs. 5000+ Rs. 9000, Rs. 14,000 will be recovered.

In the third year, Rs. 14,000 + 10,000 = Rs. 24,000 will be recovered similarly.

In the fourth year, in the same way, Rs. 24,000+10,000, we get Rs. 34,000, which is more than what we invested. Thus, to get the exact time needed to recover the investment, we can divide the cash flow of the fourth year by 12 to get the value of the cash flow each month. We get Rs. 833.33/- every month of the 4th year.

Thus, we need 3 years and 2 months to recover the investment. This is our payback period.

Conclusion

From the above, we can conclude certain things, such as always choosing a project with the highest NPV. If the NPV is the same, the project with the highest IRR is chosen. The project has an early payback period if the NPV and IRR are the same. One must never forget that the payback period is a major consideration for every project, business, or organization. It tells us how soon we can recover our investment, which can be utilized for other business needs or projects later.

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