CAPITAL BUDGETING

Capital Budgeting is defined as the process by which a business determines which fixed asset purchases or
project investments are acceptable and which are not. Using this approach, each proposed investment is given
a quantitative analysis, allowing rational judgment to be made by the business owners.

Capital asset management requires a lot of money; therefore, before making such investments, they must do
capital budgeting to ensure that the investment will procure profits for the company. The companies must
undertake initiatives that will lead to a growth in their profitability and also boost their shareholder’s or
investor’s wealth.

An organization is often faced with the challenges of selecting between two projects/investments or
the buy vs replace decision. Ideally, an organization would like to invest in all profitable projects but
due to the limitation on the availability of capital an organization has to choose between different
projects/investments. Capital budgeting as a concept affects our daily lives.

FEATURES OF CAPITAL BUDGETING:

 Long-term: It involves making long-term investment decisions that will affect your
company’s financial health.
 Time-sensitive: It takes into account the time value of money, which means that a dollar today
is worth more than a dollar in the future. It’s like trying to decide whether to eat a cookie now
or wait for two cookies later – you have to consider the value of delayed gratification.
 Risk-conscious: Another feature is risk assessment. Businesses must carefully evaluate the
potential risks and rewards of each investment opportunity to make informed decisions.
  Predictive: Capital budgeting requires accurate financial forecasting, which involves
predicting future cash flows and expenses.
 Needs collaboration: Finally, capital budgeting requires collaboration and communication
among different departments and stakeholders within a company.

OBJECTIVES OF CAPITAL BUDGETING:

Capital expenditures are huge and have a long-term effect. Therefore, while performing a capital
budgeting analysis an organization must keep the following objectives in mind:
1. Selecting profitable projects: An organization comes across various profitable projects
frequently. But due to capital restrictions, an organization needs to select the right mix of
profitable projects that will increase its shareholders’ wealth.

2. Capital expenditure control: Selecting the most profitable investment is the main objective
of capital budgeting. However, controlling capital costs is also an important objective.
Forecasting capital expenditure requirements and budgeting for it, and ensuring no investment
opportunities are lost is the crux of budgeting.

3. Finding the right sources for funds: Determining the quantum of funds and the sources for
procuring them is another important objective of capital budgeting. Finding the balance
between the cost of borrowing and returns on investment is an important goal of Capital
Budgeting.

CAPITAL BUDGETING PROCESS:

The process of capital budgeting is as follows:

1. Identifying investment opportunities:

An organization needs to first identify an investment opportunity. An investment opportunity can be
anything from a new business line to product expansion to purchasing a new asset. For example, a
company finds two new products that they can add to their product line.

2. Evaluating investment proposals:

Once an investment opportunity has been recognized an organization needs to evaluate its options for
investment. That is to say, once it is decided that new product/products should be added to the product
line, the next step would be deciding on how to acquire these products. There might be multiple ways
of acquiring them. Some of these products could be:

 Manufactured In-house
 Manufactured by Outsourcing manufacturing the process, or
 Purchased from the market

3. Choosing a profitable investment:

Once the investment opportunities are identified and all proposals are evaluated an organization needs
to decide the most profitable investment and select it. While selecting a particular project an
organization may have to use the technique of capital rationing to rank the projects as per returns and
select the best option available. In our example, the company here has to decide what is more profitable
for them. Manufacturing or purchasing one or both of the products or scrapping the idea of acquiring
both.

4. Capital Budgeting and Apportionment:

After the project is selected an organization needs to fund this project. To fund the project it needs to
identify the sources of funds and allocate it accordingly. The sources of these funds could be reserves,
investments, loans or any other available channel.

5. Performance Review:
The last step in the process of capital budgeting is reviewing the investment. Initially, the organization
had selected a particular investment for a predicted return. So now, they will compare the investments
expected performance to the actual performance.

FACTORS AFFECTING CAPITAL BUDGETING DECISIONS:

1. Risk and Uncertainty:

Companies need to consider the risks associated with the investment and the uncertainties involved in
estimating the future cash flows. Higher risk investments require higher return expectations to justify
the investment, while lower risk investments may be acceptable at a lower rate of return.

2. Capital Constraints:
Capital constraints refer to the limitations on the amount of available capital for investment.
Companies must balance their capital needs with their available resources, including equity, debt, and
retained earnings. Capital constraints may affect a company’s ability to pursue all of its desirable
investment opportunities and may require the company to prioritize investments based on their
profitability.

3. Business Environment:

Companies must assess the potential impact of changes in the business environment on their
investment opportunities and factor in the effects of these changes in their capital budgeting decisions.

4. Government Policies:

Changes in tax laws, environmental regulations, and other government policies can significantly affect
the profitability of investment opportunities.

5. Social and Environmental Factors:

Companies need to consider the social and environmental impact of their investments and factor in
potential reputational risks associated with their investment decisions.

ADVANTAGES AND LIMITATIONS OF CAPITAL BUDGETING:

Advantages:

 Helps in maximizing returns: It helps in identifying profitable investment opportunities and

maximizing returns on investments.
 Ensures effective utilization of resources: It helps in the effective allocation and utilization
of resources by identifying the most profitable investment opportunities.
 Provides a long-term perspective: it enables companies to take a long-term perspective while
making investment decisions, which helps in achieving the long-term goals of the company.
 Reduces risk: By considering factors such as risk, uncertainty, and the time value of money,
capital budgeting helps in reducing the risk associated with investment decisions.
 Facilitates decision-making: It provides a structured and systematic approach for evaluating
investment proposals, which facilitates decision-making.
Limitations:

 Inaccurate estimates: It relies heavily on estimates of future cash flows and discount rates,
which may be inaccurate, leading to incorrect investment decisions.
 Ignores qualitative factors: Capital budgeting does not consider qualitative factors such as
social responsibility or environmental impact, which may be important in certain cases.
 High degree of complexity: Budgeting techniques can be complex and time-consuming to
implement, especially for large and complex investment projects.
 Limited scope: Some techniques are limited in scope as they only consider financial factors
and do not take into account non-financial factors such as reputation or brand value.

CAPITAL BUDGETING TECHNIQUES AND METHODS:

1. Payback Period:

1.1 Definition
The payback period is a capital budgeting technique used to determine the amount of time required for
a project to generate enough cash flow to recover the initial investment.

To calculate the payback period, you need to divide the initial investment by the expected annual cash
inflows until the investment is fully recovered.

1.2 Calculation of payback period

Payback Period = Initial Investment / Expected Annual Cash Inflows

1.3 Advantages and Limitations of payback period:

Advantages:
 Simple and easy to understand

 Useful for evaluating short-term projects

 Provides a quick assessment of the project’s risk and liquidity

 Can help avoid investments that take too long to recoup their costs

 Does not require estimating future cash flows or discount rates

Limitations:
 Ignores the time value of money

 Does not consider cash flows beyond the payback period

 Ignores profits earned after the payback period

 Ignores the risk associated with future cash flows

 Cannot be used to compare projects with different lifespans

2. Net Present Value (NPV):

2.1 Definition
The Net Present Value (NPV) method is a capital budgeting technique used to determine the value of
an investment by comparing the present value of its expected cash inflows to the initial investment
cost.

2.2 Calculation of NPV

Formula

NPV = -Initial Investment + PV of Expected Cash Inflows

Where:
PV = Present Value
Initial Investment = Total cost of the investment
Expected Cash Inflows = Future cash inflows discounted to their present value
2.3 Advantages and Limitations of NPV:
Advantages:
 Considers the time value of money

 Accounts for all expected cash inflows and outflows

 Provides a measure of the investment’s profitability

 Can be used to compare multiple investment opportunities

Limitations:
 Requires accurate estimates of future cash flows and discount rates

 Can be complex and time-consuming to calculate

 Does not consider non-financial factors such as environmental impact or social responsibility.
3. Internal Rate of Return (IRR):

3.1 Definition:

The Internal Rate of Return (IRR) method is a capital budgeting technique that determines the expected
rate of return of an investment. It is the discount rate that makes the net present value of the project’s
expected cash inflows equal to the initial investment cost.

3.2 Calculation of IRR

Formula

IRR is calculated by finding the discount rate that makes the present value of cash
inflows equal to the initial investment.

3.3 Advantages and Limitations of IRR:

Advantages:
 Considers the time value of money

 Accounts for all expected cash inflows and outflows

 Provides a measure of the investment’s profitability

 Can be used to compare multiple investment opportunities

Limitations:
 Requires accurate estimates of future cash flows and discount rates

 May lead to incorrect decisions when evaluating mutually exclusive projects

 May result in multiple IRR values for some projects

4. Profitability Index (PI):

4.1 Definition
The Profitability Index (PI) method technique is used to evaluate investment opportunities by
calculating the ratio of the present value of cash inflows to the initial investment cost.

4.2 Calculation of PI
Formula

PI = PV of Expected Cash Inflows / Initial Investment

Where:
PV = Present Value
Initial Investment = Total cost of the investment
Expected Cash Inflows = Future cash inflows discounted to their present value

4.3 Advantages and Limitations of PI:

Advantages:
 Considers the time value of money

 Accounts for all expected cash inflows and outflows

 Provides a measure of the investment’s profitability

 Can be used to compare multiple investment opportunities

Limitations:
 May lead to incorrect decisions when evaluating mutually exclusive projects

 May not always lead to the best investment decisions when budgets are limited.

5. Modified Internal Rate of Return (MIRR):

5.1 Definition

The Modified Internal Rate of Return (MIRR) method is a capital budgeting technique used to
determine the rate of return on investment by considering both the cost of the investment and the
reinvestment rate of future cash flows.

5.2 Calculation of MIRR

Formula

MIRR = [(FV of positive cash flows / PV of negative cash flows)^(1/n)]

–1
Where:
FV = Future Value
PV = Present Value
n = Number of periods
5.3 Advantages and Limitations of MIRR
Advantages:
 Considers the reinvestment of future cash flows

 Accounts for the time value of money

 Provides a measure of the investment’s profitability

Limitations:
 Requires accurate estimates of future cash flows and reinvestment rates

 Can be complex and time-consuming to calculate

 May not be appropriate for investments with uneven cash flows

6. Capital Rationing

6.1 Definition
Capital Rationing technique is used when a company has limited funds and must prioritize its
investment opportunities based on the availability of capital.

6.2 Calculation of Capital Rationing: The capital rationing method of capital budgeting is not based
on a single formula like the other methods. Instead, it involves setting a fixed budget for capital
investments and then selecting the combination of projects that maximizes the overall value of the firm
within that budget constraint.

Therefore, the capital rationing method involves a complex decision-making process that considers
multiple factors such as project profitability, risk, and liquidity. The decision-making process often
involves using quantitative and qualitative criteria to evaluate each project’s potential impact on the
firm’s financial performance.

6.3 Advantages and Limitations of Capital Rationing:

Advantages:
 Enables a company to prioritize investments based on available funds

 Helps avoid over-committing to investments

 Encourages better financial management

Limitations:
 May limit a company’s ability to pursue all profitable investments
 May result in missed opportunities

 Can be difficult to determine the optimal allocation of capital.