Capital Budgeting and Its Importance for Your Business
Capital budgeting is made up of two words ‘capital’ and ‘budgeting.’ In this context, capital expenditure is the spending of funds for large expenditures like purchasing fixed assets and equipment, Budgeting is setting targets for projects to ensure maximum profitability.
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.
If your company is considering taking on a large investment project to improve your manufacturing process or sales, you will want to have a financial plan in place.
How Capital Budgeting Works
When a firm is presented with a capital budgeting decision, one of its first tasks is to determine whether or not the project will prove to be profitable. The payback period (PB), internal rate of return (IRR) and net present value (NPV) methods are the most common approaches to project selection.
Although an ideal capital budgeting solution is such that all three metrics will indicate the same decision, these approaches will often produce contradictory results.
Depending on management’s preferences and selection criteria, more emphasis will be put on one approach over another. Nonetheless, there are common advantages and disadvantages associated with these widely used valuation methods.
— — — — — — — — — — — — — — — — — — — capital budgeting methods
The payback period calculates the length of time required to recoup the original investment. For example, if a capital budgeting project requires an initial cash outlay of $1 million, the PB reveals how many years are required for the cash inflows to equate to the one million dollar outflow. A short PB period is preferred as it indicates that the project would “pay for itself” within a smaller time frame.
Example of Payback Period Method:
An enterprise plans to invest $100,000 to enhance its manufacturing process. It has two mutually independent options in front: Product A and Product B. Product A exhibits a contribution of $25 and Product B of $15. The expansion plan is projected to increase the output by 500 units for Product A and 1,000 units for Product B.
Here, the incremental cash flow will be calculated as:
(25*500) = 12,500 for Product A
(15*1000) = 15,000 for Product B
The Payback Period calculation
Product A = 100,000 / 12,500 = 8 years
Product B = 100,000 / 15,000 = 6.7 years
===This brings the enterprise to conclude that Product B has a shorter payback period and therefore, it will invest in Product B.
Net Present value
The net present value is calculated by taking the difference between the present value of cash inflows and the present value of cash outflows over a period of time. The investment with a positive NPV will be considered. In case there are multiple projects, the project with a higher NPV is more likely to be selected.
Internal Rate of Return (IRR)
IRR refers to the method where the NPV is zero. In such as condition, the cash inflow rate equals the cash outflow rate. Although it considers the time value of money, it is one of the complicated methods.
It follows the rule that if the IRR is more than the average cost of the capital, then the company accepts the project, or else it rejects the project. If the company faces a situation with multiple projects, then the project offering the highest IRR is selected by them.
Here, The IRR of Project A is 7.9% which is above the Threshold Rate of Return (We assume it is 7% in this case.) So, the company will accept the project. However, if the Threshold Rate of Return would be 10%, then it would be rejected as the IRR would be lower. In that case, the company will choose Project B which shows a higher IRR as compared to the Threshold Rate of Return.
This method provides the ratio of the present value of future cash inflows to the initial investment. A Profitability Index that presents a value lower than 1.0 is indicative of lower cash inflows than the initial cost of investment. Aligned with this, a profitability index great than 1.0 presents better cash inflows and therefore, the project will be accepted.
source https://www.deskera.com/blog/capital-budgeting/ , https://www.investopedia.com/articles/financial-theory/11/corporate-project-valuation-methods.asp, https://corporatefinanceinstitute.com/resources/excel/functions/npv-function/
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