CAPITAL BUDGETING

  • Capital budgeting is the process to identify, evaluate and implement investment decisions.
  • A company would seek investments that could improve their competitive advantage and increase shareholders’ wealth.
  • Incorrect capital investment decisions could lead to a company’s downfall.

MOTIVES FOR CAPITAL BUDGETING

Companies should conduct capital budgeting for the following reasons:

  • Expansion. During growth phases management should evaluate the feasibility of buying additional assets.
  • Replacement. In a mature phase management need to evaluate the need to incur capital expenditure to maintain the companies activities.
  • Improvement. Management need to evaluate any technological improvements.
  • Other reasons. Management need to evaluate the long term allocation of funds to projects such as research and development and advertising.

CAPITAL BUDGETING PROCESS

The capital budgeting process consist of the following steps.

  • Step 1: Identifying investment opportunities
  • Step 2: Project development
  • Step 3: Evaluating and selection
  • Step 4: Acquisition / Implementation
  • Step 5: Post-implementation control

CAPITAL BUDGETING TECHNIQUES

The following techniques could be used as basis to accept or reject a decision in capital budgeting

(i)   Pay-back Period Methods

(ii)Discounted Pay-back Methods

(iii)Accounting Rate of Return

(iv) Present Value Method

(v) Internal Rate of Return Method

(vi)Profitability Index Method

Pay-back Period

Pay-back period is the time required to recover the initial investment in a project. (It is one of the non-discounted cash flow methods of capital budgeting).

Pay-back period =   Initial investment / Annual cash inflows

Merits of Pay-back method

  • It is easy to calculate and simple to understand.
  • Pay-back method provides further improvement over the accounting rate return.
  • Pay-back method reduces the possibility of loss on account of obsolescence.

Demerits

  • It ignores the time value of money.
  • It ignores all cash inflows after the pay-back period.
  • It is one of the misleading evaluations of capital budgeting.

Accept /Reject criteria

If the actual pay-back period is less than the predetermined pay-back period, the project would be accepted. If not, it would be rejected.

Uneven Cash Inflows

Normally the projects are not having uniform cash inflows. In those cases the pay-back period is calculated, cumulative cash inflows will be calculated and then interpreted.

Accounting Rate of Return or Average Rate of Return

Average rate of return means the average rate of return or profit taken for considering the project evaluation. This method is one of the traditional methods for evaluating the project proposals:

Merits

  • It is easy to calculate and simple to understand.
  • It is based on the accounting information rather than cash inflow.
  • It is not based on the time value of money.
  • It considers the total benefits associated with the project.

Demerits

  • It ignores the time value of money.
  • It ignores the reinvestment potential of a project.
  • Different methods are used for accounting profit. So, it leads to some difficulties in the calculation of the project.

Accounting Rate of Return or Average Rate of Return

Accept/Reject criteria

If the actual accounting rate of return is more than them predetermined required rate of return, the project would be accepted. If not it would be rejected.

Internal Rate of Return

Internal rate of return is time adjusted technique and covers the disadvantages of the traditional techniques. In other words it is a rate at which discount cash flows to zero.

It is expected by the following ratio  = Cash inflow / Investment initial

A company needs to determine its own required rate of return. This rate should be based on their capital structure and sources of funds as well as the risk profile of the project. The required rate of return would be used to determine if a project should be accepted or rejected.

  • Decision criteria
  • If IRR > k, Accept the project
  • If IRR < k, reject the project
  • If IRR = k, neutral
  • Where
  • K = required rate of return

1.To calculate a project’s IRR with the help of a financial calculator,

  1. one needs to input the cash flows of all the respective years,

INTERNAL RATE OF RETURN (IRR)

Merits

  1. It consider the time value of money.
  2. It takes into account the total cash inflow and outflow.
  3. It does not use the concept of the required rate of return.
  4. It gives the approximate/nearest rate of return.

Demerits

  1. It involves complicated computational method.
  2. It produces multiple rates which may be confusing for taking decisions.
  3. 3. It is assume that all intermediate cash flows are reinvested at the internal rate of

Accept/Reject criteria

If the present value of the sum total of the compounded reinvested cash flows is greater than the present value of the outflows, the proposed project is accepted. If not it would be rejected.

 

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