by Capital budgeting is a process that companies use to evaluate and select long-term investment opportunities that will help achieve their financial objectives. The process involves analyzing and comparing potential investments based on their expected cash flows, risks, and returns.
The following are the steps involved in capital budgeting:
- Identify Potential Projects: The first step in capital budgeting is to identify potential projects that can create long-term value for the company. This can include projects related to expanding the business, acquiring new assets, or investing in new products or services.
- Estimate Cash Flows: The next step is to estimate the expected cash flows from each potential project. This includes identifying the initial investment required, the expected operating cash flows over the project’s life, and any salvage value that can be recovered at the end of the project.
- Evaluate Risks: The third step is to evaluate the risks associated with each potential project. This involves analyzing the uncertainty of the cash flows and identifying potential risks that could impact the project’s success.
- Determine Cost of Capital: The cost of capital is the required rate of return that investors expect to receive from an investment. It is the minimum return required to compensate investors for the time value of money and the risks associated with the investment.
- Analyze Investment Opportunities: Once the cash flows, risks, and cost of capital are estimated, the potential projects can be analyzed and compared. This involves using various financial metrics such as Net Present Value (NPV), Internal Rate of Return (IRR), and Payback Period to determine which project is the most financially viable.
- Select the Best Investment: Based on the analysis, the company can select the best investment opportunity that maximizes shareholder value and aligns with the company’s financial objectives.
- Monitor and Review: After selecting an investment, it is essential to monitor and review its progress regularly. This involves comparing actual cash flows to the estimated cash flows and identifying any deviations from the original projections. If necessary, corrective action can be taken to ensure that the investment remains financially viable.
There are two main categories of capital budgeting techniques: discounted and non-discounted.
Discounted Cash Flow Techniques:
Net Present Value (NPV):
NPV is the most popular and widely used discounted cash flow technique. It calculates the present value of future cash flows and compares them to the initial investment. If the NPV is positive, it indicates that the investment is expected to generate positive returns and create value for the company.
For example, a company is considering investing in a new project that requires an initial investment of $100,000. The project is expected to generate cash flows of $30,000 per year for the next five years. The company’s cost of capital is 10%. The NPV of the project can be calculated as follows:
NPV = PV(Cash inflows) – PV(Initial investment)
PV(Cash inflows) = [($30,000 / 1.1) + ($30,000 / 1.1^2) + ($30,000 / 1.1^3) + ($30,000 / 1.1^4) + ($30,000 / 1.1^5)] = $112,824
PV(Initial investment) = $100,000
NPV = $112,824 – $100,000 = $12,824
Since the NPV is positive, the company should invest in the project.
Internal Rate of Return (IRR):
IRR is the discount rate that makes the NPV of the project equal to zero. It is a measure of the project’s profitability and is used to compare investment opportunities. If the IRR is greater than the cost of capital, the investment is considered acceptable.
For example, using the same investment opportunity above, the IRR of the project can be calculated as follows:
NPV = 0 = [($30,000 / (1 + IRR)) + ($30,000 / (1 + IRR)^2) + ($30,000 / (1 + IRR)^3) + ($30,000 / (1 + IRR)^4) + ($30,000 / (1 + IRR)^5)] – $100,000
The IRR of the project is 16.14%, which is greater than the cost of capital (10%). Therefore, the company should invest in the project.
Non-Discounted Cash Flow Techniques:
Payback Period:
Payback period is the amount of time it takes to recover the initial investment in a project. It does not consider the time value of money, and it is easy to calculate.
For example, a company is considering investing in a project that requires an initial investment of $100,000. The project is expected to generate cash flows of $30,000 per year. The payback period of the project can be calculated as follows:
Payback Period = Initial Investment / Annual Cash Flows
Payback Period = $100,000 / $30,000 = 3.33 years
Therefore, the payback period of the project is 3.33 years.
Accounting Rate of Return (ARR):
The accounting rate of return is a measure of the profitability of an investment based on accounting profits. It is calculated by dividing the average annual accounting profit by the initial investment. The higher the ARR, the better the investment.
ARR = Average Annual Accounting Profit / Initial Investment
For example, if an investment requires an initial investment of $100,000 and generates an average annual accounting profit of $20,000, the ARR would be:
ARR = $20,000 / $100,000 = 20%
This means that the investment is expected to generate a 20% return on investment based on accounting profits. However, this method does not take into account the time value of money and may not reflect the true profitability of an investment.
