What’s it: Capital budgeting is a process for estimating revenue and capital expenditure. It is usually associated with assessing how profitable or worthy the company’s capital investments or key projects are.
The capital investment may involve purchasing new machinery and equipment, replacing current machinery and equipment, or spending on building a new factory. Such investments require substantial funds. Thus, its success and failure can significantly impact the company.
A company may have plans to develop several long-term projects. The company needs analysis to assess the projects. Through capital budgeting, management can determine and choose which projects offer the highest return to maximize the firm’s value. Thus, the company’s money is not wasted.
Why is capital budgeting important?
Several reasons explain why capital budgeting is important. First, it helps management to determine investment decisions. The decision may involve management selecting a new facility or expanding an existing facility. In other cases, management may need to decide whether to replace an existing facility with a new one.
Second, capital budgeting provides a method for assessing projects accountable and measurable manner. It is a scalable way for businesses to assess long-term economic and financial profitability when introducing new projects. They can make a quantitative view for each proposed capital investment, thus providing a rational basis for making judgments and decisions.
Third, capital investment consumes substantial costs. Thus, its failure can significantly impact the company’s finances.
Fourth, long-term strategic projects to support the company’s long-term competitive advantage. Its success will bring more growth in the future, maximizing shareholder wealth. On the other hand, failure can cause the company to be unable to compete with competitors.
What are the three methods in capital budgeting to measure investment viability?
Capital budgeting decisions are key in supporting the company’s long-term growth and profitability. Thus, management needs tools or methods to make wise investment decisions. These tools guide them in comparing the benefits and costs of various investment alternatives. Thus, they can choose the most feasible project among the alternatives.
Several methods are available for capital budgeting, such as:
- Net Present Value (NPV)
- Internal Rate of Return (IRR)
- Payback period
- Accounting rate of return
- Profitability Index (PI)
However, in this article, we will briefly discuss the first three.
Net Present Value (NPV)
Net Present Value (NPV) is considered the most important and widely applied method. It compares how much money is spent and earned on a project after adjusting for time value. In other words, we calculate it by comparing the outflows for the initial investment with the discounted future after-tax cash inflows. The NPV mathematical formula is as follows:
CF represents the cash inflows generated by the project for each t period. That is the cash inflow after adjusting for taxes. Then, we must discount it to determine its present value at the assumed discount rate (i.e., the minimum required rate of return).
The discounting is to get an equivalent value when we compare it to the initial investment. As with the concept of the time value of money, cash inflows now are worth more than the same amount in the future. Therefore, we must discount the future cash inflows to get their present equivalent.
How to take a decision from NPV? Capital investment is feasible if the NPV is positive (more than zero). The greater the NPV value, the more profitable the investment. A positive NPV indicates the investment generates greater cash flow than the initial investment.
On the other hand, a project with a negative NPV is not feasible. This is because future cash inflows cannot cover the initial investment, and therefore, the project is a loss.
And the NPV may also be equal to zero. So, it is neither beneficial nor detrimental. Management may consider intangible benefits to make decisions.
Internal Rate of Return (IRR)
The Internal Rate of Return (IRR) represents the discount rate at which the NPV equals zero. In other words, it equates the initial investment with the total present value of the cash inflows.
The following is the formula for the Internal Rate of Return (IRR):
If we see, the IRR in the above calculation is similar to the “r” in the NPV calculation. We say r is the minimum required rate of return. So, when the NPV equals zero, the discount rate (“r”) we get will equal the IRR.
So how do we make decisions using IRR? The investment is worth it if the IRR is higher than the required rate of return. Conversely, if it is lower, the investment is not worth it.
So how does it relate to making decisions using NPV?
An investment yields a positive NPV when the IRR is higher than the required rate of return; therefore, we say the investment is feasible. Conversely, when the IRR is lower than the required rate of return, the NPV is negative, and therefore, the investment is not worth it.
The payback period shows us how long the project investment can take to recover the initial investment. Of course, management wants the project to quickly recover its initial investment and generate positive cash flow. For this reason, a shorter payback period is preferable because the project can quickly cover the initial investment.
Let’s take a simple case to explain how the payback period works. A project requires an initial investment and generates after-tax cash inflows as follows:
|Cumulative cash flow||−3,000||-2,300||-1,500||-600||400||1,400|
From the table above, we can see the project requires an initial investment of $3,000. However, in its first year, the project generated an after-tax cash inflow of $700. In other words, in year one, the project still reported a negative cash flow of $2,300. Thus, the project still needs time to fully recover the initial investment.
In year two, the project generates a cash flow of $800. So there’s still $1,500 of the initial investment to recover and so on.
The project has generated positive cash flow in its fourth year. In other words, the project’s break-even point is between the third and fourth years, where the cumulative cash flows change from negative to positive.
Since the break-even point is between the third and fourth years, the payback period is three years plus some time, but not more than one year. To calculate the remaining time, we divide the unrecovered amount ($600) by $1,000, the cash inflows earned in year four. Therefore, the payback period equals 3 + ($600/$1,000) = 3.6 years.
Reading in this series
- Capital Budgeting: Importance, Methods For Assessing Project Feasibility
- What is the Capital Budgeting Process?
- What are the Types of Projects in Capital Budgeting?