Capital budgeting techniques are related to investment in fixed assets. Fixed assets are that portion of balance sheets which are long term in nature. On the other hand current assets are short term by nature. We may also said that capital budgeting is technique employed to determine the value of project and investment in fixed assets.
Capital budgeting is very important area of financial management on the basis of a number of reasons. First of all is that the fixed assets like machinery & equipment etc depreciate with the passage of time. After a number of years those assets must be replaced with the new ones which definitely involve investment in fixed assets. Secondly when a new project is under consideration by a company, then it must apply capital budgeting & capital techniques in order to ascertain the financial soundness of the new project. In this way the company can effectively determine that whether the new project should be started or not.
In larger companies, there are specific departments along with specified teams which work only on the area of capital budgeting. Other members of the organizations also work as team member on the task of capital budgeting like department managers, project managers, cost accountants, market researchers etc. The main objective of capital budgeting is to those projects that can increase the value of the organization.
Techniques of Capital Budgeting
Capital budgeting is mathematical in nature which means that there are certain techniques related to quantitative investment and are employed to determine the worth of an opportunity of investment. Following are the important techniques of capital budgeting.
- Pay Back Period
- Return on Investment
- Net Present Value (NPV)
- Profitability Index (PI)
- Internal Rate of Return (IRR)
Which employing the above techniques, discount rate or the interest rates or required rate of return are given. Now each of these techniques is discussed below.
- Pay Back Period:
This is the technique through which the time duration is ascertained that is required to recover all the invested capital with the help of positive cash flows.
Mr. Ali wanted to start new project of café in certain college. Let suppose the initial investment is $ 255,000 and there is expectation of $ 15,000 per month in the first year and $ 25,000 per month in the second year.
Now it is easy to find the duration of time required to recover the initial investment of 255,000. It is expected that in the first year total 180,000 is earned (in twelve months). Now only 75,000 are left which is recovered in the next three months of the second year because the expected earning is 25,000 per month. In this way it is determined easily that it will take 15 months to recover all the invested amount of the café project.
Pay Back Period technique is simple but still there are certain limitations like the time value of money is not included and the timing of the occurring cash flows is not taken into account.
- Return on Investment:
Return on investment can be analyzed by a number of ratios in general. But in capital budgeting return on investment is defined as the generation of annual average cash flow by a business as a percentage of investment. It is also defined as the average percentage of investment regained in cash each year.
Following is the formula for return on investment
ROI = (∑CF/n)/Io
The return on investment can be calculated by the division of average investment cash flow with the initial investment.
Let’s take the above café example in which there is initial investment of $ 255,000, the expected per month profit in the first year is 15,000 whereas the expected per month profit in the second year is $ 25,000. The ROI can easily be calculated
ROI = (180,000+300,000/2)/255,000
ROI = 0.94 = 94%
The concept of time value of money is not taken into account in return on investment. The higher rate of return of 90% is healthy option for the business but other alternative opportunities should also be considered before this one. The current rate of inflation in the country should also be considered in order to adjust the returns accordingly.
- Net Present Value (NPV):
It is one of the most important Techniques of Capital Budgeting in which discounting is made. The current value of the future incremental after tax net cash flows minus initial investment is referred to as net present value.
Following is the formula of net present value
NPV = -Io+∑CFt / (1+i)t
Where – Io = Initial cash outflow
CFt = cash flow taking place in different time periods
i = Interest rate/discount
t = year in which cash flow occurs
The outflow is always negative so as expressed in initial cash outflow (- Io)
Although NPV is the famous criteria of capital budgeting but still it holds one disadvantage which is that its calculations are based on too many estimates and therefore it is quite difficult to calculate.
The sales & future cash flows need to be forecasted in calculation of NPV. There is also another estimate which is discount factor. Whenever the value of NPV is higher than zero than that projected is regarded as favorable. When two projectors are under consideration than the project with the higher NPV should be pursued. The value of the company or the wealth of the shareholders increases by following the project having positive NPV. Moreover the economic value added & market value added is also increased.
By considering the same café example in which there is initial investment of $ 255,000 and expected profit of $ 15,000 in the first year while $ 25,000 in the second year. There should also be discount rate which is assumed to be 10% which reflects the minimum return that is expected from the business. The business should provide the return more than that 10% otherwise it is not beneficial one.
Following is the data provided in the example
Initial cash outflow = – Io = -255,000
CFt = cash flows taking place at various time periods which are figured as $ 180,000 in the first year and $ 300,000 in the second year.
i = Interest rate/discount = 10%
t = 2 years
By putting values in the formula
NPV = -Io+∑CFt / (1+i)t
NPV = -255,000+180,000/(1+0.10)+300,000/(1+0.10)2
NPV = -255,000+163,636+247,933
NPV =+ 156,569
- Profitability Index (PI):
The concept & calculation of Profitability Index (PI) is similar to the NPV. The ratio of current value of future cash flows to the initial investment is referred to as PI.
Following is the formula of PI
PI = [∑CFt / (1+i)t] / Io
The projects having PI greater than 1 are regarded as favorable ones. Moreover the projects that are approved through the NPV method are also favorable on criteria of PI.
By considering the same example of café, PI is calculated as follow
PI = [180,000/(1+1.0)]+[300,000/(1+0.10)2] / 255,000
PI = 163,636 + 247,933 / 255,000
PI = 411,569 / 255,000
PI = 1.61 > 1.0
As the value is more than 1 therefore the project is favorable.
- Internal Rate of Return (IRR):
Internal Rate of Return (IRR) is more commonly used measure of capital budgeting techniques than NPV. Unlike the NPV, IRR is expressed in terms of percentage and therefore it is quite useful to compare it with other interest rate or other market interest rates.
The same equation is used in the calculation of Internal Rate of Return that is used in the calculation of NPV. The main difference is that the value of NPV is kept as zero in the equation and then the value of “i” is calculated. The IRR of return is that value of “i” where the NPV of the project is equal to zero. Also it is important to remember that the value of IRR is constant in every year throughout the life of the project. Moreover, the IRR is the break-even rate of return which means that it is that rate at which the initial investment is will be recovered throughout the life of the project.
Trial & error method or iteration method is used to calculate the IRR. The higher degree polynomial equation is required to solve out for finding unknown variable. Therefore trial & error method or iteration method is quite easy way to find out the solution. In trial & error method the value of “i” is set out in order to makes the whole equation equal to zero. If the first value does not bring the equation equal to zero than try another value and if that value also does not equalize the equation to zero then try the third value and so on. The higher value of IRR is considered as good one but it is quite difficult to measure that which value of IRR is more acceptable.
Another important point that needs to be clarified is that the internal rate of return is quite different from the discounting rate that is employed in the NPV calculation. In NPV, the discount rate is used as required rate of return that is expected from the project to generate. On the other hand in IRR equation, the forecasted return is ascertained through existing cash flows. SO in calculation of NPV & IRR the two different interpretations of “i” should be remembered.
By taking the similar above example of café and by using the same formula of NPV, the IRR can be calculated as follow
NPV = -Io + CF1 / (1+IRR) + CF2 / (1+IRR)2
= 0 = -255,000+180,000/(1+0.1)+300,000/(1+0.1)2
In order to solve the equation if IRR is assumed to be 10% than the NPV will be equal to 156,569 which is much higher figure. The NPV should be bringing down to zero and therefore the rate of IRR would consider being higher equal to 50%. So now
NPV = -Io + CF1 / (1+IRR) + CF2 / (1+IRR)2
= 0 = -255,000 + 180,000/(1+0.494) + 300,000/(1+0.494)2
= 0 = -255000 + 120,481 + 134,406
The answer of above equation is equal to -113 which is less than zero, so the rate of IRR need to be kept slightly lower than 50%. By considering IRR equal to 49.4% the NPV is -113, which is quite near to zero and therefore IRR of the café project is 49.4% approximately.