Last updated on April 2nd, 2024 at 05:09 am
One of the most important processes used by businesses, capital budgeting helps to analyse and evaluate probable investments. Capital budgeting has various techniques that help to assess a company’s cash inflows and outflows via risk management, creating a particular target or benchmark.
Also referred to as investment appraisal, it allows one to decide the probable returns over a certain period. Examples of capital budgeting are the construction of new plants, and procuring of stakes from an outside volunteer.
Which Capital Budgeting Techniques can help in assessing investments?
Businesses require capital budgeting because of factors such as accountability and risk management. Several techniques of capital budgeting are identified and incorporated by several companies in contemporary times. These methods can be distinguished into traditional techniques or non-discount techniques and discounted cash-flow techniques. Examples of traditional techniques include the Payback period and the Accounting Return Rate. NPV method, IRR, and Profitability Index Method fall under the discounted cash flow method.
Traditional Techniques
Traditional methods focus on the value of investment projects, mainly after understanding their usefulness and returns. Also, these techniques never consider the concepts of money and time value.
Payback Period Month
The Payback Period Month method indicates the particular period where a certain proposal will generate the required cash to recover preliminary investments. It majorly focuses on financial aspects such as cash inflows, investments and the project’s economic life. The selection of a scheme, according to this technique, is established on the earning capacity of the whole project. This is further performed with simple calculations, acceptance and denial of ideas, with results finally undergoing risk management for greater clarity.
One of the cons of the Payback Period Month is it disregards the importance of factors such as time and profitable dimensions since it is based on the thumb rule.
Example: This table indicates how the payback period of Project B is shorter than Project A. But since Project A supports a higher rate of return, it is superior to Project B.
| Particulars | Project A | Project B |
| Cost | 2,00,000 | 2,00,000 |
| Expected cash flow (3 years) | ||
| Year 1 | 50,000 | 2,00,000 |
| Year 2 | 1,50,000 | 10,000 |
| Year 3 | 1,10,000 | 10,000 |
| Total | 3,10,000 | 2,20,000 |
| Payback | 2 years | 1 year |
Accounting Rate of Return (ARR)
This technique is utilised to subjugate the negative aspects found in the Payback Period technique. The Rate of Return here is indicative of a percentage of all the earnings of an investment towards a specific project. It focuses on the criteria that any project with an ARR higher than the lowest rate fixed by the company shall be accepted and others below the rate will be rejected.
ARR deals with the entire economic life of the specific project, leading towards greater means of comparison. This method also ensures a certain level of compensation for the anticipated profitability of all projects through net earnings.
However, ARR also does not focus on factors such as the time value of finances and the length of economic life in all projects. It is also inconsistent with the objectives of maximising the share market values.
Example:
Initial Investment: Rs, 250,000
Expected Revenue Return every Year: Rs, 70,000
Period: 5 years
ARR calculation: Rs. 70,000 (annual revenue)/Rs.250,000
ARR: .28 or 28%
Discounted Cash Flow Method (DCF)
Discounted Cash Flow attributes to a technique that provides a value estimation of an investment utilising approximate cash flows. It concentrates on financial reporting in the present context, based on estimates of the amount of money that can be retrieved shortly.
DCF is a viable option for those who are considering options such as whether to acquire a firm or purchase securities for greater decision-making. It is also used to assist managers and owners to focus on capital budgeting or related problems.
Net Present Value Method (NPV)
NPV refers to the sum of all the present values of incremental cash flows available in a project. This sum is further discounted considering the necessary return rate is less than the current value of the investment costs.
In simpler words, NPV can be understood as the difference between the current values of cash inflows and the initial cost value of the project. One of the major tools of capital budgeting, it analyzes the profits related to an investment or a project. It is a comprehensive technique which understands the value of the investment and the time value of finances.
Example:
Initial Outlay: Rs. 50,000
Projected Cash Flows in 5 years: INR, 10,000, INR 20,000, INR 40,000, INR 20,000 and INR 50,000
Rate of Return: 12%
NPV: (10000/(1+.12)^1 + 20000/(1+.12)^2 + 40000/(1+.12)^3 + 20000/(1+.12)^4 + 5000/(1+.12)^5) – 50000
= 68,891-50,000
= INR 18,891
Hence, the NPV is recorded as Rs. 18,891 in this case.
Internal Rate of Return (IRR)
The IRR is a tool which is used in financial analysis to understand the approximate profitability of investments. It is more of a discount rate that indicates the NPV of every cash flow is equal to zero in the context of a discounted cash flow analysis.
The formula of IRR and NPV are the same. However, IRR is different as it is the annual return which turns NPV=0. It is applicable in various forms of investments and can also help in ranking projects and investments evenly.
Example:
A company is assessing the profit rate of a particular investment, Project A. Project A requires the funding of Rs. 250,000 and is supposed to generate over Rs. 100,000 in after-cash flows during the first annum and Rs. 50,000 for the next 4 years.
In this scenario, the IRR is over 56.72% indicating a high note.
Profitability Index
Also known as Value Investment Ratio, the Profitability Index refers to an index which focuses on the cost-benefit analysis of a particular project. It is calculated as the ratio between values in the present and future along with the total amount of cash flows used in the investment.
The Profitability Index focuses on the time value of money and allows a high level of comparison of projects which is not visible in other techniques. It is used in projects with different lifespans even under capital constraints.
Example:
Simply, a project having an initial investment of Rs. 1.1 million and Rs. 1.2 million as a present value of future cash flows will have a profitability index of 1.1.
Conclusion
There are several pitfalls that can be identified when it comes to capital budgeting. For instance, several companies misinterpret net income as a cash flow. In order to understand cash budgeting in the right ways, the Certified Management Accountant Course by Imarticus is the best option one can go for. This 6-8 months long US CMA course provides modules and programs useful for the US CMA exam, great placement opportunities, and sustainable career growth.
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