Capital budgeting is also known as investment appraisal. Capital budgeting is a process by which any business determines whether it should pursue any project or not. The projects can include new plant, building, making investments, R&D, miscellaneous expenditures etc. It is a planning process. If the project can increase the value of the business, it is worth pursing of. So, the project mainly increases value to the company. But it should earn Rate of Return more than the capital cost. In a nutshell, the valuation of real assets is dealt with capital budgeting.
Capital budgeting is used for planning of raising large and long term sums. This is usually done to raise money for investment to add value to the company. There are various methods which are used in creating capital budgeting. Such as:
- Net Present Value
- Internal Rate of Return
- Payback Period etc.
Net Present Value (NVP):
It is used for profitability analysis of any investment/project. NVP is the difference between the present cash inflows value and present cash outflows value.
It is calculated as:
In the above formula:
Ct = Net cash inflow during period
C0 = the initial investment
r = discount rate
t = no. of time periods
NVP is also calculated with help of tables and MS Excel spreadsheets.
Internal Rate of Return (IRR)
Internal rate of return is also known as economic rate of return. It is used for comparing and measuring the investment profitability. It is also referred as discounted cash flow rate of return (DCFROR).
IRR is calculated as
0 = P0+P1/(1+IRR) + P2/(1+IRR)2 + P3/(1+IRR)3 + . . . Pn/ (1+IRR) n
Here in the formula P0, P1 . . . Pn equals cash flow in periods 1, 2, 3 . . . n. Rate or return equals the IRR of project.
Payback period is the time period which is required to recover the investment cost. It is an easy investment appraisal method.
The calculation depends on the evenness or unevenness of the cash flow per period from the project.
Payback Period = ( Initial Investment ) / (Cash Inflow per Period)
In case of uneven cash flow
Payback Period = A + B/C
A = last period wit –ve cumulative cash flow
B = Absolute value of cumulative cash flow at end of A period
C = total cash flow during the period after A
Other methods used for capital budgeting as profitability index, real options analysis and profitability index.
The amount available for investment in new projects is limited; businesses are required to apply capital budgeting techniques. So that, it can be identified that how much the yield the project will generate. And will it cover the cost of investment over the time period. The firms decide which long term projects and investments should be undertaken. These investments/projects are expected to yield cash flows for long time, over several years. With a systematic analysis of cash flow yielded by projects and its cost, the projects can be rejected.
The capital budgeting decision rules must consider all the cash flow of the project. It must take the time value of the money into considerations. While selecting among the mutually exclusive projects, the decisions should be correct.
While due to changing marketing scenario, businesses have to face many problems. These changes can invite profit as well as loss. So, many companies have limited projects at a time. Businesses’ future profits can be maximized by using capital budgeting. The capital available can be used to buy new equipments, repairing & rebuilding, building constructions, delivery vehicles purchases etc. These are some larger projects. These projects are expected to increase the profit. These projects need large amount of money to be invested. This large amount of money is known as Capital Expenditures.
Capital budgeting provides revenue forecasts. It frames a financial model to know how to increase business performance. It is mainly associated with project ranking. When long term investment is taken into consideration, it is involved.
Long term investments/projects such as constructing a new building or buying new equipments need huge amount of money to be spent on. If the decisions taken are uneconomic or wrong, the amount spent can be easily wasted away. Here capital budgeting plays an important role. Capital budgeting is used for relatively large projects. These periods need a significant time period.
There are various factors which can affect the capital budgeting. Some of them are listed below:
- Capital Structure – Taxation Policy – Immediate Need of Project
- Government Policy – Funds Availability
- Financial Lending Policy – Earning & Earning Trends
- Project’s Economic Value – Political Unrest
- Geographical Condition – Market Forecast
- Business Size & Business Risk – Working Capital & Capital Structure
- Accounting Practice – Exchange Rate of Currency
Capital budgeting is an important task. A large amount of capital in invested. It influences the profitability of firm. Moreover, once the investment is made, it can’t be reversed. If it is reversed, there is loss of invested capital. So, capital budgeting helps in making strategic goals for long term projects. It forecasts and estimates the future cash flow. All the expenditures and investments are monitored and controlled. It is a tool for risk management, as long term funds commitment can lead to financial risk.
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