Companies always make challenging and risky investments. But, the investment decision depends on the project returns compared to the risk that you undertake.
Capital Budgeting is one of the pivotal tools that helps a business evaluate the returns expected from a project. This blog covers all that you need to know about capital budgeting.
What is Capital Budgeting?
When we hear about a budget, the first thing that comes to mind is the monthly expenditure budget. But for businesses, budgeting takes a grander scale. Since the projects in concern span many years, it is tricky to evaluate and predict future performance accurately.
Capital Budgeting helps a business evaluate and analyze the outflows and inflows of a project. By comparing both of them, a company can select the most appropriate investment opportunity. With a robust capital budgeting exercise, a company can assess the risks and returns properly and make informed decisions to achieve its objectives.
Types of Costs Evaluated in Capital Budgeting
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Fixed Costs
Usually, a project involves many long-term investments. These include costs like:
- Licenses and Approvals
- Initial Project Setup
- Land
- Vehicles
- Fixed Assets
- Plant & Machinery
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Working Capital
Apart from fixed costs, companies also have to invest funds for variable expenses every year. These include the costs like material, labor, electricity, overheads, etc. The amount of these expenses remains invested in a business until one working capital cycle is completed.
A working capital cycle means the time taken from the purchase of raw material to the final receipt of money after sales. Depending on the type of business and the practices, the working capital required can vary.
Why Capital Budgeting?
Now the question arises, what is the importance of capital budgeting? As you can see, the investments involved in a project are major costs. Thus, companies need to compare the potential cash flows of a project with the initial investment. Here’s why capital budgeting is essential:
- Assessing the project risks: Generally, a project carries financial, operational, technological, regulatory, and market risks. Although, depending on the type of variables involved, there can be more risks that a business faces. With capital budgeting, a company can study these risks well in advance and evaluate the returns by discounting them.
- Projecting Cash Flows: The inflows generated by a project are pivotal for its selection. Capital budgeting techniques allow businesses to predict future cash flows accurately.
- Long-Term Planning: Capital budgeting is used to evaluate projects that keep generating returns for several years. Hence, the investment amount is also high. One wrong decision in such large projects can cause huge financial damage to a business. Hence, following capital budgeting techniques properly is the key to evaluating projects correctly.
- Maximizing Shareholder’s Returns: Shareholders want higher returns on their investments, and the management’s objective is to increase their profits. With capital budgeting, businesses can choose the correct projects that can help in maximizing shareholder returns.
- Assessment of Market Conditions: Capital Budgeting process cannot be carried out until the market conditions and demand for the product are properly assessed. It is the most important exercise for businesses looking to enter into new markets.
- Comparing the Opportunity cost: Generally, businesses have many investment proposals at a time. The returns foregone as a result of discarding a project is called opportunity cost for the selected project. The purpose of capital budgeting is to help the management make the right investment choices that provide the highest returns.
- Availability of Funds: The funds involved in a project depend on many variables like interest rates, inflation, cash flows, etc. Capital budgeting helps a company to make an accurate financial model and identify the sources of capital.
Capital Budgeting Process
To understand how capital budgeting works, it is important to learn about the step-by-step process. Here’s how capital budgeting works:
- Identifying Opportunities: The first step is to identify the investment opportunities that are available for the business. These can be related to the following:
- Expansion of existing operations
- Modernization of the processes
- Development of new product
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- Entering into new markets
- Setting up new production facilities
- Research & Development
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- Investment Proposal: The next step in the capital budgeting process is to prepare the investment proposal. It comprises all the details about the identified projects. These include the investment required (both capital and operating expenses), risks involved, estimated benefits, and objectives of the proposal.
- Data Collection: In this stage, all the data about the market conditions, risks, costs, and cash flows are collected and checked for correctness.
- Selecting the Method of Evaluation: Many capital budgeting methods are used by companies to evaluate projects. The selection of the evaluation method depends on the type of business and the variables involved.
- Predicting the Cash Flows: Now comes the trickiest part. In this step, the company needs to calculate the revenues, operating costs, taxes, etc. Doing this can lead to accurate predictions of future cash flows.
- Risk Assessment: Now, to compare the inflows and outflows, the various types of risks involved need to be quantified.
- Comparing various projects: Once the Net Cash Flows are calculated, these return projections of all the projects need to be compared.
- Decision Making: After comparing all the projects, the management decides to invest in the one that provides the maximum returns.
- Implementation and Performance Review: Although the capital budgeting process is complete at the previous stage, the management needs to evaluate the performance of the project in hindsight. This also helps to rectify errors that occurred earlier.
Popular Capital Budgeting Techniques
There are many ways to assess or evaluate a project. Understanding the benefits of each of the capital budgeting methods can help a business in selecting the proper evaluation technique. Here are the most popular methods of capital budgeting:
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Net Present Value (NPV)
Net Present Value (NPV) uses the Discounted Cash Flow method for evaluating the viability of a project. This is done to compensate for the value that money loses over a year.
In this capital budgeting method, all the future cash flows are discounted at the cost of capital or the expected returns. After this, the initial cost is reduced from the present value. A higher NPV makes the project viable. Here’s an example:
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Internal Rate of Return (IRR)
Another popular capital budgeting method is IRR. It goes a step further than the NPV method. Internal Rate of Return (IRR) is the rate at which the NPV of a project is zero. A higher IRR means the project is viable. Take the above example:
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Profitability Index (PI)
Another popular capital budgeting method is PI. In this method, the total present value of inflows is divided by the present value of outflows. If the PI is more than 1, the project is profitable. Here’s the PI calculation for the above example.
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Payback Period
The payback period is the time within which the company can recover the initial capital outflow in the form of returns. A shorter payback period is preferred by businesses. But, this method doesn’t consider the time value of money making it a less popular method compared to the other methods.
In a nutshell
Capital Budgeting is an essential exercise for all businesses for evaluating the potential returns that projects can generate. It is time-tested and is popularly used by companies to plan their future investments. Capital budgeting methods like NPV, IRR, and PI are used to assess the projected returns and ease the decision-making process.
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