Capital Budgeting
Capital BudgetingAssignmentSubmitted to: Mr. Muntazir HussainBy:
Adnan RashidM.Phil. II (Finance)University of Lahore
Capital BudgetingWhen one can look at the word capital
budgeting, he can find a combination of two words capital and
budget. Where capital refers to the long term investment in assets
for production or shareholder maximization, and budgeting
represents the planning for getting the maximum income from such
investment over the extended life of the investment. So, normally
we can say that Capital budgeting is a process or combination of
steps that help the organization to evaluate the long term
investments, and enable them to invest in a bets suitable / optimal
investment. It is a process that contains several techniques
through which organization as well as individual investor can
easily find the best suitable project for investment and also find
out its future performance. In capital budgeting, the decision of
either acceptance of rejection is made on the basis of cash
generation capacity of the project. The background of capital
budgeting resembles with security valuation, but different from
that valuation in sense of difference between organization and
individual investor. The importance of capital budgeting process is
not ignorable for an organization, because of its involvement in
the achievement of organization primary goal. This is because
organization manages finance to raise the wealth of the
shareholders and in this regard, capital budgeting techniques or
process enable managers to effectively manage investments by
raising accountability and measurability. The importance of capital
budgeting can also be observed from the situation of the
organization, who make investment in projects without consideration
of risk and return find less return and cannot fulfill the main
objective of the organization. As we discussed earlier that capital
budgeting is a process, and this process contains several stages
that starts from analyzing the projects, creation of their lists
and comes through an end of investment in an project through
evaluation stage, which shows the analysis of taxes, incremental
costs etc. So, in nutshell capital budgeting process is also
somewhat similar to decision making process. However there are
certain factors that can affect the capital budgeting process of an
organization. Like any other process there are certain factors that
influence the capital budgeting process, and are as following:
Availability of Funds Capital Structure of an organizationUrgency
of investmentExchange rate position and policy Taxation and other
governmental policies Trends of risk and return adoptionCapital
Budgeting Process: First, the cost of that particular project must
be known. Second, estimates the expected cash out flows from the
project, including residual value of the asset at the end of its
useful life. Third, riskiness of the cash flows must be estimated.
This requires information about the probability distribution of the
cash outflows. Based on projects riskiness, Management find outs
the cost of capital at which the cash out flows should be
discounted. Next determine the present value of expected cash
flows. Finally, compare the present value of expected cash flows
with the required outlay. If the presentvalue of the cash flows is
greater than the cost, the project should be taken. Otherwise, it
should be rejected.OR If the expected rate of return on the project
exceeds its cost of capital, that project is worth taking.
Capital Budgeting Techniques: 1) Profitability
IndexProfitability index (PI) is the ratio of investment to payoff
of a suggested project. It is a useful capital budgeting technique
for grading projects because it measures the value created by per
unit of investment made by the investor.
This technique is also known as profit investment ratio (PIR),
benefit-cost ratio and value investment ratio (VIR).
The ratio is calculated as follows:Profitability Index = Present
Value of Future Cash Flows / Initial Investment
If project has positive NPV, then the PV of future cash flows
must be higher than the initial investment.Thus the Profitability
Index for a project with positive NPV is greater than 1 and less
than 1 for a project with negative NPV.This technique may be useful
when available capital is limited and we can allocate funds to
projects with the highest PIs.
2) Discounted Payback PeriodOne of the limitations in using
payback period is that it does not take into account the time value
of money. Thus, future cash inflows are not discounted or adjusted
for debt/equity used to undertake the project, inflation, etc.
However, the discounted payback period solves this problem. It
considers the time value of money, it shows the breakeven after
covering such costs. This technique is somewhat similar to payback
period except that the expected future cash flows are discounted
for computing payback period.Discounted payback period is how long
an investments cash flows, discounted at projects cost of capital,
will take to cover the initial cost of the project. In this
approach, the PV of future cash inflows are cumulated up to time
they cover the initial cost of the project. Discounted payback
period is generally higher than payback period because it is money
you will get in the future and will be less valuable than money
today.For example, assume a company purchased a machine for $10000
which yields cash inflows of $8000, $2000, and $1000 in year 1, 2
and 3 respectively. The cost of capital is 15%. The regular payback
period for this project is exactly 2 year. But the discounted
payback period will be more than 2 years because the first 2 years
cumulative discounted cash flow of $8695.66 is not sufficient to
cover the initial investment of $10000. The discounted payback
period is 3 years.
Decision Rule of Discounted Payback:If discounted payback period
is smaller than some pre-determined number of years then an
investment is worth undertaking.
3) Internal Rate of ReturnInternal Rate of Return is another
important technique used in Capital Budgeting Analysis to access
the viability of an investment proposal. This is considered to be
most important alternative to Net Present Value (NPV). IRR is The
Discount rate at which the costs of investment equal to the
benefits of the investment. Or in other words IRR is the Required
Rate that equates the NPV of an investment zero.NPV and IRR methods
will always result identical accept/reject decisions for
independent projects. The reason is that whenever NPV is positive ,
IRR must exceed Cost of Capital. However this is not true in case
of mutually exclusive projects.The problem with IRR comes about
when Cash Flows are non-conventional or when we are looking for two
projects which are mutually exclusive. Under such circumstances IRR
can be misleading.Suppose we have to evaluate two mutually
exclusive projects. One of the project requires a higher initial
investment than the second project; the first project may have a
lower IRR value, but a higher NPV and should thus be accepted over
the second project (assuming no capital rationing
constraint).Decision Rule ofInternal Rate of Return:If Internal
Rate of Return exceeds the required rate of Return, the investment
should be accepted or should be rejected otherwise.4) Payback
PeriodPayback period is the first formal and basic capital
budgeting technique used to assess the viability of the project. It
is defined as the time period required forthe investments returns
to cover its cost. Payback period is easy to apply and easy to
understand technique; therefore, widely usedby investors.For
example, an investment of $5000 which returns $1000 per year will
have a five year payback period.Shorter payback periods are more
desirable for the investors than longer payback periods. Itis
considered as amethod of analysis with serious limitations and
qualifications for its use. Because it does not properly account
for the time value of money, risk and other important
considerations such as opportunity cost.5) Net Present value: Net
present value among other techniques of capital budgeting simply
tell us about the contribution of a certain project to the
shareholders wealth. The higher the addition of wealth by the
project, higher will be the shareholders wealth, which means the
higher will be the share price. A formal definition of this
technique of capital budgeting defines it as a ranking methods of
projects, which rank the projects on the basis of their difference
between outflow and present value of inflows. Formula of this
technique is as following: NPV= present value of Inflow +
OutflowThe higher the net present value of the project, higher will
be the chances of profitability from that project. Here we talk
about chance of profitability because on the basis of prediction of
future. So, the decision criteria in this approach of capital
budgeting is the selection of project with a higher net present
value. For example, we find a project which requires an outflow of
RS. 1000 and inflows of 500, 400, 300, 200 at the required rate of
10% for next 4 years. Is it project is feasible for investment.
NPV= -1000 + 500/(1.10)^4 + 400/(1.10)^3 +300/(1.10)^2 +
200/(1.10)^1NPV= -1000 + 1071.785 NPV= 71.785 As the Net present
value of this project is positive, so we can conclude that the
investment in this project is feasible and result in profitable
investment.
