An Introduction to Capital Budgeting

  • Bhumika Dutta
  • Oct 01, 2021
  • Financial Analytics
An Introduction to Capital Budgeting title banner

All firms in the market, large or small, must deal with finances. Finance entails the task of managing capital in such a way that it returns a profit to the business. The concept we will be discussing today is ‘Capital Budgeting,' and as the name indicates, it is the process of making decisions about a company's assets in order to maximize profits over a long stretch of time. 

 

This process includes planning expenditures and investments and making rational choices for the benefit of the company. Capital Budgeting is a great help in the process. In this article, we will focus on the topics given below:

 

  • What is Capital Budgeting 

  • How does Capital Budgeting work?

  • Objectives of Capital Budgeting

  • Importance of Capital Budgeting

 

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What is Capital Budgeting?

 

Capital Budgeting is the process of making logical and well-calculated decisions by companies to which capital-intensive projects they should invest in that would return them maximum profits. These projects could be anything ranging from any purchase to an investment in assets.  

 

All companies need to make decisions themselves or take help from professionals who have expertise in the topic. Capital budgeting is essential because it establishes transparency and measurability. 

 

Any company that wants to spend its resources on a project without fully comprehending the risks and rewards involved will be viewed as irresponsible by its owners or shareholders. 

 

Importance of Capital Budgeting:

 

Capital Budgeting is very important for any firm as sometimes, the investment done by the firm can be a huge amount and can lead to bankruptcy of the company if the plan fails. 

 

As a result, capital budgeting is a required task for bigger fixed asset plans. This is less of an issue for smaller investments; in these cases, it is preferable to significantly streamline the capital budgeting process, so that the focus is more on getting the investments made as quickly as possible; by doing so, profit centers’ operations are not hampered by the analysis of their fixed asset proposals.

 

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Objectives of Capital Budgeting:

 

Clear tax discusses a few objectives of capital budgeting that an organization must follow. Some of them are given below:

 

  1. An organization must select projects that will be beneficial for them in the near future or in the long term. There might be many available projects but they have to plan according to their budget and choose the most profitable one.

  2. It is important to determine the source of funds in capital budgeting because an organization must find a balance between the cost of borrowing and returns on investment.

  3. The investment opportunities can come in various forms like assets, projects, funds, expansion, etc. It is very important to identify those opportunities before it gets too late.

  4. It is also important to determine what processes would give maximum profit in return to the investments made. For example, if product expansion is the chosen investment opportunity, the company needs to decide if in-house manufacture of products gives the maximum profit or outsourcing.

  5. Even if every process is followed correctly, the investment needs to be reviewed to understand if the expectations meet the actual results. This is the last step of capital budgeting. 

 

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How does Capital Budgeting work?

 

To start with capital budgeting, the company needs to determine if any upcoming decisions regarding the capital will prove to be profitable for the firm in the long term or short term. 

 

According to Investopedia, the following methods are generally used to determine this factor:

 

  1. Payback Period:

 

The payback period is the amount of time necessary to recover the initial investment. 

 

For example, if a capital budgeting project needs an initial cash outlay of Rs. 1,00,000, the payback period indicates how many years are necessary for cash inflows to equal the one lakh outflow. A short payback term is desired since it suggests that the project will "pay for itself" in a shorter period of time. 

 

When liquidity is a key problem, payback periods are commonly employed. If a firm only has a limited quantity of money, it may only be able to take on one significant project at a time. 

 

As a result, management will place a high priority on recouping their initial investment in order to pursue future ventures. Once the cash flow is predicted, it is easier to make future plans and calculations.

 

The only disadvantage of this system is that it does not account for the time value of money (TVM), which is a concept that a sum of money in hand now is worth more than the same sum which is supposed to be paid in the future, due to its earning potential in the meantime. 

 

Calculating the payback offers a measure that emphasizes payments received in year one and year two equally. This violates one of the fundamental rules of finance. 

 

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  1. Internal Rate of Return:

 

The internal rate of return on a project is the discount rate that results in a zero net present value. The net present value of any project is inversely correlated with the discount rate, that is if the discount rate rises, future cash flows become more unpredictable and hence less valuable.

 

The actual rate used by the company to discount after-tax cash flows serves as the baseline for IRR computations. An IRR greater than the weighted average cost of capital indicates that the capital project is profitable, and vice versa. 

 

The major benefit of using the internal rate of return as a judgment tool is that it offers a standard number for each project that can be evaluated in relation to a company's capital structure. 

 

The IRR often yields the same sorts of judgments as net present value models and allows companies to assess projects based on returns on invested capital.

 

The only disadvantage is that the IRR does not provide a genuine sense of the value that a project will contribute to a business; rather, it serves as a guideline for which initiatives should be approved depending on the firm's cost of capital. 

 

Because the internal rate of return does not allow for a meaningful comparison of mutually incompatible projects, managers may be able to conclude that projects A and B are both advantageous to the business, but they will be unable to decide which is better if only one can be approved.

 

 

  1. Net Present Value:

 

The net present value technique is the most obvious and reliable capital budgeting appraisal approach. Managers can assess if a project will be profitable or not by discounting the after-tax cash flows by the weighted average cost of capital. 

 

Moreover, unlike the IRR approach, NPVs show how lucrative a project will be in contrast to alternatives. According to the NPV rule, all projects with a positive net present value should be accepted, while those with a negative net present value should be refused. If funds are restricted and all initiatives with a positive net present value cannot be launched, those with a high discounted value should be approved.

 

The NPV method has several important advantages, including its general utility and the fact that it gives a clear measure of increased profitability. It enables the comparison of many mutually incompatible projects at the same time, and although the discount rate is susceptible to change, a sensitivity study of the NPV can generally flag any significant potential future issues.


 

Although an ideal capital budgeting system would have all three measures indicating the same choice, these techniques frequently give conflicting outcomes. Depending on management's preferences and selection criteria, one technique will be prioritized over another.

 

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Conclusion

 

The success of any business lies in taking the right decisions at the right times, and capital budgeting helps in doing that and hence is a very important aspect of any business. 

 

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In this article, we have learned about the basic definition of capital budgeting along with its working, objectives, and importance. 

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