Capital budgeting is the process in which a business determines and evaluates potential expenses or
investments that are large in nature. These expenditures and investments include projects such as building
a new plant or investing in a long-term venture. Often times, a prospective project's lifetime cash inflows
and outflows are assessed in order to determine whether the potential returns generated meet a sufficient
target benchmark, also known as "investment appraisal."
Ideally, businesses should pursue all projects and opportunities that enhance shareholder value. However,
because the amount of capital available at any given time for new projects is limited, management needs
to use capital budgeting techniques to determine which projects will yield the most return over an
applicable period of time. Various methods of capital budgeting can include throughput analysis, net
present value (NPV), internal rate of return (IRR), discounted cash flow (DCF) and payback period.
MAJOR APPRAISAL TECHIQUES:
1. DCF Analysis: DCF analysis is similar or the same to NPV analysis in that it looks at the
initial cash outflow needed to fund a project, the mix of cash inflows in the form of
revenue, and other future outflows in the form of maintenance and other costs. These
costs, save for the initial outflow, are discounted back to the present date. The resulting
number of the DCF analysis is the NPV. Projects with the highest NPV should be ranked
over others, unless one or more are mutually exclusive.
2. Payback Analysis: Payback analysis is the most simple form of capital budgeting
analysis and is therefore the least accurate. However, this method is still used because
it's quick and can give managers a "back of the napkin" understanding of the efficacy of
a project or group of projects. This analysis calculates how long it will take to recoup the
investment of a project. The payback period is identified by dividing the initial
investment by the average yearly cash inflow.
capital project which can have much value. In this way, the capital
budgeting maximize the worth of equity shareholders.
INFORMATION REQUIRED FOR CAPITAL BUDGETING DECISIONS
+/-
Operating expenses
Depreciation
Earning Before Interest & Tax
Interest
Taxable income (Profit Before Tax)
Income taxes
Net income (Profit After Tax)
Depreciation
Note: For finding operating cash flows generally Profit after tax but before depreciation is
taken into consideration. It is calculated as
Cash Inflow = ((EBIT- Interest Expense)* (1- Tax Rate)) + Depriciation
Here EBIstands for Earning Before Interest & tax; from this depreciation expenses has
already been deducted.
A format for calculating the terminal cash flows is:
Format for Calculating Terminal Cash Flows
Salvage value
Cost of removing assets and shutting down
Salvage value before taxes
The riskiness of the project can be tackled by having a shorter payback period as it may
ensure guarantee against loss.
3.
As the emphasis in pay back is on the early recovery of investment, it gives an insight to
the liquidity of the project.
Limitations:
1. It fails to take account of the cash inflows earned after the payback period.
2. It is not an appropriate method of measuring the profitability of an investment project, as it
does not consider the entire cash inflows yielded by the project.
3. It fails to consider the pattern of cash inflows, i.e., magnitude and timing of cash inflows.
4. Administrative difficulties may be faced in determining the maximum acceptable payback
period.
2. Accounting Rate of Return method:
The Accounting rate of return (ARR) method uses accounting information, as revealed by
financial statements, to measure the profit abilities of the investment proposals. The accounting
rate of return is found out by dividing the average income after taxes by the average investment.
ARR= Average income/Average Investment
Advantages:
1. It is very simple to understand and use.
2. It can be readily calculated using the accounting data.
3. It uses the entire stream of incomes in calculating the accounting rate.
Limitations:
1. It uses accounting, profits, not cash flows in appraising the projects.
2. It ignores the time value of money; profits occurring in different periods are valued equally.
3. It does not consider the lengths of projects lives.
4. It does not allow for the fact that the profit can be reinvested.
3. Net present value method:
The net present value (NPV) method is a process of calculating the present value of cash flows
(inflows and outflows) of an investment proposal, using the cost of capital as the appropriate
discounting rate, and finding out the net profit value, by subtracting the present value of cash
outflows from the present value of cash inflows.
The equation for the net present value, assuming that all cash outflows are made in the initial
year (tg), will be:
Where A1, A2. represent cash inflows, K is the firms cost of capital, C is the cost of the
investment proposal and n is the expected life of the proposal. It should be noted that the cost of
capital, K, is assumed to be known, otherwise the net present, value cannot be known.
Advantages:
1. It recognizes the time value of money
2. It considers all cash flows over the entire life of the project in its calculations.
Advantages:
1. Like the NPV method, it considers the time value of money.
2. It considers cash flows over the entire life of the project.
3. It satisfies the users in terms of the rate of return on capital.
4. Unlike the NPV method, the calculation of the cost of capital is not a precondition.
5. It is compatible with the firms maximising owners welfare.
Limitations:
1. It involves complicated computation problems.
2. It may not give unique answer in all situations. It may yield negative rate or multiple rates
under certain circumstances.
3. It implies that the intermediate cash inflows generated by the project are reinvested at the
internal rate unlike at the firms cost of capital under NPV method. The latter assumption seems
to be more appropriate.
5. Profitability index:
It is the ratio of the present value of future cash benefits, at the required rate of return to the
initial cash outflow of the investment. It may be gross or net, net being simply gross minus one.
The formula to calculate profitability index (PI) or benefit cost (BC) ratio is as follows.
PI = PV cash inflows/Initial cash outlay A,
1. It gives due consideration to the time value of money.
2. It requires more computation than the traditional method but less than the IRR method.
3. It can also be used to choose between mutually exclusive projects by calculating the
incremental benefit cost ratio.
Definition of Capital Rationing
It can be defined as a process of distributing available capital among the various investment
proposals in such a manner that the firm achieves maximum increase in its value.
Based on the source of restriction imposed on the capital, the capital rationing is divided into
two types viz. hard capital rationing and soft capital rationing.
Soft Capital Rationing: It is when the restriction is imposed by the management.
Hard Capital Rationing: It is when the capital infusion is limited by external sources.
Advantages and Disadvantages of Capital Rationing
Capital Rationing Decisions
Capital rationing decisions by managers are made to attain the optimum utilization of the
available capital. It is not wrong to say that all the investments with positive NPV should be
accepted but at the same time the ground reality prevails that the availability of capital is limited.
The option of achieving the best is ruled out and therefore, rational approach is to make most
out of the on hand capital.
Capital Rationing Method
The method of capital rationing can be bifurcated in four steps. The steps are
1. Evaluation of all the investment proposals using the capital budgeting techniques of
Net Present Value (NPV), Internal Rate of Return (IRR) and Profitability Index (PI)
2. Rank them based on various criterion viz. NPV, IRR, and Profitability Index
3. Select the projects in descending order of their profitability till the capital budget
exhausts based on each capital budgeting technique.
4. Compare the result of each technique with respect to total NPV and select the best out
of that.
IRR
NPV
Ranking
PI
IRR
NPV
PI
350
19%
150
1.43
300
28%
420
2.4
250
26%
10
1.04
150
20%
100
1.67
100
37%
110
2.1
100
25%
130
2.3
In the table, if we select based on individual method, we will arrive at following result:
IRR
Projec
ts
ICO
NPV
NPV
IRR
Projec
ts
ICO
PI
NPV
Projec
ts
ICO
NPV
PI
100
110
37%
300
420
300
420
2.4
300
420
28%
350
150
100
130
2.3
250
10
26%
Total
650
570
100
110
2.1
Total
650
540
150
100
1.67
Total
650
760
The results are quite obvious and we will go with B,F,E and D to achieve maximum value of
760.