Capital Budgeting

Capital budgeting is a technique of evaluating big investment projects. Net Present Value (NPV), Benefit to Cost Ratio, Internal Rate of Return (IRR), Payback Period and Accounting Rate of Return are some prominent capital budgeting techniques widely used in the finance arena. A project is passed for implementation after it is approved by these techniques.

Capital budgeting techniques are utilized by the entrepreneurs in deciding whether to invest in a particular asset or not. It has to be performed very carefully because a huge sum of money is invested in fixed assets such as machinery, plant etc. The analysis is based on the stream of expected cash flows generated by using those assets and initial or future outlays required for acquisition of the asset. Such investment techniques or capital budgeting techniques are broadly divided into two criteria:

Discounting Cash Flow Criteria:

Discounting cash flow criteria has three techniques for evaluating an investment.

Net Present Value (NPV)

Net present value (NPV) technique is a well know method for evaluating investment projects or proposals. In this technique or method, present value of all

Capital Budgeting

Capital Budgeting

the future cash flows whether negative (expenses) or positive (revenues) are calculated using and appropriate discounting rate and added. From this sum, the initial outlay is deducted to find out the profit in present terms. If the figure is positive, the techniques show green signal to the project and vice versa. This figure is called net present value (NPV).

Suppose, our proposed investment is $100 million and present value (PV) of future cash flows come to be $120 million. The NPV would be $20 million and hence, the project should be undertaken. If the PV is $80 million, the NPV would be negative $20, the project is not advisable in this case.

The benefit to Cost Ratio

Benefit to cost ratio presents the analysis in a proportion or ratio format. Here, just like in the NPV method, the present value of future cash flows is calculated and a ratio of this sum to the initial outlay is seen. If this ratio is more than 1, the project should be accepted and if it is less than 1, it should be rejected.

Let us assume the same example as taken in NPV method. Benefit to cost ratio would be 1.2 in the first case and as per the rule, the project should be executed and in the second example, the ratio is 0.8 which is less than 1, so the project should be rejected.

Internal Rate of Return

This method is also a well-known method of evaluation. This has a severe connection with the first method i.e. Net Present Value (NPV). In the NPV method, the discounting rate is assumed to have known to the evaluator. On the contrary, the rate of discounting is not known in this method of Internal Rate of Return (IRR). IRR is found out by equating the NPV equal to 0 with an unknown variable as the discounting rate. This discounting rate is found out using trial and error method or extrapolating and interpolating methods and it is known as Internal Rate of Return (IRR). For evaluation purpose, IRR is compared with the cost of capital of the organization. If the IRR is greater than a cost of capital, the project should be accepted and vice versa.

Non-Discounting Cash Flow Criteria:

Non-discounting cash flow criteria have two techniques for evaluation of investment.

Payback Period

Payback period is the method of evaluation where no discounting of cash flow comes into play.The term ‘payback period’ is the period in which the initial outlay is covered

with the revenues. Suppose an initial outlay is $100 million and the revenue stream is $40 for the first 4 years. Then, the payback period is 2.5 years. Essentially, in 2.5 years, the entrepreneur gets his investment back and revenue after this period is the profit for him.

Accounting Rate of Return

Accounting rate of return is calculated with the help of accounting data. The ratio of profit after tax and book value of investment is the accounting rate of return. If the book value of investment is $100 and profit after tax is $25, then the ratio results into 25%. Hence, accounting rate of return is 25%.

Last updated on : July 12th, 2017
What’s your view on this? Share it in comments below.

Leave a Reply

Equity Valuation Methods
  • Discounted Payback Period
    Discounted Payback Period
  • Tobin’s Q / Q Ratio
    Tobin’s Q / Q Ratio
  • Portfolio Management Process
    Portfolio Management Process
  • Opportunity Cost of Capital/ Hurdle Rate/ Discounting Rate in Net Present Value Evaluation
    Hurdle Rate
  • Subscribe to Blog via Email

    Enter your email address to subscribe to this blog and receive notifications of new posts by email.

    Join 122 other subscribers

    Recent Posts

    Find us on Facebook

    Related pages

    meaning of inventory turnoverwhat is the difference between current assets and noncurrent assetsmodigliani miller dividend policyirr wikipediatotal assets turnover calculatorbep in accountingcapitalisation of r&dfccb indiaconglomerate integration examplesshares with perksadvantages and disadvantages of eoq modelmeaning of breakevenoverdraft benefitslc advising processwhat is the meaning of miscellaneous expenseseoq calculation inventory managementcalculation of quick ratiopayback period examplemishappening meaningdividend payout ratio formula examplequick asset ratio interpretationmultiple growth model formulawacc and cost of equityfinancial irrdefinition payback periodcalculating hurdle ratewhat is the difference between notes payable and accounts payableconglomerate mergers examplesdebtor collection periodoperating breakeven pointbank overdraft defineimport documentary crediteoq model of inventory controlformula for epshow to calculate cash ratiolessor or lesseeconstant dividend growth modelhow to calculate cash ratioredeemable convertible preference sharesamerican depository receipttrade debtor collection perioddefine classified balance sheetzero coupon bond vs coupon bondearning retention ratioformula for receivable turnoverwhy buy a zero coupon bondexample of capital reserveasset revaluationrumus tobin's qvalue of callable bondtypes of budgets in cost accountingdiff between cash flow and fund flowforeign currency convertible bondsmeaning of hypothecateddeed of hypothecationbudgeting wikipediaconstant growth dividend valuation modeladvantages and disadvantages of budgetswacc projectzero coupon loanmeaning of mishappeningexample of inventory turnoverpayback period discount rateshareholder value maximizationoptimal capital budget definitionmotives of mergersadvantages of residual incomenon current asset turnover ratioirr formulaebudgeting concepts management accountingdebtors velocityasset turnover ratio calculatorexamples of period costsrevenue turnover formularevenue maximization definitioninvestment appraisal payback perioddefine noiwacc ratiohiring and leasing definitioncogs depreciation