Capital budgeting involves determining the most advantageous investment options for your small business’s liquid assets, that is, the money you have readily available on hand for expenses. Accountants use several complex calculations to analyze possible investment returns, but many small businesses lack personnel with awareness of the complexity of capital budgeting. Simply estimating yearly returns in cash flow doesn’t offer your small business an accurate representation of an investment’s real return value, but simple approaches to capital budgeting can give you a realistic picture.
What Are Examples of a Capital Budgeting Project
Let’s see some simple to advanced examples of capital budgeting to understand it better.
Example #1 (Pay Back Period)
Pay Back Period Definition and how to understand that. Let’s discuss this by considering the below example?
An XYZ limited company looking to invest in one of the new projects and the cost of that project is $10,000 before the company wants to analyze how long it will take a company to recover invested money in a project?
Solution:
Let’s say in a year one, and so on, the company recovers a profit as listed in the table below.
So how long will it take the company to recover invested money from the above table it shows three years and some months. But this is not the right way to find out a payback period of initial investment because the company’s base is profit. It is not a cash flow, so profit is not the right criteria, so a company should use it here as cash flow. So profit is arrived after deducting depreciation value, so to know the cash flows, we have to add depreciation in profit. The depreciation value is $2,000, so net cash flows will be as listed in the below table.
So from Cash flow analysis, the company will recover the initial investment within two years. So the payback period is nothing but the time taken by cash inflows to recover the investment amount.
Example #2
Calculate the Payback Period and Discounted Pay Back Period for the project, which costs $270,000 and projects expected to generate $75,000 per year for the next five years? The company required rate of return is 11 percent. Should the company go ahead and invest in a project? The rate of return is 11%. Do we have to find it here, PB?DPB?Should the project be purchased?
Solution:
After adding each year’s cash flows, the balance will come, as shown in the below table.
From the above table, positive balance is in between 3 and 4 years, so,
- PB= (Year – Last negative Balance)/Cash Flows
- PB=[3-(-45,000)]/75,000
- PB= 3.6 Years
Or
- PB= Initial Investment/Annual Cash Flows
- PB= 270,000/75,000
- PB= 3.6 Years.
The Discounted rate of return of 11% Present Value of Cash Flows are shown below.
- DPB= (Year – Last negative Balance)/Cash Flows
- DPB= [(4-(37,316.57)/44,508.85)
- DPB= 4.84 Years
So from both capital budgeting methods, it is clear that the company should go ahead and invest in the project as though both methods will cover the initial investment before five years.
Example #3 (Accounting Rate of Return)
The accounting rate of Return technique of capital budgeting measures the annual average rate of return over the assets life. Let’s see through this example below.
XYZ limited company planning to buy some new production equipment, which costs $240,000, but the company has unequal net cash inflows during its life, as shown in the table, and $30,000 residual value at the end of its life. Calculate the accounting rate of return?
Solution:
First, calculate the Average Annual Cash Flows
- =Total cash Flows/Total Number of Year
- =360,000/6
Average Annual Cash Flows =$60,000
Calculate Annual Depreciation Expenses
=$240,000-$30,000/6
=210,000/6
Annual Depreciation Expenses =$35,000
Calculate ARR
- ARR=Average Annual net cash flows – Annual Depreciation Expenses/ Initial Investment
- ARR=$60,000- $35,000/$240,000
- ARR=$25,000/$240,000 × 100
- ARR=10.42%
Conclusion – If ARR is higher than the hurdle rate established by company management, it will be considered, and vice versa, it will be rejected.
Example #4 (Net Present Value)
Met Life Hospital is planning to buy an attachment for its X-ray machine, The cost of the attachment is $3,170, and life of 4 years, Salvage value is zero, and an increase in cash inflows every year is $1,000. No investment is to be made unless having an annual of 10%. Will MetLife Hospital invest in the attachment?
Solution:
Total investment Recovered (NPV)= 3170
The above table shows that cash inflows of $1,000 for four years are sufficient to recover the initial investment of $3,170 and provide exactly a 10% return on investment. So MetLife Hospital can invest in X-ray attachment.
Example #5
ABC limited company is looking to invest in one of the project costs of $50,000 and cash inflows and outflows of a project for five years, as shown in the below table. Calculate Net Present Value and Internal Rate of Return of the Project. The interest rate is 5%.
Solution:
First, calculate net cash flows during that period by Cash inflows – Cash outflows, as shown in the table below.
NPV= -50,000+15,000/(1+0.05)+12,000/(1+0.05)²+10,000/(1+0.05)³+ 10,000/(1+0.05)⁴+
14,000/1+0.05)5
NPV= -50,000+14,285.71+10,884.35+8,638.56+8,227.07+10,969.21
NPV= $3,004.84 (Fractional Rounding of)
Calculate IRR
Internal Rate of Return = 7.21%
If you take IRR 7.21% the net present value will be zero.
Points to Remember
- If IRR is > than Discount (interest) rate, than NPV is > 0
- If IRR is < than Discount (interest) rate, than NPV is < 0
- If IRR is = to Discount (interest) rate, than NPV is = 0
Definition of Capital Budgeting
Capital budgeting makes decisions about the long-term investment of a company’s capital into operations. Planning the eventual returns on investments in machinery, real estate and new technology are all examples of capital budgeting. Managers may adopt one of several techniques for capital budgeting, but many small businesses rely on the simplest technique, called “payback period,” which simply measures the time needed for the investment to return its value. As your business grows beyond the small business, starting-up phase, you may want to consider adopting more-sophisticated methods of calculating investment returns.
Understanding the Time Value of Money
The payback period computation does not account for the time value of money, which calculates how much money will be worth in the future based on projected interest rates. The money spent in capital budgeting is actually worth more in the future because your business could have invested the money and received interest payments. Small businesses using payback period computations should account for the time value of money in order to create a more accurate representation of when investments become profitable.
Accounting for Inflation
Small businesses must also account for inflation when evaluating investment options through capital budgeting. When inflation increases, the value of money falls. Projected returns are not worth as much as they appear if inflation increases, so seemingly profitable investments may only break even or perhaps lose money when you account for inflation. Most small businesses have neither the staff or the accounting experience to be aware of these factors, so their return projections are less accurate than larger businesses’ projections.
Full Example of Capital Budgeting
Capital budgeting for a dairy farm expansion involves three steps: recording the investment’s cost, projecting the investment’s cash flows and comparing the projected earnings with inflation rates and the time value of the investment. For example, dairy equipment that costs $10,000 and generates a $4,000 annual return would appear to “pay back” on the investment in 2.5 years.
However, if economists expect inflation to rise 30 percent annually, then the estimated return value at the end of the first year ($14,000) is actually worth $10,769 when you account for inflation ($14,000 divided by 1.3 equals $10,769). The investment generates only $769 in real value after the first year.
apital budgeting is the evaluation and selection of long-term investments on the basis of their costs and potential returns. The process provides a framework for formulating and implementing the appropriate investment strategies. Cash flow estimates are used to determine the economic viability of long-term investments. The cash flows of a project are estimated using discounted and nondiscounted cash flow methods.
Discounted Cash Flows
- Discounted cash flow, or DCF, methods account for the time value of money when determining the viability of projects. This time value is the change in the purchasing power of the dollar over time. The DCF methods also indicate the opportunity cost — that is, the consequences of forgoing alternative investments to make the chosen investment. The main types of DCF methods are net present value, internal rate of returns and the profitability index.
Net Present Value
- Net present value, or NPV, is the difference between an investment’s present value of cash inflows and its present value of cash outflows. The cash flow estimates are determined using a market-based discount rate, also know as a hurdle rate, which accounts for the time value of money. NPV expresses the wealth generation impact of an investment in dollar terms. The rule of thumb is to accept capital investments with positive cash flows and reject the ones with negative cash flows. This is because a positive NPV confirms that the investment’s cash flow will sufficiently compensate its costs, the cost of financing and the underlying cash flow risks.
Internal Rate of Return
- Internal rate of return, or IRR, is the rate at which an investment is expected to generate earnings during its useful life. IRR is actually the discount rate that pushes the NPV to zero. This is more or less the discount rate at which the present value of cash outflows equals the present value of cash inflows. Accept a capital investment if the IRR is greater than the cost of capital, and reject it if the IRR is lower than the cost of capital.
Profitability Index
- The profitability index, or PI, is the ratio of an investment’s NPV. It shows the ratio of the present value of cash inflows to the present value of cash outflows. This method facilitates the ranking of investments, especially when dealing with mutually exclusive investments or rationed capital resources. Accept a capital investment when the PI is greater than 1, and reject it when the PI is less than 1.
Nondiscounted Cash Flows
- Non-DCF methods do not account for the time value of money; they assume the value of the dollar will remain constant over the economic life of a capital investment. The payback period, or PBP, is the only non-DCF method that uses cash flow estimations. PBP is the duration it takes to recover the initial capital of an investment. Investments with short PBP are preferred over investments with longer PBP. However, this method has major shortcomings, because it does not show the timing of cash flows and the time value of money.
Risk Analysis
- Risk analysis is the process of evaluating the nature and scope of expected and unexpected setbacks that may derail the achievement of investment goals. A capital budgeting risk is the likelihood of a long-term investment failing to generate the expected cash flows. Such risks arise from imperfections in future cash flow estimates, a situation that exposes your business to possibilities of embracing loss-making capital investments. Always analyze such probable risks and apply the appropriate risk premiums — that is, the applicable rate of returns you should earn for embracing the extra risks.
Importance of Capital Budgeting
Long-term Goals
For the growth & prosperity of the business, long-term goals are very important for any organization. Every investment carries risk and uncertainty. And the longer the investment period, the more is the risk and uncertainty. A wrong decision can be disastrous for the long-term survival of the firm. Capital budgeting has had its effect over a long time span. It also affects companies’ future costs & growth. It assists the management in understanding the complications and challenges of long-term proposals.
Involvement of a Large Number of Funds
Capital Investment requires a large number of funds. As the companies have limited resources, the management has to make wise & correct investment decisions. The wrong decision would harm the sustainability of the business. The large investment includes the purchase of an asset and rebuilding or replacing existing equipment.
Irreversible Decision
Capital investment decisions are generally irreversible as they require large funds. It isn’t easy to find the market for that asset. The only way remains with the company is to scrap the asset & incur heavy losses. A good project can turn bad if there is no control over the costs.
Monitoring & Controlling the Expenditure
The capital budget carefully identifies the necessary expenditure and R&D required for an investment project. Since a good project can turn bad if expenditures aren’t carefully controlled or monitored, this step is a crucial benefit of capital budgeting.
Transfer of Information
The time that project starts off as an idea, it is accepted or rejected; numerous decisions have to be made at various levels of authority. The capital budgeting process facilitates the transfer of information to appropriate decision-makers within a company.
Difficulties of Investment Decision
Long-term investment decisions are difficult because it extends several years beyond the current period. Uncertainty indicates a higher degree of risk. Management loses its flexibility and liquidity of funds in making investment decisions, so it must thoroughly consider each proposal. This is because management has an assurance that capital budgeting will assist them in making better decisions. And these decisions would eventually help to maximize the shareholders’ wealth.
Maximization of Wealth
Long-term investment decision of the organization helps in safeguarding the interest of the shareholder in the organization. If the organization has invested in a planned manner, the shareholder would also be keen to invest in that organization. This helps in the maximization of the wealth of the organization. Any expansion is fundamentally related to further sales and future profitability of the firm, and asset acquisition decisions are based on capital budgeting.
Other Important Aspects of Capital Budgeting
Capital budgeting involves two important decisions at once: a financial decision and an investment decision. By taking the project, the business has agreed to make a financial commitment to a project which involves its own set of risks. Project delay, cost overruns & regulatory restrictions can all delay & increase the cost of the project.
In addition to a financial decision, a company is also making an investment in its future direction and growth. It is likely to have an influence on future projects that the business considers & evaluates. So the capital investment decision must be taken considering both perspectives, i.e., financial & investment.
In December 2009, ExxonMobil, the world’s largest oil company, announced that it was acquiring XTO Resources in the U.S. for $41 billion. It was one of the largest natural gas companies. That acquisition was a capital budgeting decision, one in which ExxonMobil made a huge financial commitment. But in addition, ExxonMobil was making a significant investment decision in natural gas. Essentially positioning the company to also focus on growth opportunities in the natural gas arena. That acquisition alone will have a profound effect on future projects that ExxonMobil will consider and evaluates for many years to come.
It can be said that running a business is nothing more than a constant exercise in capital budgeting decisions. Understanding that both a financial and investment decision is useful for making successful capital investment decisions.
Capital budgeting techniques
- Payback period method:
As the name suggests, this method refers to the period in which the proposal will generate cash to recover the initial investment made. It purely emphasizes on the cash inflows, economic life of the project and the investment made in the project, with no consideration to time value of money. Through this method selection of a proposal is based on the earning capacity of the project. With simple calculations, selection or rejection of the project can be done, with results that will help gauge the risks involved. However, as the method is based on thumb rule, it does not consider the importance of time value of money and so the relevant dimensions of profitability.
This method helps to overcome the disadvantages of the payback period method. The rate of return is expressed as a percentage of the earnings of the investment in a particular project. It works on the criteria that any project having ARR higher than the minimum rate established by the management will be considered and those below the predetermined rate are rejected.
This method takes into account the entire economic life of a project providing a better means of comparison. It also ensures compensation of expected profitability of projects through the concept of net earnings. However, this method also ignores time value of money and doesn’t consider the length of life of the projects. Also it is not consistent with the firm’s objective of maximizing the market value of shares.
- Discounted cash flow method:
The discounted cash flow technique calculates the cash inflow and outflow through the life of an asset. These are then discounted through a discounting factor. The discounted cash inflows and outflows are then compared. This technique takes into account the interest factor and the return after the payback period.
- Net present Value (NPV) Method:
This is one of the widely used methods for evaluating capital investment proposals. In this technique the cash inflow that is expected at different periods of time is discounted at a particular rate. The present values of the cash inflow are compared to the original investment. If the difference between them is positive (+) then it is accepted or otherwise rejected. This method considers the time value of money and is consistent with the objective of maximizing profits for the owners. However, understanding the concept of cost of capital is not an easy task.
Conclusion
Capital budgeting is an important tool for leaders of a company when evaluating multiple opportunities for investment of the firm’s capital. However, this is not the only step in budgeting for a new asset. It would be best to talk with a financial professional when applying the concepts discussed above while budgeting for a purchase.