Capital budgeting is the process of determining whether an organization’s long term investments such as new machinery, new product line, new building and research development projects are worth the funding of cash through the firm’s capital structure (equity, debt, or retained earnings).
It is also known as “investment appraisal.” It is the process in which resources are allocated for capital, investment or expenditure.
The mail aim of Capital Budgeting is to maximise shareholders’ wealth.
Need for Capital Budgeting
- A large sum of money is involved in long term investments which affect the growth and profitability of the business concern.
- Long term investment once made cannot be abandoned without significant loss of invested capital.
- The capital budgeting decisions are subject to the higher degree of risk and uncertainty than short run decisions because of the time factor involved.
A bad capital budgeting decision can severely damage the financial fortune of a business enterprise. Therefore, these decisions must be taken with utmost care.
Methods of Capital Budgeting
A business enterprise must pursue all projects that enhance shareholders’ wealth. However, due to limited availability of capital for a new project, the management uses capital budgeting techniques to determine the projects which will yield the most return over a period of time.
1. Net present value
Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows. NPV is used to analyze the efficiency of the proposed investment.
An investment with a positive NPV indicates that the projected earnings generated by it (in present dollars) exceeds the anticipated costs (also in present dollars) and thus is a profitable one.
Investments with negative NPV indicate net loss.
Thus, according to the Net Present Value Rule, only those investments which yield a positive NPV should be made.
2. Internal Rate of Return
Internal rate of return is a discount rate that makes the Net Present Value of all cash flows from a particular investment equal to zero. It is used to measure investment efficiency.
IRR can be defined as the rate of growth a project is expected to yield.
While the actual rate of return that a given project will generate may differ from its estimated IRR rate, a project with a higher IRR value would provide a better chance of strong growth.
A project with an IRR greater than its cost of capital is a profitable one, and thus it is in a company’s interest to undertake such a project.
3. Payback Period
The payback period is the time required to recover the cost of an investment.
It is calculated as
The payback period is used in capital budgeting to determine whether to undertake an investment, as shorter payback period is desirable.
4. Equivalent Annuity Method
The equivalent annuity method expresses the NPV as an annualized cash flow by dividing it by the present value of the annuity factor.
It is used to assess only the costs of investments that have the same cash inflows.