Capital Budgeting is a process to evaluate the profitability of an investment opportunity for a company. It evaluates the profitability by comparing the expenses incurred and the revenue generated from the investment.
- In simple words, Capital Budgeting tells a company whether to invest in a project or not on the grounds of cash flow and profitability.
- High Risk: The entire process is based on assumptions and trends hence involves a great risk.
- Complete Analysis: The process counts for every expense and revenue generated however large or small it may be.
- Life Cycle: The process calculates all the factors for the entire life cycle of the project considering all the stages and cash flows involved.
Capital Budgeting Process
The Capital Budgeting process is a combination of several steps which are as follows:- Identifying Opportunities: This is the first step in Capital Budgeting which involves, shortlisting the various opportunities for investment.
- Project Evaluation: Once the opportunities are shortlisted, the next step is to evaluate and compare them among each other, the motive is to rank all the projects based on the profitability index.
- Investment Selection: This step is the final selection of the most suitable opportunity obtained after comparing all the options from Step 2.
- Project Implementation: This step involves funding of the selected project, the source of funds is identified and assigned to the project. The responsibilities regarding deadlines and implementation are being allotted.
- Performance Review: This step is the final step that includes comparing the actual performance parameters along with the expected parameters to judge the decision-making capabilities. If the actual performance exceeds the expectation, then the project is outstanding and vice -versa.
Project Categories
Profit is the key decision-maker for any Project, but profit does not create a need for a new investment/project, there are other factors that lead to an investment:- Replacement/Repair Project: Every Asset has a life after which it needs to be replaced and during its life, it needs repairs/modifications at various stages. However, at various times the cost of repairing exceeds the cost of replacement, thus the decision to repair or replace the asset is itself a project.
- Regulatory Projects: The government has various set of protocols for the industry to follow, these are mandatory protocols which cannot be deferred. These may or may not be profitable at times but are necessary for the survival of the organization, hence a regulatory protocol is itself a project that every company must undertake.
- Expansion Projects: Every entity in this world needs to grow with time in order to survive and maximize profit, this is a never-ending process and hence needs continuous efforts and support, for any organization, this is one of the most important projects.
- Product Enhancement: Every product has a definite Product Life Cycle after which it either needs to be renovated or replaced by a new product, this is a never-ending process that requires continuous attention, this itself is a huge project it undertakes.
Corporate Usage of Various Capital Budgeting Methods
Capital Budgeting is a process that is used to calculate the profitability of a project. Corporates undertake several projects to generate revenue, increase the company’s net worth, or meet regulatory requirement, hence Capital Budgeting is of great importance to them.
- Capital Budgeting gives an insight of the net returns of an investment, this insight combined with other factors gives a clear picture of the investment and help companies to make decisions.
- Net Present Value (NPV), Internal Rate of Return (IRR), and Payback Period (PB) are among the most used methods to calculate the viability of a project on the Grounds of Profits.
- Net Present Value (NPV): This is the most trusted and recommended method that calculates the future tax-free net cash flows of an investment considering the initial investment as well. A positive value of NPV is considered acceptable.
- Internal Rate of Return (IRR): This is the rate at which NPV = 0 if IRR > 0 then the project is acceptable.
- Payback Period (PB): This is the time in which the initial investment is recovered from the future cash flows without taking into consideration the time value of money. Shorter Payback Periods are preferred over the longer ones. PB alone does not give full insight, but when combined with IRR or NPV gives better clarity over the returns.
- Discounted Payback Period: Discounted Payback Period is the time required to recover the original cost of an investment from the net cash flows considering the time value of money. It is an enhanced version of the Payback Period where the time value of money is not considered.
- Average Accounting Rate of Return (ARR): Average Accounting Rate of Return is a technique that measures the profitability of a project using the accounting profits of the company. ARR is the average net income expected by a project divided by the average capital cost. ARR is also known as the Average Rate of return or Simple Rate of Return.
Related topics
- Principles of Capital Budgeting
- Discounted Payback Period
- Payback Period
- Internal Rate of Return (IRR)
- Average Accounting Rate of Return (ARR)
- Net Present Value
- Ranking Conflicts Between NPV and IRR
- Net Present Value Profile (NPV Profile)
- Profitability Index (PI)
- Investment Decision Criteria
- The Multiple IRR Problem and the No IRR Problem
