Introduction



In modern days, where the market is having so much competition, every company is trying to grow and staying ahead from the peers by acquiring more market shares, expanding their sales in new targeted markets and taking new project initiatives. In this process of growing and expanding, a company always stays in need of a huge sum of capital, though acquiring capital is difficult as it is scarce to invest in every project. Thus the optimal use of available capital is important for the finance manager. In this process of capital optimisation, a financial manager needs to do capital budgeting.





In this article, the importance of capital budgeting in modern days is established through the brief discussion on the concept of capital budgeting whereas later it focuses on the various approaches (Traditional and modern approaches) of capital budgeting with appropriate examples.





Definition of Capital Budgeting



Capital budgeting is a decision-making process where the firm analyses the viability and profitability of any capital intensive long term project or purchasing of fixed assets and machinery. It helps the financial manager to compare similar projects and finding the most suitable or profitable project among them. Capital intensive assets or projects make up the long-term assets portion of the balance sheet. These capital intensive projects or assets may require a huge amount of capital that these decisions need a sound capital budgeting that in turn may decide the future of many corporations. A sound capital budgeting process helps in the maximisation of shareholders wealth as well as provides a roadmap for profit maximisation through investing in new projects which generate maximum profits.





Different approaches to Capital Budgeting








Like one can take various routes to reach on a particular destination similarly there are various approaches which a financial manager can follow to make an optimal capital budgeting decision.


Based on the various approaches it can be classified under two broad categories


1.      Traditional Approaches or Non-Discounted Methods


2.      Modern Approaches or Discounted Cash Flow Methods





Traditional Approaches or Non-discounted Methods



            As the name highlighted this type of approaches does not take any consideration of the time value of money or the discounting factor. These are further classified into two categories - 


●       Payback Period Method


●       Accounting Rate of Return Method (ARR)


Payback Period Method



Here the decision takes into consideration the time period through which the initial investment value will be recovered completely. It only considers the cash inflows during the time period, the useful life span of the project and the initial capital invested at the beginning of that project. The financial manager makes the decision on the basis of earning capacity of the project. As it does not consider the time value of money, the relevant dimensions of the profitability also get eliminated. One can calculate the Payback Period by using the following formula -


Payback Period = Cash outflow as Initial investment / Annual Cash Inflow





Example: Payback Period





















































Particulars

Project A


Amount (Rs.)

Project B


Amount (Rs.)

Cost

10,00,000

10,00,000

Expected Future Cash Flow







Year 1

5,00,000

10,00,000

Year 2

5,00,000

50,000

Year 3

10,10,000

50,000

Year 4

None

None

Total

20,10,000

11,00,000

Payback

2 Years

1 Years



Here the payback period for Project B is less than the Project A but here we can see that the Project A provides higher return compare to Project B. Hence the project A will be selected due to the higher return.





Accounting Rate of Return (ARR) Method



 In this method of capital budgeting, the rate of return is considered as a return percentage of the earnings of the investments that are made for the project. Accounting Rate of Return (ARR) helps to eradicate drawbacks of Payback Period Method. Here in case of the decision making the process, a financial manager refers to a minimum predetermined rate of return, if the Accounting Rate of Return (ARR) comes above or more than the minimum rate of return then it gets selected and projects with ARR below the predetermined rate gets rejected. In order to calculate the Accounting Rate of Return (ARR) -





Accounting Rate of Return (ARR) = Incremental Accounting Income / Initial investment





Example: The ABC Company wants to buy a new machine and replace the old one against it. The old one can be sold to another company for Rs.10,000. The new machine would increase the annual revenue by Rs.1, 50,000 and annual operating expenses increases by Rs.60,000. The new machine would cost Rs.3, 60,000. The estimated working life of the machine is 12 years and the salvage value will be zero.


 Determine the accounting rate of return. Should the company ABC purchase the new machinery if the management needs a return of 12% of the capital investments?


Solution: Incremental Accounting Income:


 Incremental Revenues - Incremental Expenses including Depreciation


Rs.1, 50,000- (Rs.60,000 + Rs.30,000)


Rs.1, 50,000- Rs.90,000


Rs.60,000


The amount of initial investment (Rs.3, 60,000-Rs.10,000) = Rs.3, 50,000


Accounting Rate of Return = Rs.60,000 / Rs.3, 50,000 = 17.14%





According to accounting rate of return method, ABC Company should purchase the new machine because it’s computed accounting rate of return (ARR) is 17.14% which is higher than the estimated rate of return is 12%.





Modern Approaches or Discounted Cash Flow Methods



            In modern approaches, the time value of money takes into consideration while making capital budgeting decisions. Discounted cash flows first calculate the cash inflows and outflows through the life of an asset or the project. Then these inflows and outflows get discounted through a discounted factor. This method takes into account the interest factor and returns after the payback period. Modern approaches or discounted cash flow methods are discussed below -


●       Net Present Value (NPV) Method


●       Internal Rate of Return (IRR)Method


●       Profitability Index (PI) Method


●       Terminal Cash Flow Approach





Net Present Value (NPV) Method



 It is one of the most useful capital budgeting indicators. Under this method, the present values of cash inflows are compared with the value of the initial investment made. Here the financial manager uses a particular discounted rate to calculate the net present value. Net present value considers the time value of money and also takes into account the concept of profit maximisation for the owners.


NPV = PVB - PVC


Where, PVB = Present Value of Benefits


            PVC = Present Value of Costs


NPVxyz = Z1/ (1+r) + Z2/(1+r)^2 - X0   


  Where Z1 = Clash flow in the first year


             Z2 = Cash flow in the second year


             r= Discount rate


             X0 = Initial Investment


Example: Suppose a project costs Rs.1000 initially. It will provide three cash flows of Rs.500 for the first year, Rs.300 for the second year and Rs.800 for the third year. The required rate of return is 8%.


Therefore, NPV = Today's Value of Expected Cash Flows - Today’s Value of Invested Cash


Rs.355.23 = Rs.500/(1+8%)^1 + Rs.300/(1+8%)^2 + Rs.800/(1+8%)^3





Internal Rate of Return (IRR) Method



The internal rate of return (IRR) estimates the profitability of investments. The internal rate of return (IRR) makes the Net Present Value (NPV) of cash flows from a particular project to zero.





NPV = 0  = CF0 + CF1/ (1+IRR) + CF2/ (1+IRR) ^2 +CF3/ (1+IRR) ^3 +.... + CFn/ (1+IRR) ^n





 Where,


CF0 = Initial investment


CF1, CF2, CF3, … , CFn = Cash flows


n = Number of period


NPV = Net Present Value


IRR = Internal Rate of Return





Example: New equipment cost of Rs. 5, 00,000. Estimated life of the new asset 4 years and expects to generate growth of Rs. 1, 60,000 in annual profits. On the fifth year, sell off the equipment for Rs. 50,000. Another investment option can provide a 10% return. This is higher than the company's current hurdle rate of 8%. The goal is to make sure the company is using its cash efficiently.


 Solution: Through calculation, we are getting IRR of 13%. The company should make the purchase as the IRR in both is greater than the IRR for the alternative investment.





Profitability Index (PI) Method:



            It indicates the relationship between the costs and benefits of a proposed project. A profitability index of 1.0 marked as an indicator where present value is negative if profitability index (PI) comes less than 1.0 similarly PI more than 1.0 indicates financial profitability of the project .








Profitability Index (PI) = Present Value (PV) of Future Cash Flow/ Initial Investments


     = 1 + (Net Present Value/Initial Investment)


Example: ABC enterprise wants to invest in a project with an initial investment of Rs. 100 million. The present value of the future cash flow of this project is Rs. 130 million. Determine whether to invest in the same or not with the help of the Profitability Index (PI).


Solution: Profitability Index = Present Value of Future cash flow / Initial investment


           = Rs. 130 million / Rs. 100 million


           = 1.3





Here the Profitability Index (PI) is 1.3. Hence it is a great project to invest in.





Terminal Cash Flow Approach:



Terminal cash flow refers to the net cash flows occurs at the end of the project and refers the after-tax revenues from the disposal of the project and recoupment of working capital.


Terminal cash flow calculated as follows:


Terminal cash flow = After-tax proceeds from disposal +/- Change in working capital


After-tax proceeds from disposal = Pre-tax proceeds from disposal - Tax on the gain on disposal


Tax on the gain on disposal = (Pre-tax proceeds from disposal - Ending book value) * Tax rate





Example: Machinery has an economic life of 5 years. The initial investment on the project is Rs.200 million. From this Rs. 200 million, Rs.20 million is due to increased working capital. For tax purposes, the company follows a straight line depreciation method for 5 years with the expected residual value of Rs.20 million. It is determined that the machinery can be salvaged for Rs.40 million. Working capital will revert back to its initial level at the end of 5 years. The applicable interest rate on the gain on disposal is 20%. Determine the terminal cash flow.





Solution:


Tax on Disposal = (Proceeds - Book value) * Tax rate 


                           = (Rs.40 million - Rs.20 million) * 20%


   = Rs. 4 million


After tax proceeds from disposal = Rs. 40 million - Rs. 4 million


     = Rs. 36 million


Terminal cash flow = After-tax proceeds from disposal + Working capital recouped


       = Rs. 36 million + Rs. 20 million


                               = Rs. 56 million








Conclusion







Capital Budgeting gives a financial manager a great tool in financial decision making. It not only helps to compare between various projects or assets to invest or purchase or not but also helps to achieve the optimum capital allocation which will lead to greater profit generation. This profit generation in turns helps in the maximisation of shareholders wealth. In the case of modern capital budgeting system time value of money is considered which helps to identify the exact financial benefits which a particular project or asset will be generating in the future course of actions. Capital budgeting is something that creates a roadmap for the firm's expansion and ensures optimum capital usage.





























References



Almazan, A., Chen, Z. and Titman, S., 2017. Firm Investment and Stakeholder Choices: A Top‐Down Theory of Capital Budgeting. The Journal of Finance, 72(5), pp.2179-2228.


Al-Mutairi, A., Naser, K. and Saeid, M., 2018. Capital budgeting practices by non-financial companies listed on Kuwait Stock Exchange (KSE). Cogent Economics & Finance, 6(1), p.1468232.


Burns, R. and Walker, J., 2015. Capital budgeting surveys: the future is now.


Hayward, M., Caldwell, A., Steen, J., Gow, D. and Liesch, P., 2017. Entrepreneurs’ capital budgeting orientations and innovation outputs: Evidence from Australian biotechnology firms. Long Range Planning, 50(2), pp.121-133.


Turner, M.J., 2017. Precursors to the financial and strategic orientation of hotel property capital budgeting. Journal of Hospitality and Tourism Management, 33, pp.31-42.