Capital Budgeting: Meaning, Methods & Examples

Meaning of Capital budgeting 

It is the planning process used to determine whether firm's long-term investments such as new machinery, replacement machinery, new plants, new products, and research and development projects are worth pursuing. Capital budgeting is a method of investment decision in capital expenditures. The expenditures of which benefit is to be received for more than one period.

The process in which a business determines whether projects such as building a new plant or investing in a long-term venture are worth pursuing. Oftentimes, a prospective project's lifetime cash inflows and outflows are assessed in order to determine whether the returns generated meet a sufficient target benchmark. It is also known as "investment appraisal". Ideally, businesses should pursue all projects and opportunities that enhance shareholder value.

However, because the amount of capital available at any given time for new projects is limited, management needs to use capital budgeting techniques to determine which projects will yield the most return over an applicable period of time. Popular methods of capital budgeting include net present value (NPV), internal rate of return (IRR), discounted cash flow (DCF) and payback period.

Many formal methods are used in capital budgeting, including the techniques as followed:

1. Net Present Value - Net present value (NPV) is used to estimate each potential project's value by using a discounted cash flow (DCF) valuation. This valuation requires estimating the size and timing of all the incremental cash flows from the project. The NPV is greatly affected by the discount rate, so selecting the proper rate–sometimes called the hurdle rate–is critical to making the right decision. This should reflect the riskiness of the investment, typically measured by the volatility of cash flows, and must take into account the financing mix. Managers may use models, such as the CAPM or the APT, to estimate a discount rate appropriate for each particular project, and use the weighted average cost of capital (WACC) to reflect the financing mix selected. A common practice in choosing a discount rate for a project is to apply a WACC that applies to the entire firm, but a higher discount rate may be more appropriate when a project's risk is higher than the risk of the firm as a whole.
2. Internal Rate of Return - The internal rate of return (IRR) is defined as the discount rate that gives a net present value (NPV) of zero. It is a commonly used measure of investment efficiency. The IRR method will result in the same decision as the NPV method for non-mutually exclusive projects in an unconstrained environment, in the usual cases where a negative cash flow occurs at the start of the project, followed by all positive cash flows. Nevertheless, for mutually exclusive projects, the decision rule of taking the project with the highest IRR, which is often used, may select a project with a lower NPV. One shortcoming of the IRR method is that it is commonly misunderstood to convey the actual annual profitability of an investment. Accordingly, a measure called "Modified Internal Rate of Return (MIRR)" is often used.
3. Payback Period - Payback period in capital budgeting refers to the period of time required for the return on an investment to "repay" the sum of the original investment. Payback period intuitively measures how long something takes to "pay for itself." All else being equal, shorter payback periods are preferable to longer payback periods. The payback period is considered a method of analysis with serious limitations and qualifications for its use, because it does not account for the time value of money, risk, financing, or other important considerations, such as the opportunity cost.
4. Profitability Index - Profitability index (PI), also known as profit investment ratio (PIR) and value investment ratio (VIR), is the ratio of payoff to investment of a proposed project. It is a useful tool for ranking projects, because it allows you to quantify the amount of value created per unit of investment.
5. Equivalent Annuity - 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 often used when comparing investment projects of unequal lifespan. For example, if project A has an expected lifetime of seven years, and project B has an expected lifetime of 11 years, it would be improper to simply compare the net present values (NPVs) of the two projects, unless the projects could not be repeated.
6. Real Options Analysis - The discounted cash flow methods essentially value projects as if they were risky bonds, with the promised cash flows known. But managers will have many choices of how to increase future cash inflows or to decrease future cash outflows. In other words, managers get to manage the projects, not simply accept or reject them. Real options analysis tries to value the choices–the option value–that the managers will have in the future and adds these values to the NPV.

These methods use the incremental cash flows from each potential investment or project. Techniques based on accounting earnings and accounting rules are sometimes used. Simplified and hybrid methods are used as well, such as payback period and discounted payback period.

1. Return on Capital Employed (ROCE) 

ROCE is also known as accounting rate of return (ARR).

The formula for calculating ROCE is:

• ROCE (Return on Capital Employed)

Formula:

Or alternatively:

Average capital investment:

Initial capital cost may include:

• Cost of new assets bought
• Net Book Value (NBV) of existing assets used in project
• Investment in working capital
• Capitalized R&D expenditure

Decision Rule

• If expected ROCE is greater than the target/hurdle rate fixed by management, accept the project.

Year	1	2	3	4	5	6	7
Cash inflows ($000)	100	200	400	400	300	200	150

Example

A project requires an initial investment of $800,000 and earns net cash inflows as follows:

At the end of Year 7, assets will be sold for $100,000.

Solution

Average annual inflows

= $1,750,000 ÷ 7

= $250,000

Average annual depreciation

= ($800,000 − $100,000) ÷ 7

= $100,000

Average annual profit

= $250,000 − $100,000

= $150,000

Average capital invested

= ($800,000 + $100,000) ÷ 2

= $450,000

(a) ROCE using Initial Capital Cost

(b) ROCE using Average Capital Investment

Advantages of ROCE

• Simplicity
• Links with other accounting measures

Disadvantages of ROCE

• No account taken of project life
• No account taken of timing of cash flows
• Varies depending on accounting policies

2. Payback Period

Payback period is the time a project takes to recover the money spent on it. It is based on expected cash flows and measures liquidity.

Formula (Constant annual cash flows)

Uneven annual cash flows

Where cash flows are uneven, calculate cumulative cash flows over project life.

Decision Rule

• Select projects that pay back within required period
• Choose option with fastest payback

Example 1 – Constant Cash Flows

Investment = $2,000,000

Annual cash inflow = $500,000

Payback period:

Example 2 – Uneven Cash Flows

Year	Cash flow ($000)
0	(1,900)
1	300
2	500
3	600
4	800
5	500

Cumulative cash flow

Year	Cash flow	Cumulative cash flow
0	(1,900)	(1,900)
1	300	(1,600)
2	500	(1,100)
3	600	(500)
4	800	300
5	500	800

Payback occurs between Year 3 and Year 4.

Remaining amount at start of Year 4 = $500

Year 4 cash flow = $800

Fraction of year:

Total payback:

Final Answer

Expected payback period = 3.625 years

Advantages and disadvantage of Payback

Advantages include:

• it is simple
• it is useful in certain situations:
• rapidly changing technology
• improving investment conditions
• it favors quick return:
• helps company growth
• minimizes risk
• maximizes liquidity
• It uses cash flows, not accounting profit.

Disadvantages include:

• It ignores returns after the payback period
• It ignores the timings of the cash flows. This can be resolved using the discounted payback period.
• It is subjective as it gives no definitive investment signal
• It ignores project profitability.