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Capital Budgeting Process

Evaluation of Capital budgeting project involves six steps:

- First, the cost of that particular project must be known.

- Second, estimates the expected cash out flows from the project,
including residual value of the asset at the end of its useful life.

- Third, riskiness of the cash flows must be estimated. This requires

information about the probability distribution of the cash outflows.

- Based on project’s riskiness, Management find outs the cost of capital

at which the cash out flows should be discounted.

- Next determine the present value of expected cash flows.

- Finally, compare the present value of expected cash flows with the
required outlay. If the present value of the cash flows is greater than
the cost, the project should be taken. Otherwise, it should be rejected.
OR

- If the expected rate of return on the project exceeds its cost of capital,
that project is worth taking.

Capital Budgeting Techniques

Cash Flow
Success of any business can be determined through its capacity to generate
positive cash flows. Therefore, Cash inflow and outflow is considered as one
of the most essential elements which gives us as idea

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about the continued existence of a business in future. Therefore, the

stake-holders focus on two things while investing in business: first, how does
business generate funds and second, where does business invest those
funds for generating more.

Objectives of a cash flow statement:

The main objective of a cash flow statement is to assist users:

- In assessing the business’s ability to generate positive cash flow

- In assessing business’s ability to bridge the gap between out flow
and inflow of funds.
- In assessing its ability to meet its short and long term obligations
- In assessing the rationale of differences between reported and related
cash flows
- In assessing the effect on finances of major projects during the year.

The statement of cash flow, therefore; shows increase and decrease in cash
and cash equivalents rather than working capital.

Profitability Index
Profitability index (PI) is the ratio of investment to payoff of a suggested
project. It is a useful capital budgeting technique for grading projects
because it measures the value created by per unit of investment made by
the investor.

This technique is also known as profit investment ratio (PIR), benefit-cost

ratio and value investment ratio (VIR).

The ratio is calculated as follows:

Profitability Index = Present Value of Future Cash Flows / Initial
Investment
If project has positive NPV, then the PV of future cash flows must be higher
than the initial investment.
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Thus the Profitability Index for a project with positive NPV is greater than 1
and less than 1 for a project with negative NPV. This technique may be useful
when available capital is limited and we can allocate funds to projects with
the highest PIs.

1) Discounted Payback Period

One of the limitations in using payback period is that it does not take into
account the time value of money. Thus, future cash inflows are not
discounted or adjusted for debt/equity used to undertake the project ,
inflation, etc. However, the discounted payback period solves this problem. It
considers the time value of money, it shows the breakeven after covering
such costs. This technique is somewhat similar to payback period except that
the expected future cash flows are discounted for computing payback period.

Discounted payback period is how long an investment’s cash flows,

discounted at project’s cost of capital, will take to cover the initial cost of the
project. In this approach, the PV of future cash inflows are cumulated up to
time they cover the initial cost of the project. Discounted payback period is
generally higher than payback period because it is money you will get in the
future and will be less valuable than money today.

For example, assume a company purchased a machine for $10000 which

yields cash inflows of $8000, $2000, and $1000 in year 1, 2 and 3
respectively. The cost of capital is 15%. The regular payback period for this
project is exactly 2 year. But the discounted payback period will be more
than 2 years because the first 2 years cumulative discounted cash flow of
$8695.66 is not sufficient to cover the initial investment of $10000. The
discounted payback period is 3 years.

Decision Rule of Discounted Payback:

If discounted payback period is smaller than some pre-determined number of
years then an investment is worth undertaking.

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2) Internal Rate of Return
Internal Rate of Return is another important technique used in Capital
Budgeting Analysis to access the viability of an investment proposal. This is
considered to be most important alternative to Net Present Value (NPV). IRR
is “The Discount rate at which the costs of investment equal to the benefits
of the investment. Or in other words IRR is the Required Rate that equates
the NPV of an investment zero.
NPV and IRR methods will always result identical accept/reject decisions for
independent projects. The reason is that whenever NPV is positive , IRR must
exceed Cost of Capital. However this is not true in case of mutually exclusive
projects.
The problem with IRR come about when Cash Flows are non-conventional or
when we are looking for two projects which are mutually exclusive. Under
such circumstances IRR can be misleading.
Suppose we have to evaluate two mutually exclusive projects. One of the
project requires a higher initial investment than the second project; the first
project may have a lower IRR value, but a higher NPV and should thus be
accepted over the second project (assuming no capital rationing constraint).

Decision Rule of Internal Rate of Return:

If Internal Rate of Return exceeds the required rate of Return, the
investment should be accepted or should be rejected otherwise.

3) Payback Period
Payback period is the first formal and basic capital budgeting technique used
to assess the viability of the project. It is defined as the time period required
for the investment’s returns to cover its cost. Payback period is easy to apply
and easy to understand technique; therefore, widely used by investors.

For example, an investment of $5000 which returns $1000 per year will have
a five year payback period. Shorter payback periods are more desirable for
the investors than longer payback periods. It is considered as a method of
analysis with serious limitations and qualifications for its use. Because it does
not properly account for the time value of money, risk and other important
considerations such as opportunity cost.