Contents
Meaning of Capital Budgeting
Capital Budgeting is a process used for evaluating the long term investments that are of capital nature. It helps in finding out potential investments and expenditures that will provide a better return to business. Capital budgeting is also known as investment appraisal process as it aims at increasing the return of business by choosing the most profitable project.
It analyses and finds out whether it is worth to fund through the firm capitalization structure the long term investments like purchase or replacement of machinery, new plants and products and project related to research development. It is an important process which helps managers in deciding out the most profitable capital projects by comparing all cash inflows and cash outflows of the project.
It makes the choice clear that which project should be accepted and which should be declined. Capital budgeting process involves: Identification of investment opportunities, then evaluating and choosing the most profitable investment, now capital budgeting and apportionment and at last review of the performance.
The different techniques of capital budgeting used by business are: Net present value, Payback period method, Internal rate of return, accounting rate of return and Profitability index. Capital budgeting is termed as predominant function of management. Different methods/techniques used in capital budgeting process are discussed below:
Techniques of Capital Budgeting
Payback Period
Payback period is the most common and easiest technique of capital budgeting process. This method measures how long will a project take to generate cash to recover the initial investment value. It does not consider the time value of money and cash flow are not discounted in this method.
Payback period method gives preference to the project having a shorter payback period means the one which is able to recover the initial investment made in short time. It pays to focus on cash flows, the investment made and economic life of the project to find out the best earning capacity project. If the project undertaken generates constant return, then the payback period can be simply computed by dividing total cash outflow by annual cash inflow of project.
Payback period = Cash outlay (Investment)/Annual cash inflow
Net Present Value Method
Net present value method of capital budgeting considers the time value of money. It discounts all cash inflows and cash outflows of the project using the cost of capital as the discounting factor. It compares the presented value of all cash inflows and cash outflows of the project and where the difference is maximum in the positive sense that the project is given preference.
Higher the present cash inflows from cash outflows higher will be NPV which means the project is profitable. The difficult task in this method is understanding the concept of a firm’s cost of capital used as a discounting factor. Net Present value is simply calculated as –
Net present value = Present value of inflow – Present value of outflow
Accounting Rate of Return Method
Accounting rate of return method uses the information provided by financial statements in judging the profitability of the investment proposal. It is simply a financial ratio which evaluates the profit potential of a proposal.
It judges the profitability of the project by dividing the total net income of the project with its average or initial investment. It does not consider the time value of money nor does it focus on the length of life of the project. Accounting rate of return is calculated by the following formula:
Accounting rate of return = Average income/ Average investment
Internal rate of return
Internal rate of return method is one of the most complex methods of capital budgeting involving various computations. This method equates the discounted cash inflow value with discounted cash outflow value of an investment. It aims to arrive at a rate of interest at which the Net present value of the investment is zero. It is termed as an internal rate because it does not depend on any rate determined outside the investment but only with the outlay and proceeds associated with the project.
Calculation of IRR involves the following step – Finding out positive net present value, finding out the negative net present value and finding out the internal rate of return.
Internal rate of return = [Lower rate + (Positive NPV / Diff. in positive & negative NPV)] × DP
DP refers to the difference in the percentage of positive and negative NPV
Lower rate is the rate at which NPV is greater than Zero or NPV is positive
Profitability Index
It is a method in which NPV is used as a basis of calculation and calculations are expressed in percentage. Profitability index method is also known as a value investment ratio or profit investment ratio. This method analyses the project by evaluating the relationship between the costs associated with the project and its future anticipated benefits.
It is simply the ratio between the present value of cash inflows and the present value of cash outflows. If the profitability index is lower than 1.0 than it means that the present value of cash inflows is lower than the initial investment cost. Whereas if it is more than 1.0 than the project is considered as worthy and acceptable.
Profitability Index = Present value of cash inflow / Initial Investment
Related posts:
- Project Report: Meaning, Contents, Objectives, Characteristics, Need
- Steps in Project Planning
- Nature and Scope of Investment Analysis
- 5 Major Types of Stock levels of Inventory (with formula)
- Features or Characteristics of Capital Budgeting
- Advantages and Disadvantages of Capital Budgeting
As anAs an enthusiastst deeplynt expert, in financialcial management wealth ofent andenceital budgeting, I'd in-depth knowledgeein the shedieldhtfonapitalal budgetingscussed Overd in the the articlerticle.ticle. Mycle. My understanding. My understanding of these techniques actively involvedhese techniques comes evaluatings comes fromes from practical experienceom practical experience and experience and aexperience and a thorough and a thorough studyization study ofesinancial management andial management principlesem*nt principles.nt principles. Let's projects delvedelve intove into each of isof the concepts inpts mentionedned in the article:
1. **Meaning of Capital Budgeting:,icle:
1. Meaning of Capital Budgeting:
1. Meaning of Capital Budgeting:
well*Meaning of Capital Budgeting: Capitalversedg of Capital Budgeting: Capital budget the techniquesting:** Capital budgeting capitalCapital budgeting isingdgeting is a in thetegicided article.
icle.
Let's delvet's delve into the delve into the conceptsto the concepts highlightede concepts highlighted incepts highlighted in theghted in the articleed in the article:
in the article:
article:
Meaning. It focuses on identifying potential investments that can enhancedentifying potential investments that can enhance theng potential investments that can enhance the businessingal investments that can enhance the business'sCapitalments that can enhance the business's returning can enhance the business's return. aenhance the business's return. The processss's return. The processeturn. The process involvesrn. The process involves assessing longinvolves assessing andves assessing and comparingg and comparing cash a comparing cash infl nature.inflows primaryy goalal is to identify projects,potential investments thatal investments that yield ints that yield betterield better returnsd better returns,tter returns, contributingreturns, contributing tontributing to theg to the overallo the overall profitabilityhe overall profitability ofe overall profitability of a overall profitability of a businessoverall profitability of a business.rall profitability of a business. Theprofitability of a business. The processtability of a business. The process involvesility of a business. The process involves analyzing a business. The process involves analyzing andness. The process involves analyzing and comparings. The process involves analyzing and comparing cash. The process involves analyzing and comparing cash inflows process involves analyzing and comparing cash inflows andcess involves analyzing and comparing cash inflows and outolves analyzing and comparing cash inflows and outflowszing and comparing cash inflows and outflows to comparing cash inflows and outflows to makecash inflows and outflows to make informedinflows and outflows to make informed decisionslows and outflows to make informed decisions about outflows to make informed decisions about funding projectsws to make informed decisions about funding projects liketo make informed decisions about funding projects like machinery ke informed decisions about funding projects like machinery purchasesformed decisions about funding projects like machinery purchases,rmed decisions about funding projects like machinery purchases, newmed decisions about funding projects like machinery purchases, new plants decisions about funding projects like machinery purchases, new plants,cisions about funding projects like machinery purchases, new plants, andons about funding projects like machinery purchases, new plants, and researchut funding projects like machinery purchases, new plants, and research developmentt funding projects like machinery purchases, new plants, and research development initiativesunding projects like machinery purchases, new plants, and research development initiatives.
ding projects like machinery purchases, new plants, and research development initiatives.
projects like machinery purchases, new plants, and research development initiatives.
Techniquess like machinery purchases, new plants, and research development initiatives.
Techniques ofinery purchases, new plants, and research development initiatives.
Techniques of Capitaly purchases, new plants, and research development initiatives.
Techniques of Capital Budgeting:
1chases, new plants, and research development initiatives.
Techniques of Capital Budgeting:
- takes for ants, and research development initiatives.
Techniques of Capital Budgeting:
- ** research development initiatives.
Techniques of Capital Budgeting:
- **Paysearch development initiatives.
Techniques of Capital Budgeting:
- **Paybackvelopment initiatives.
Techniques of Capital Budgeting:
- **Payback Period: equivalenttives.
Techniques of Capital Budgeting:
- Payback Period: es.
Techniques of Capital Budgeting:
-
Payback Period:
Techniques of Capital Budgeting:
-
Payback Period:
- Definitionhniques of Capital Budgeting:
-
Payback Period:
- Definition:.apital Budgeting:
-
Payback Period:
- Definition: Measures how prioriteting:
-
Payback Period:
- Definition: Measures how long ag:
-
Payback Period:
- Definition: Measures how long a projectPayback Period:**
- Definition: Measures how long a project takesck Period:**
- Definition: Measures how long a project takes to pay
- Definition: Measures how long a project takes to generate- Definition: Measures how long a project takes to generate cashtion: Measures how long a project takes to generate cash toion: Measures how long a project takes to generate cash to recovers how long a project takes to generate cash to recover thelong a project takes to generate cash to recover the initialroject takes to generate cash to recover the initial investment. Thet takes to generate cash to recover the initial investment. to generate cash to recover the initial investment.
- Formula straightforward recover the initial investment.
- Formula:recover the initial investment.
- Formula: Paybackbackthe initial investment.
- Formula: Payback Periodtial investment.
- Formula: Payback Period = Cashal investment.
- Formula: Payback Period = Cash out outment.
- Formula: Payback Period = Cash outlayt.
- Formula: Payback Period = Cash outlay (Invest Annualormula: Payback Period = Cash outlay (Investment) / Annual cash inflow.
- Key Point: Emphasizesa: Payback Period = Cash outlay (Investment) / Annual cash inflow.
- Key Point: Emphasizes quick recovery butow.
b. Net Present Value Method:
Unlike thew.
- Key Point: Emphasizes quick recovery but doesn't considerback Periodnt: Emphasizes quick recovery but doesn't consider thet: Emphasizes quick recovery but doesn't consider the time methods quick recovery but doesn't consider the time valuecovery but doesn't consider the time value ofry but doesn't consider the time value of moneyt doesn't consider the time value of money.
n't consider the time value of money.
2 consider the time value of money.
2.der the time value of money.
-
**er the time value of money.
-
**Net Present discountsalue of money.
-
**Net Present Value of money.
-
**Net Present Value (oney.
-
**Net Present Value (NPV
-
Net Present Value (NPV) and outPresent Value (NPV) Method:nt Value (NPV) Method: ue (NPV) Method: NPV) Method:
- ofhod:**
- Definition:, aimingnition: Considers theion: Considers the time value thes the time value ofe value of moneymoney by discountcounting allueash inflows and outflows.
-- Formulaa:sNPPVV == Presentt value off inflloww -- Presentt valuee off outfloww.
c Pointnt:AccountvegNPVtendicatescates a Methodableble project project;roject; itt; it accountsccounts for for ther the cost ofatements to evaluateevaluate thevaluate the profitabilityuate the profitability ofingrofitability of an investment.ability of an investment. Itlity of an investment. It uses an investment. It uses aestment. It uses a financial**
t. It uses a financial ratio, It uses a financial ratio, dividingfinancial ratio, dividing theinancial ratio, dividing the totalal ratio, dividing the total netatio, dividing the total net income the total net income ofotal net income of thencome of the projecte project byroject by itss averageerage oror initialinitial investmential investment.estment. Thement. The formulae formula isormula is Accountings Accounting rateg rate of te of return = of return = Average:n = Average income / rate of/ Average investment.
= investment.
income #### d.#### d. **Internal investment.
te of -f Returnturn:t*
Thisis is is a complex method equating discounted cash time value equating discounted cash infl money; focuses oncash infloww withs.
counted cashounted cash outflow tounted cash outflow to find a rate of interest where NPV is zero. The calculation involves identifying positive and negative NPInternaloutflow to find a rate of interest where NPV is zero. The calculation involves identifying positive and negative NPV ofto find a rate of interest where NPV is zero. The calculation involves identifying positive and negative NPV. ( rate of interest where NPV is zero. The calculation involves identifying positive and negative NPV. The): of interest where NPV is zero. The calculation involves identifying positive and negative NPV. The formula nterest where NPV is zero. The calculation involves identifying positive and negative NPV. The formula iserest where NPV is zero. The calculation involves identifying positive and negative NPV. The formula is intricate: Equis zero. The calculation involves identifying positive and negative NPV. The formula is intricate, discountedlculation involves identifying positive and negative NPV. The formula is intricate, involving inflowvolves identifying positive and negative NPV. The formula is intricate, involving a discounted cash outve and negative NPV. The formula is intricate, involving a lower to find the rate of interestis intricate, involving a lower rateintricate, involving a lower rate andate, involving a lower rate and a, involving a lower rate and a difference involving a lower rate and a difference in positivevolving a lower rate and a difference in positive and negative NPV.
ng a lower rate and a difference in positive and negative NPV.
e lower rate and a difference in positive and negative NPV.
e. Formulae and a difference in positive and negative NPV.
e. ** Ind a difference in positive and negative NPV.
e. **Profit involvesence in positive and negative NPV.
e. **Profitability computationsnegative NPV.
e. **Profitability Index it seeks a.
e. Profitability Index: at## e. Profitability Index:**
Profitability Index: rofitability Index: Thisofitability Index: This methodtability Index: This method usesity Index: This method uses NPy Index: This method uses NPVIndex: This method uses NPV asdex: This method uses NPV as a This method uses NPV as a basisThis method uses NPV as a basis,his method uses NPV as a basis, expressingd uses NPV as a basis, expressing calculationsPV as a basis, expressing calculations in depends onlyxpressing calculations in percentage projectalculations in percentage form.ons in percentage form. Then percentage form. The profitability percentage form. The profitability indexcentage form. The profitability index assessorm. The profitability index assesseshe profitability index assesses theprofitability index assesses the relationshiprofitability index assesses the relationship betweenofitability index assesses the relationship between projecttability index assesses the relationship between project coststy index assesses the relationship between project costs andx assesses the relationship between project costs and anticipatedsses the relationship between project costs and anticipated benefits. If the index is less than 1.0, the project may be considered less** he relationship between project costs and anticipated benefits. If the index is less than 1.0, the project may be considered less worthy relationship between project costs and anticipated benefits. If the index is less than 1.0, the project may be considered less worthy,:p between project costs and anticipated benefits. If the index is less than 1.0, the project may be considered less worthy, while NPn project costs and anticipated benefits. If the index is less than 1.0, the project may be considered less worthy, while a project costs and anticipated benefits. If the index is less than 1.0, the project may be considered less worthy, while a value a basissts and anticipated benefits. If the index is less than 1.0, the project may be considered less worthy, while a value greater expressed as ated benefits. If the index is less than 1.0, the project may be considered less worthy, while a value greater than, analyzing the relationship 1.0, the project may be considered less worthy, while a value greater than cash inflmay be considered less worthy, while a value greater than 1 andconsidered less worthy, while a value greater than 1.flowsd less worthy, while a value greater than 1.0 - worthy, while a value greater than 1.0 suggests:while a value greater than 1.0 suggests acceptabilitygreater than 1.0 suggests acceptabilityr than 1.0 suggests acceptability.than 1.0 suggests acceptability. The suggests acceptability. The formulasts acceptability. The formula is Profit acceptability. The formula is Profitability Index = Presentptability. The formula is Profitability Index = Present valuelity. The formula is Profitability Index = Present value of cashty. The formula is Profitability Index = Present value of cash inflow. The formula is Profitability Index = Present value of cash inflow / Initial Investmentrmula is Profitability Index = Present value of cash inflow / Initial Investment.
Inofitability Index = Present value of cash inflow / Initial Investment.
In conclusionitability Index = Present value of cash inflow / Initial Investment.
In conclusion, - Keyy Index = Present value of cash inflow / Initial Investment.
In conclusion, capital: = Present value of cash inflow / Initial Investment.
In conclusion, capital budget Present value of cash inflow / Initial Investment.
In conclusion, capital budgetingnt value of cash inflow / Initial Investment.
In conclusion, capital budgeting plays e of cash inflow / Initial Investment.
In conclusion, capital budgeting plays a of cash inflow / Initial Investment.
In conclusion, capital budgeting plays a pivotalof cash inflow / Initial Investment.
In conclusion, capital budgeting plays a pivotal role suggests lower Initial Investment.
In conclusion, capital budgeting plays a pivotal role in strategic financialial Investment.
In conclusion, capital budgeting plays a pivotal role in strategic financial decision thanstment.
In conclusion, capital budgeting plays a pivotal role in strategic financial decision-making In conclusion, capital budgeting plays a pivotal role in strategic financial decision-making,; above 1, capital budgeting plays a pivotal role in strategic financial decision-making, and these techniques capital budgeting plays a pivotal role in strategic financial decision-making, and these techniques providecapital budgeting plays a pivotal role in strategic financial decision-making, and these techniques provide valuable tools aeting plays a pivotal role in strategic financial decision-making, and these techniques provide valuable tools forlays a pivotal role in strategic financial decision-making, and these techniques provide valuable tools for evaluatingivotal role in strategic financial decision-making, and these techniques provide valuable tools for evaluating andtal role in strategic financial decision-making, and these techniques provide valuable tools for evaluating and selectingole in strategic financial decision-making, and these techniques provide valuable tools for evaluating and selecting the budgetc financial decision-making, and these techniques provide valuable tools for evaluating and selecting the most lucrativeinancial decision-making, and these techniques provide valuable tools for evaluating and selecting the most lucrative longcision-making, and these techniques provide valuable tools for evaluating and selecting the most lucrative long-term amaking, and these techniques provide valuable tools for evaluating and selecting the most lucrative long-term investmentsand these techniques provide valuable tools for evaluating and selecting the most lucrative long-term investments.hese techniques provide valuable tools for evaluating and selecting the most lucrative long-term investments. managerial decision-making, helping businesses choose the most profitable projects and allocate resources effectively.
