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Why is capital budgeting important?
2023-01-25 • Updated
What is capital budgeting?
Capital budgeting is a process of chosing a project accroding to returns on investments.
An organization always faces challenges of selecting between several projects worth investing in. An organization would like to pick all profitable projects as an investment but due to the limitation of capital an organization has to choose only some of them.
As organizations search for the best project to invest in people make their investments every day, that’s why capital budgeting is a concept that affects our daily lives.
For example, your laptop has stopped working. You can buy a new one or repair the old one. There could be a possibility that there is cheaper to a new laptop than to repair an old one. So, you decide to replace your laptop and proceed to look at different ones that fit your budget!
How Capital Budgeting Works
The main goal of capital budgeting is to determine whether a project will bring profit to a firm or not. The procedure the procedure is carried out in different methods. The payback period (PB), internal rate of return (IRR), and net present value (NPV) methods are the most common ones. Also, some organizations calculate profitability index, real options analysis, equivalent annuity.
In an ideal situation all these methods will point to the same result, but in reality results are always defferent. Depending on management's preferences and selection criteria, more emphasis will be put on one approach over another. Nonetheless, there are common advantages and disadvantages associated with these widely used valuation methods.
Common Steps in the Capital Budgeting Process
1. Identify and evaluate potential opportunities
Any company has several investment opportunities to consider. For example, a company which produce any product, should choose whether to deliver its product by ships, planes or trains to customers. As such, each option must be evaluated to see what makes the most financial and logistical sense. Once the most feasible opportunity is identified, a company should determine the right time to pursue it, keeping in mind factors such as business need and upfront costs.
2. Estimate operating and implementation costs
The next step is to define the cost of the project. This process requires both internal and external research. If a company is developing a transportation option it should compare costs of transportation themselves and costs of transportation by the other company. After it choses the cheepest method it might attempt to further narrow down the cost of implementing whichever option it chooses.
3. Estimate cash flow or benefit
The next step is to determine how much revenue a new project is able to generate.
The first variant is to check the data about similar successful projects. In case, the project will not generate the money itself, a company should calculate the amount of money this project might save and decide if this project is worth to be done or not.
4. Assess risk
The company needs to estimate risks associated with the project. Here a company needs to decide if they are ready to fail the project and lose all the money and compare the amount with the potential revenue. Fail of the project should not damage the whole process of the company’s workflow.
If a company decides to work on a project plan should be created. It consists of payment methods, a cost tracing method, a process for recording the cash flows or benefits generated by the project. A plan should also include a project’s timeline with a deadline as well.
The payback period is the time it takes to pay off the initial investment. For example, if a project requires a $1 million investment, the payback period shows how many years it takes for a cash inflow to match an outflow of $1 million. Shorter the payback period, better more attractive a project for investment.
Companies usually use the payback period method when liquidity is a serious problem. If a company has limited funds, it can only deal with one major project at a time. Therefore, management will pay great attention to recovering its initial investment for subsequent projects.
There are several limitations of using the PB method. First, the payback period does not take into account the time value of money (TVM).
Another disadvantage is that cash flows that arise at the end of a project's life cycle, such as residual value excluded in payback periods and discounted payback periods methods. Thus, PB is not a direct indicator of profitability.
Internal Rate of Return
Internal Rate of Return (IRR) is a method of discounting cash flow that provides with the project’s rate of return. The internal rate of return is the discount rate at which the sum of the original cash costs and the discounted cash receipts is zero. In other words, it is the discount rate at which the net present value (NPV) is zero.
If different projects have the same costs, a company will select the project with the highest IRR. When an organization needs to choose between several projects with the same value, then these projects will be racked by IRR measure and the most profitable one will be selected. Ideally, a company will select an IRR with a higher cost than the cost of capital.
Net Present value
Net present value is calculated as the difference between the present value of cash inflows and the present value of cash outflows over a period of time. Companies usually consider only investments with a positive NPV. In the case of several similar projects, the project with a higher NPV will be selected.
The NPV is greatly affected by the discount rate. Selecting the proper 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. 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.
The Profitability Investment Index (PI), also known as the Return on Investment Ratio (PIR) and Value on Investment Ratio (VIR), is the ratio of the return on investment to a proposed project. It is a useful tool for ranking projects as it quantifies the amount of value created per unit of investment.
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 lifespans. 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.
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