First, we need to understand that Capital budgeting is not the same as a capital budget. Rather, it’s the process of identifying the potential return on a given investment (ROI) in a capital asset to determine whether the investment makes sense (economically viable) and to compare alternative investment options to maximize value of money spent (investment) per ROI. Thus, capital budgeting is thus a key step in preparing a capital budget.
If many different departments are competing to have proposed investments funded, you may be asked to justify your proposals using capital budgeting techniques.
The four main techniques used are:
- Net Present Value (NPV) represents the current value of future cash flows, that is, it takes inflation into account. It tells you how much cash the investment will generate versus how much must be spent to make the investment, in current and future dollars. In determining NPV, you compute each year’s cash flow separately.
- Internal Rate of Return (IRR) is a percentage that is used to compare a potential investment against the hurdle rate to determine whether it’s worthwhile. The IRR is derived by dividing the estimated profit by the estimated expenditure. An IRR must exceed the hurdle rate in order to justify the investment. The higher the IRR, the more profitable the project.
- Profitability index (PI) represents the relationship between the costs of a potential project and its estimated benefits. To determine the profitability index, divide the current value of future cash flows by the initial investment. If the ratio is less than 1.0, the investment outweighs the expected returns. Conversely, the higher the index value, the more attractive the project.
- Payback period denotes the length of time it will take to recoup an investment or the break-even point (in years) on your chart. A period of 1 means it will take one year. This technique is used less frequently today because (a) it ignores the time value of money; and (b) it is biased toward products or services that generate most of their money on the front end.
Of the four techniques, NPV is most difficult to calculate, but is more accurate and therefore preferred by most companies.
Here is the steps to calculate an NPV:
- Prepare a schedule of estimated cash flows.This schedule identifies the capital outlays you want, the timing of those outlays, and the expected cost savings or revenue that will result from the investment. For substantial investments, consider annual cash flows over a period of several years. If an expense will be capitalized, the full outlay is recorded for the year in which it is incurred. Also record the expected tax savings that will result in subsequent years as capitalized items are depreciated.
- Use appropriate interest rates in your calculation, don’t sugar-coat your interest rate. Because NPV is the current value of future cash flows, you calculate it by dividing each future cash flow by the compounded interest rate and then adding up all of the discounted cash flows. You can create a spreadsheet (for situations in which the cash flows or the interest rates used are different from year to year) or use a financial calculator or app (if the cash flow and interest rate are constant throughout the period).
The NPV formula is:
In this formula, each CF represents a future cash flow, n is the number of years over which the cash flow is expected to occur, and i is the interest rate.
Some companies use the weighted average cost of capital, while others use a rate that reflects the uncertainty of the future cash flows of the project being evaluated. Check with your manager to find out how your company handles this question.
- Evaluate the NPV. A positive NPV indicates that the investment will potentially benefit the company. A negative NPV indicates a losing proposition.
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