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What is Capital Budgeting, Process, Features and Importance?

Before companies or businesses decide on projects or investments to undertake, they normally carry out the capital budgeting process. The capital budgeting process involves analyzing a particular project or investment, its cash inflows, and cash outflows to determine the one with the highest return on investment. Capital budgeting is meant to identify projects that can yield the highest returns over a certain period.

In this article, we are going to focus on capital budgeting, process, features, importance and its limitations. 

What is Capital Budgeting?

Capital budgeting is the process a business or company undertakes to evaluate potential investments or projects. Its aim is to identify those projects or investments with the highest returns on investment. It involves analyzing projected cash inflows and outflows to determine projects that a company can invest in. The capital budgeting process is also known as investment appraisal.

The Capital Budgeting Process

The following is the capital budgeting process:

1. Identifying Investment Opportunities

The first capital budgeting process step is to identify an investment opportunity. It can be anything from venturing into a new product, buying a new asset, or expanding an existing product line.

2. Evaluating Investment Projects

Once an investment opportunity has been spotted, a company will need to judge the investment proposal. The project must match the mission of the company. Besides, the business must also consider the benefits and costs it will incur and the pros and cons of the project.

3. Choosing a Profitable Investment

Once an organization identifies investment opportunities and evaluates all proposals, it needs to decide on a profitable project to invest in. When selecting a viable investment, the organization needs to rank the projects as per returns to select the best option.

4. Capital Budgeting Implementation

Upon selecting a viable project, an organization will need to implement the project. This involves processes like funding the project.  This requires the organization to identify the source of funds and allocate it accordingly.

5. Performance Review

From time to time, the entity needs to review the performance of the project. The company will compare the investment’s expected performance to the actual performance.

Also read: Impact of social media on small businesses. 

Capital Budgeting Techniques or Methods

There are various techniques or methods that can help an organization select the best investment. The techniques involve comparing cash inflows and outflows. Capital budgeting methods include the following:

1. Payback Period (PB) Method

An organization calculates the period a proposed project will take to earn or generate enough revenue to cover the initial investment. This period is called the payback period and is identified by dividing the initial cash investment in the project by the average yearly cash inflow that the project will generate. Entities should select investments with the shortest or the quickest payback period.

Payback Period = Initial cash investment / Annual cash flow

2. Average Rate of Return (ARR) Method

The average rate of return is a formula that measures the net profit or returns expected on investment compared to the initial cost. With the average rate of return technique, the total net income of the investment is divided by the initial or average investment to derive the most profitable investment.

ARR = Average Net Profit / Average Investment

Where:

  • Average Annual Profit = Total profit over Investment Period / Number of Years
  • Average Investment = (Book Value at Year 1 + Book Value at End of Useful Life) / 2

3. Net Present Value (NPV) Method

The Net Present Value (NPV) technique is used by companies to evaluate capital investment projects. The net present value is calculated by taking the difference between the present value of cash inflows and the present value of cash outflows over a period of time. An organization should pick a project with a positive Net Present Value. If there are multiple projects with positive net present values, the project with the higher Net Present Value should be preferred.

    NPV = Rt / (1+ i) ^ t

Where: 

  • NPV = Net Present Value 
  • Rt = Net Cash Flow at time t 
  • i = discount rate 
  • t = time of the cash flow

4. Internal Rate of Return (IRR) Method

A discount rate is used for NPV computation. IRR is the rate at which the NPV becomes zero. In such a situation, the cash inflow rate equals the cash outflow rate. If the IRR is more than the average cost of the capital, an organization should accept the project. Otherwise, it should reject the project. In the case of multiple projects, an organization should pick the project with the highest IRR.

NPV = {Cn / (1 + r)^n}

Where 

  • NPV = Net Present Value
  • N = total number of periods 
  • n = non negative integer 
  • Cn = Cash flow
  • r = internal rate of return

5. Profitability Index (PI) Method

The Profitability Index is the ratio of the present value of future cash flows of the project to the initial investment required for the project. A Profitability Index that presents a value lower than 1.0 indicates lower cash inflows than the initial cost of investment. A profitability index great than 1.0 presents better cash inflows. The latter project should be accepted.

Profitability Index = Present value of Cash Inflows / Initial Investment

Capital Budgeting Features

The following are some of the features of capital budgeting.

  • Long-term effect. Capital budgeting leads to long-term effects on the future profitability of a business. it helps corporates select the most profitable investments.
  • Irreversible decisions. It would be challenging to revert a decision since the sale of a high-value asset would be detrimental to the business. 
  • Affects the future competitiveness of a business. The decisions made affect how profitable a business would be in the future and its competitiveness.
  • A high degree of risk. Capital budgeting process decisions are made based on estimated returns. Other factors like changes in taste and preference can lead to greater risk.

Importance of Capital Budgeting

The capital budgeting process is important for every business. It has the following advantages:

  • Chooses investments wisely. All factors considered; the capital budgeting process plays a critical role in selecting profitable investment options for businesses. It helps to decide whether a particular project is beneficial or not.
  • Control project expenditure. Capital budgeting will focus on minimizing the expenditure on investment projects. The process ensures that the proposed investment project has an adequate amount of inflows for meeting its expenses and providing the anticipated return.
  • It creates accountability. A business seeking to invest its resources in a project should understand the risks and returns involved. Capital budgeting helps businesses understand the risks involved and the rate of return on a particular project.
  • Measurability. Capital budgeting helps businesses measure the effectiveness of their investment decisions. The process will help your business determine the long-term economic and financial profitability of your investment project.
  • Avoid over and under-investment. Capital budgeting helps companies determine the appropriate investment amount for their projects. If a business is to earn better returns and avoid losses, it must have the right amount of investment.
  • Maximize shareholder’s wealth. The process helps to maximize the overall value of shareholders by enabling businesses to deploy their funds in the most effective ways possible.

Limitations of Capital Budgeting

Although the capital budgeting process gives insight into the future profitability of a business, it is also has limitations.  The include:

1. Higher risk. Capital budgeting decisions are usually risky in nature as the process involves a large amount of capital expenditure. As such, companies need to make decisions with utmost care because any wrong decision will affect the success of the business.

2. Time horizon. Capital budgeting is a process that works mostly for long-term projects. While it is easier to estimate and compute figures for short-term projects, long-term forecasts are bound to be miscalculated. Hence, an expanded time horizon can be a potential problem in capital budgeting while computing figures.

3. Ignores non-financial aspects. Capital budgeting only considers financial aspects and ignores all non-financial aspects when analyzing investment plans. Non-financial factors also have a critical role in the profitability of the project. Maximum profits cannot be realized if these factors are ignored.

4. Irreversible decisions. Decisions made through capital budgeting process are long-term and irreversible in nature. Since decisions have an impact on the long-term durability of a company, managers need to make these decisions with utmost care. Any wrong decision can have adverse effects on the business's profitability and going concern.

5. Relies on assumptions and estimations. Capital budgeting methods rely on assumptions and estimations for analyzing investment proposals. Cash flow and the duration of the project estimates are not always true and may increase or decrease than the anticipated values. These untrue estimations may lead to losses.

Summary of Capital Budgeting, Process, Features, Limitations, and Importance

Capital budgeting is fundamental for the expansion and growth of any business. Through the capital budgeting process, a business can make the right decisions that can help it to expand its operations. Besides, a company can select the most profitable projects that can help it to grow and become profitable.

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