written by | March 8, 2022

Everything about Capital Budgeting - Processes and Calculations

Budgeting is a tool that helps control and plan your future activities. Hence capital budgeting is the process of using management tools to control and plan an enterprise’s future activity. It includes the plans for saving, spending, borrowing, etc, the capital finance needed by the management for its projects. You also need to evaluate the capital budgeting process, project benefits, costs, and the viability of future projects. Hence, capital budgeting helps you plan the revenue and expenses related to your budget and its plans. Let us then take a look at how to define capital budgeting, the capital budgeting process steps and use some capital budgeting decisions examples to understand these topics better.

Did You Know? Capital Budgeting is needed for every business firm because it cannot dip into the working capital for every project proposal aimed at increasing revenue.

What is Capital Budgeting?

Capital budgeting helps to make a practical analysis of a project's cash inflows and outflows. It helps to determine whether the anticipated returns will be met with the benchmarks set by the organisation.  Your budget and plans are a part of capital budgeting wherein the first step in the capital budgeting process is to plan the formal process and its financial outlay for the firm’s future investments and acquisitions. Of course, allocating the current funds and the steps of capital budgeting taken for asset disposition, replacement, additions, and modifications of fixed assets is a part of the capital budgeting examples with solutions. Every firm aims at growth and expansion as a long-term strategy. This objective is possible only if sufficient funds are available to implement the project proposals. If there is a lack of fixed assets for project implementation, then capital budgeting becomes critical. The entire process of fixed assets capital budgeting is a management plan wherein the capital needed for the project proposal is properly assessed, budgeted, monitored, and reported.  Thus, capital budgeting is an exercise of strategizing the long-term financial objectives to achieve future growth plans. An example of capital budgeting is when a firm plans to sell off some machines and buy new ones to improve production capacity. Capital budgeting aims to ensure expected returns and sustainable growth through complete or partial project proposals.

Key features of the capital budgeting process:

  • It has several huge potential benefits that can be anticipated.
  • Since capital budgeting has a high outlay of capital and cash it is always a long term plan and has a high degree of risk attached to it.
  • From the initial capital outlay to achieving the anticipated returns generally involves a long period of time or gestation period.
  • Capital budgeting is a must where large amounts of capital and large estimated profits are anticipated.
  • The process involves future markets and uncertainties and is therefore highly risky.
  • It is a long-term fixed asset capital investment over the project’s life cycle.
  • The future financial position and returns depend on the project’s capital investments.
  • Every project proposal needs sustained funding and hence capital budgeting.
  • The capital investment amounts and budget have a direct bearing on the company’s profitability.

Limitations in Capital Budgeting:

Some of the limitations of Capital Budgeting are as follows: 

  • Cash Flow: Estimating the cash flow is a task since future revenues and present up-front costs are being used. If the costs are underestimated and revenues overestimated, it indicates that the actual expenses were not budgeted for. Similarly, when you underestimate revenues and overestimate costs, you could end up with a non-profitable proposal.
  • Time Horizon: Disruptions in the long periods involved can affect your forecasting as the cash flows are estimated on present values and are only an estimate of future revenues.
  • Time Value: Calculation methods in capital budgeting like the Payback method do not factor in the money’s time value, interest rates on borrowing, actual changes in money value, or inflation. 
  • Discount Rates: This is an assumed rate and any changes to it in the future affect the decision process of capital budgeting.

Also read: Small Scale Business Ideas with Low Investment

Processes involved in capital budgeting:

1. Generating the Project: 

This is the first step of the capital budgeting process. Your project proposal could fall under the following categories.

  • Expansion of the production line: The existing production line can be expanded in two ways. Firstly to meet growing market demand, or, to expand the capacity of the production line. 
  • Adding new products: The proposal could be to introduce an allied or new product line. 
  • Reducing costs: The proposal to maintain the production scale, but, reduce the cost of the existing product-line output results in savings and profit increase.

2. Evaluating the Project:

Efficient capital budgeting depends heavily on the evaluation step. In this step, the proposal is subjected to a cost versus benefit analysis using the capital budget formula, followed by a criteria selection process to evaluate the future market, risks and uncertainties present. The Benefits Vs Cost Analysis evaluates the project’s cash flows which in turn depend on the future market, uncertainties, risks, sufficiency of cash, etc. Once this analysis is completed you need to do the project’s selection of criteria in terms of feasibility, matching the enterprises’ objectives, and improving the market value.

3. Selecting the Project:

This involves selecting the best proposal and its investment process. 

4. Funds arrangements: 

When the capital expenditure and project proposal are approved, the finance team has to arrange sufficient capital funds and alternatives for raising such funds. Based on these alternatives, the capital budget is drawn up. 

5. Monitoring the Project: 

The finance team and the firm will also have to monitor through periodical reviews and reports the sufficiency and working of the approved capital budget and the project’s performance. The budget and project monitoring process lasts for as long as the project runs and is a learning experience for the firm when it takes up further projects. Here the actual performance is compared with the estimated or projected results. 

Also read: Fund Flow Statement - Meaning, Format And Examples

Terms used in the steps in capital budgeting:

The profitability of the project proposal is the firm’s long-term and ultimate goal. To assess these, some of the most common methods to select projects involve three or more metrics described below. Namely,

•    IRR or Internal Rate of Return

•    PB or Payback Period

•    NPV or Net Present Value

•    PI or Index of Profitability

Note that all three criteria above are never met by all projects. These metrics must be looked at objectively keeping in mind the firm’s objectives, goals, selection criteria, factors unique to the business model, and more, to decide the time of investment and the benefits versus costs analysis. 

Also read: Net Present Value Explained - Definition, Formula & Examples - Khatabook

The formula of capital budgeting in the various methods:

1. Method of Payback Period Assessment:

The payback period is the time taken for the firm’s project proposal to get sufficient income from it to cover the initial cost of capital investment. You always should choose the quickest payback period.

The formula applied here is: 

The payback period is the Initial Investment divided by the Annual Cash Flow.

Consider an example of a fictitious firm named ‘ABC’ that invests an amount of 125,000 ₹ on two products ‘Relays’ costing 250 ₹ each and Junction Boxes costing 150 ₹ each. ABC Company plans to increase the production of relays by 500 units and the junction boxes by 1,000 units. 

The revenue to be generated is hence 250x 500= 125,000₹ for relays and 1000x 150= 150,000 ₹ for the junction boxes. Now calculate the Payback periods for each.

The payback period for relays is 125,000 /125,000 or 1 year.

Payback Period for Junction Boxes is 125,000/150,000= 0.833 or 8 months and 10 days.

Capital budgeting decisions examples: 

Let us consider an example to define the capital budgeting formula. Going on just the payback period the Junction Boxes proposal has a shorter payback period and hence should be preferred.

Particulars

Proposal for Relays

Proposal for Junction Boxes

Initial investment

125,000

125,000

Increased capacity

500 units

1,000 units

Cost per unit

250

150

Income to be generated

125,000

150,000

Payback Period

1 year

8 months and 10 days

If both proposals have the same payback period, you should consider the time-efficient proposal with better cash flows in the early stages to factor in the value of your money.

2. NPV or Nett Present Value Method: 

This method helps if the cash flows over some specified time period are inconsistent with expected values. At this point, the evaluation of the NPV is a must to decide if the proposal is sustainable or should be dropped. The method is time and value-of-money considerate.

The formula used here is NPV is the value of cash inflow into the rate of discount.

Capital budgeting examples for NPV and IRR methods

Let’s take an example of an ABC Company whose expectations of a project proposal are as follows:

Capital investment      = 100,000 ₹

First Year inflow expected   = 110,000 ₹

Second Year inflow expected   = 150,000 ₹

Third Year inflow expected   = 200,000 ₹

Fourth Year inflow expected   = 250,000 ₹

Fifth Year inflow expected      = 300,000 ₹

Rate of Discount = 10%

The Net Present Value (NPV) is calculated as follow:

The NPV calculation is tabulated below.

Year

Cash Flow

NPV

Calculation

0

100,000

100,000

NA

1

100,000

110000

10,000(1.10)

2

150,000

165000

15000(1.10)

3

200,000

220000

20000(1.10)

4

250,000

275000

25000(1.10)

5

300,000

330000

30,000(1.10)

Total

1,100,000

1,200,000

 

This has a positive increase in the Net Present Value i.e. 1,200,000 over 5 years and therefore makes for an excellent choice of proposal.

3. Internal Return Rate Method (IRR): 

This capital budgeting formula method is especially useful when the NPV is nil or zero meaning the cash outflow rate is the same as the cash inflow rate. A company normally accepts a proposal when the average capital cost is more than the IRR and the IRR is greater than the acceptable threshold rate of IRR. In the case of many project proposals, it is wisest to accept the proposal with the best IRR.

The formula used here is the IRR is the discounted cash flows of a period.

Year

Proposal-1 Returns in ₹

Proposal-2 Returns in ₹

0

-100,000

-100,000

1

25,000

30,000

2

25,000

30,000

3

25,000

30,000

4

25,000

30,000

5

25,000

30,000

Total 

125,000

150,000

IRR

7.9 per cent

15.2 per cent

Suppose the threshold IRR is 7 %. Since Proposal-1 has an IRR of 7.9 it just scrapes through. If the threshold IRR is 8, then the proposal should be rejected. However, Proposal-2 has an IRR of 15.2 % and should thus be taken as the better proposal.

Also read: GST Calculator – Online Goods and Services Tax Calculator

Conclusion

Capital Budgeting is critical to sustainability and growth in a firm. It is used to strategize the capital budgeting decisions examples in business processes like project investments, fixed asset purchases, etc. The process involves a step-by-step qualitative and financial needs analysis and forming a capital budget towards the goals of sustainable growth and getting the anticipated returns. 

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FAQs

Q: What happens when both proposals under consideration have the same payback period?

Ans:

In that case, you should consider the time-efficient proposal with better cash flows in the early stages to factor in the value of your money.

Q: How do you define capital budgeting?

Ans:

Capital budgeting is the process of using management tools to control and plan an enterprise’s future activity. It includes the plans for saving, spending, borrowing, etc, the capital finance needed by the management for its projects. You also need to evaluate the capital budgeting process, project benefits, costs, and the viability of future projects.

Q: When is the capital budget drawn up?

Ans:

When the capital budget example, its expenditure, and project proposal is approved, the finance team has to arrange sufficient capital funds and alternatives for raising such funds. Based on these alternatives, the capital budget is drawn up.

Q: What reasons underlie project proposals?

Ans:

Your project proposal could deal with these reasons mainly.

• Expanding the production line: The existing production line can be expanded in two ways. Firstly to meet growing market demand, or, to expand the capacity of the production line.

• Adding new products: The proposal could be to introduce an allied or new product line. 

• Reducing costs: The proposal to maintain the production scale, but, reduce the cost of the existing product-line output results in savings and profit increase.

Q: What methods are used for capital budgeting decisions?

Ans:

The profitability of the project proposal is the firm’s long-term and ultimate goal. To assess these some of the most common methods to select projects involve the following three or more metrics that are described below. Namely,

• IRR or Internal Rate of Return

• PB or Payback Period

• NPV or Net Present Value

• PI or Index of Profitability

Q: What is meant by the Payback Period?

Ans:

The payback period is the time taken for the firm’s project proposal to get sufficient income from it to cover the initial capital investment. You always should choose the quickest payback period.

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