Question

B1) Do you think capital budgeting is important? Justify?

B2) List all the techniques of Capital Budgeting? You think are relevant today?

Answer 1

Step 1 Importance of Capital Budgeting

#1 – Long Term Effect on Profitability

For the growth & prosperity of any organization, a long term vision is necessary, because a wrong decision may severely impact the survival of the firm, which may influence capital Budgeting in the long run. Not only this, but it also impacts the companies future cost &growth. In the long run, capital spending has a significant impact on business profitability. If the expenditures occurred after preparing a budget appropriately, there are certain chances of increasing the profitability of an organization.

#2 – Huge Investments

Any organization needs considerable investment to grow as the company has limited resources to grow while taking the investment decision; it has to make a wise decision. Because the wrong decision may blow up the sustainability of the business, it may profoundly impact the purchase of an asset, rebuilding or replacing existing equipment.

 

#3 – Decision cannot be Undone

Most of the time, the capital investment decision are irreversible in nature; it caters to vast investment, and it is difficult to find the market for it. The only way to remains with the company is to scrap the asset and bear the losses.

#4 – Expenditure Control

Capital budgeting requires more attention to the expenditure and do R&D for an investment project if needed. A good project turns into bad if the expenses were not done in a controlled manner and not monitored carefully, While this step is quite crucial in the capital budgeting process.

#5 – Information Flow

The initialization of the project is merely an idea, whether it is accepted or rejected, depends upon the various level of authority and circumstances. The capital budgeting facilitates the transfer of information to appropriate decision-makers so they can make a better decision in the growth of the organization.

#6 – Helps in Investment Decision

The long-term investment decisions are time-consuming as it takes several years for accomplishment beyond the current period. Uncertainty defines the involvement of the risk in it. Management loses his flexibility and liquidity of funds when making an investment decision. It must be considered while accepting the proposal.

#7 – Wealth Maximization

Motivate the organization to invest in long term investment to safeguard the interest of the shareholder in the organization. If the organization invests in certain projects in a planned manner, the shareholder will show their interest in the organization. It will help them to maximize the growth of the organization. Any expansion of the organization is further related to the growth, sales, and future profitability of the firm and assets based on capital budgeting.

 

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Step 2 Techniques of Capital Budgeting which are being used today

There are different methods adopted for capital budgeting.

The traditional method relies on the non-discounting criteria that do not consider the time value of money, whereas the modern method includes the discounting criteria where the time value of money is taken into the consideration.

 

Traditional methods

The traditional methods comprise of the following evaluation techniques:

 

1. Payback Period Method

2. Average Rate of Return or Accounting Rate of Return Method

 

Modern Methods which are relevant today

 

The modern methods comprise of the following evaluation techniques:

 

1. Net Present Value Method

This is one of the widely used methods for evaluating capital investment proposals. In this technique the cash inflow that is expected at different periods of time is discounted at a particular rate. The present values of the cash inflow are compared to the original investment. If the difference between them is positive (+) then it is accepted or otherwise rejected. This method considers the time value of money and is consistent with the objective of maximizing profits for the owners. However, understanding the concept of cost of capital is not an easy task.

NPV = PVB – PVC

where,

PVB = Present value of benefits

PVC = Present value of Costs

 

      2.Internal Rate of Return

 

This is defined as the rate at which the net present value of the investment is zero. The discounted cash inflow is equal to the discounted cash outflow. This method also considers time value of money. It tries to arrive to a rate of interest at which funds invested in the project could be repaid out of the cash inflows. 

It can be determined by solving the following equation:

 

 

If IRR > WACC then the project is profitable.

If IRR > k = accept

If IR < k = reject

 

  3.Profitability Index

 

It is the ratio of the present value of future cash benefits, at the required rate of return to the initial cash outflow of the investment. It may be gross or net, the net being simply gross minus one. The formula to calculate profitability index (PI) or benefit-cost (BC) ratio is as follows.

 

 

PI = PV cash inflows/Initial cash outlay A,

 

 

 

 

 

 

 

 

PI = NPV (benefits) / NPV (Costs)

 

 

All projects with PI > 1.0 is accepted