Compiled by Dharini Desai & Aishwarya Ade
│What is Capital Budgeting?
A corporation is often faced with the challenges of selecting between two projects/investments or the buy vs replace decision. In an ideal situation, an organization would like to invest in all possible profitable projects, but due to the limited availability of capital, has to choose one between different projects/investments. A company will undertake capital budgeting as per its business needs such as: Opening a new store in a different location, Construction of a new plant or a Big investment in an outside venture, Expansion of warehouse facility, Investment in new equipment/machinery, Investment in real estate and new technology, or Spending money on specialised employee training.
Capital budgeting process also known as investment appraisal is evaluation of prospective major projects/investments & huge expenses with the objective to achieve the best returns on investment. The main goal is to identify projects that generate positive cash flows that exceed the organization’s initial cost of the project.
│Parameters on which to make Capital Budgeting
Certain business decisions are irreversible in nature, therefore, they need to be taken after thorough analysis and research. Some of the decision rules to consider to aid in choosing the optimal capital project are:
- The Payback Period (PBP) can be used as a decision criterion to select an investment proposal. If the PBP is less than the maximum acceptable payback period, accept the project. If the PBP is greater than the maximum acceptable payback period, reject the project. The projects may be ranked according to the length of PBP and the project with the shortest PBP should be selected.
- The Average Rate Of Return (ARR) can also be used as a decision criterion to select an investment proposal. If the ARR is higher than the minimum rate established by the management, accept the project. If the ARR is less than the minimum rate established by the management, reject the project.
- The Net Present Value (NPV) method can be used as an accept-reject criterion. The present value of the future cash streams or inflows would be compared with present value of outlays. If the NPV is greater than 0, accept the project. If the NPV is less than 0, reject the project. The market value of the firm’s share would increase if capital projects with positive NPVs are accepted.
- With the Profitability Index (PI) Ratio Method, Accept the project when PI>1, Reject the project when PI<1, May or may not accept when PI=1, the firm is indifferent to the project.
- When the Internal Rate Of Return (IRR) is greater than the initial cost of capital, accept the project (r >k), & if the IRR is less than the initial cost of capital, reject the project (r<k).
│Capital Budgeting Evaluation Process & Steps:
The capital budgeting process comprises of five steps:
│Common Pitfalls Businesses Face During Capital
Capital Budgeting Decisions are usually complex & critical in nature. Any corporation that invests its resources, without understanding the risks and returns involved, would be held as irresponsible by its shareholders.
Company managers commonly make errors during evaluation of capital projects. Some of these common errors include:
- Failure to account for economic reactions: When a company introduces a highly profitable product to the market, this attracts increasing competition wherein future profitability can deteriorate. Thus, the company fails to take into account and consider for possible economic reactions.
- Standard approach for all capital projects: A company may deploy a standard approach for different capital projects & use a common model to evaluate all of its capital projects, despite differences across all the capital projects that it considers.
- Focussing on accounting results: A company’s management may have an aggressive focus on accounting results, with the motivation of being incentivized to initiate projects, that show positive short term accounting results at the expense of long-term projects with High Net Present Values.
- Choosing IRR over NPV: Most companies prioritize IRR over NPV, which may not lead to optimal decision making especially in the scenario of evaluating mutually exclusive projects.
- Pet Projects: Influential company managers may initiate pet projects which advance their own self-interests rather than creating any company value.
- Cash Flow Errors: As many estimates and assumptions go into forecasting cash flows in the capital budgeting process, this can make the cash flows more prone & subject to error.
- Inappropriate discount rate: The discount rate is just an estimate based on the cost of capital & the prevailing risk free rate. The concept of the perfect discount rate does not really exist. A company can make use of an inappropriate discount rate, such as a very low discount rate for a high-risk project which will overstate the project’s NPV, & conversely a high discount rate may underestimate the NPV.
- Misunderstanding sunk & opportunity costs: A common error businesses make in capital budgeting is, misunderstanding the difference between sunk costs & opportunity costs. A company may exclude opportunity costs and incorrectly include sunk costs into the analysis.
Capital budgeting decisions involve an outlay of enormous sums of money. And as such transactions are typically irreversible in nature, it is important to get the whole process right in the first step itself. No trials and errors are affordable at this stage. Capital budgeting decisions are complex in nature, & it’s success is dependent on correctly choosing the right project with the best possible returns. Since such projects are capital intensive, an organization requires an expert’s help on correctly identifying all the underlying risks and benefits associated with the capital project, to minimize the value at loss and maximize company profitability.