Capital budgeting can be considered as the process by which companies evaluate and make decisions regarding investments and expenditures. It determines expected returns and aligns these returns to achieve the company’s financial goals and resources by analysing their projects and investments.
For example, let’s say your PC is not functioning properly. Now you have only two choices: whether you will buy a new PC or whether you will pay for the repair of your PC. But you found out that the repair cost is higher than buying a new PC. So that’s how you made the decision to buy a new PC instead of repairing it.
How Capital Budgeting and Assets Acquisition are related?
While capital budgeting involves evaluating long-term projects, asset acquisition plays a significant role in the process by purchasing assets from investments. Effective capital budgeting maximises the company’s growth and value by allocating funds to acquire assets.
Methods of Capital Budgeting
Internal Rate of Return (IRR) and Net Present Value (NPV) are two important methods utilised in this procedure. Let’s dissect these ideas and examine their applicability.
In Capital budgeting Net Present Value (NPV) and Internal Rate of Return (RR) are the two techniques that are mostly used. Let’s break these concepts and understand with clarity.
1. Net Present Value (NPV)
To assess the profitability of an investment, we use a method known as Net Present Value (NPV). Net present value (NPV) is a method that comes into the field. It is used to know the difference between the present value of cash inflows and outflows over a period of time. NPV provides information about how much profit an investment will make in the present time.
Example: Imagine a textile company in Mumbai planning to buy new weaving machines for ₹10 crore. The expected additional cash flow from these machines is ₹3 crore per year for five years. If the discount rate (a rate used to convert future cash flows into today’s value) is 10%, the company will calculate the present value of each year’s cash flow and subtract the initial investment.
Year 1: ₹3 crore / (1 + 0.10) = ₹2.73 crore
Year 2: ₹3 crore / (1 + 0.10) ² = ₹2.48 crore
Year 3: ₹3 crore / (1 + 0.10) ³ = ₹2.25 crore
Year 4: ₹3 crore / (1 + 0.10) ⁴ = ₹2.05 crore
Year 5: ₹3 crore / (1 + 0.10) ⁵ = ₹1.86 crore
Adding these values gives the total present value of future cash flows as ₹11.37 crore. Subtracting the initial investment of ₹10 crore, the NPV is ₹1.37 crore. Since the NPV is positive, the investment is considered profitable.
2.Internal Rate of Return (IRR)
Internal Rate of Return is another method that is used for evaluating the profitability of an investment. It can be treated as a discount rate that is used for a particular investment to make it zero from Net Present Value of cash flows (inward and outward). It determines the rate of investment growth by considering the future cash flows.
Example: Continuing with the same textile company example, if the company wants to find the IRR for the new weaving machines, it will adjust the discount rate until the NPV equals zero. Let’s assume the IRR comes out to be 15%. This means that the investment in weaving machines will generate a 15% return per year.
To decide whether to go ahead with the investment, the company will compare the IRR with its required rate of return or cost of capital. If the IRR is higher, the investment is considered good. In this case, if the company’s required rate of return is 12%, the IRR of 15% indicates a profitable investment.
Questions to understand your ability
Q 1: What is capital budgeting?
- The process of creating a company’s annual budget
- Evaluating and making decisions regarding long-term investments and expenditures
- Monitoring daily expenses
- Setting employee salaries and benefits
Q 2: Which of the following best describes the relationship between capital budgeting and asset acquisition?
- Capital budgeting is only about short-term projects, while asset acquisition is about long-term projects.
- Capital budgeting involves evaluating projects, and asset acquisition involves purchasing assets from those projects.
- Asset acquisition is unrelated to capital budgeting.
- Capital budgeting is about managing daily expenses, and asset acquisition is about buying assets.
Q 3: In the context of capital budgeting, what does Net Present Value (NPV) indicate?
- The rate at which an investment will break even
- The difference between the present value of cash inflows and outflows over time
- The total cost of an investment
- The future value of an investment
Q 4: What is the Internal Rate of Return (IRR)?
- The future value of an investment
- A method to evaluate the profitability of an investment by determining the discount rate that makes the NPV zero
- The amount of profit an investment will generate in the first year
- The initial investment cost
Q 5: Which scenario is an example of a capital budgeting decision?
- Deciding whether to repair or buy a new PC based on cost analysis
- Setting the annual budget for office supplies
- Determining the salary increment for employees
- Planning a team-building event
Conclusion
Capital Budgeting is the key to making wise investments. Techniques like NPV and IRR provide clarity about an investment’s potential profitability. These techniques are instrumental in making decisions that contribute to the growth of the company. The NPV and IRR principles remain the same for small and large companies. Complexities related to asset acquisition can be turned down with the help of Capital budgeting.
