What Is Capital Budgeting?
When a business starts to make money from its assets, the manager has to think about how and where to invest the money. He needs to find out new ways to maximize returns; thus, increase shareholder value.However, when looking for new opportunities to invest, the business owner has to go through a process of evaluating potential projects. He has to calculate each project's expected cost and revenue and uses the results to determine whether to approve or reject the new project.
Capital budgeting is the process used by businesses to evaluate which projects to invest in and how to finance them. The process is often used for major projects such as buying new equipment, developing a new product, purchasing or renting new properties, or buying a new company.
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Also referred to as investment appraisal, capital budgeting consists of conducting a thorough analysis of potential projects. The company’s financial analysts or managers first have to estimate the expected cash inflow and outflow of future projects. Next, they will discount the expected cash flows to their present value. Last, the company will compare the results of each project and select the one with the highest potential profit.
Long Term Investment
Capital budgeting involves identifying a long term period (one year or more) projects susceptible to generate large profits but also carry high risks. In the end, the capital budgeting process will allow managers to make certain decisions of whether to accept or reject a project or rank a set of projects and set out the winner.
The capital budgeting process is vital as it prevents companies from spending time and money on unprofitable projects. It also helps to reveal potential risks in pursuing a project so that managers make informed decisions in the future. Besides, once the project starts, the process can be used as a project’s checklist since it includes all financial layouts (initial cost, plan to track future cash flows, how to use generated revenue) from the beginning to the end.
Furthermore, companies or individuals can use capital budgeting to determine the profitability of new investment in the financial market. They can use the process to analyze and manage their investment portfolios (stocks, bonds, forex, real estate, mutual funds, and more).
Capital Budgeting Process.
In businesses, the amount of capital available for new projects is limited. Also, the new ideas of an investment may require a considerable amount of money, which is why owners use capital budgeting to determine the most profitable and favorable investment.
Financial analysts carry the process into three significant steps:
1. Identify projects:
The first step involves exploring new potential business opportunities. There are various reasons for a company to take up new investments. They either want to purchase new assets or another business, open a new territory (locally or internationally), or develop a new product.
Identifying desirable proposals to improve the business can be tricky. Business owners have to consider many criteria to judge their effectiveness; they have to find multiple projects, study each project's characteristics (excepted costs and benefits, the life of the project, desired rate of return, and more) before deciding which one is worth executing.
When analyzing potential projects, owners have to estimate the initial cost of the project. The initial value is an estimate of all expected expenses from the beginning of the project (period 0) to its realization. They also have to predetermine the life of the project (two, ten, twenty years, etc.) and how much money the project will generate each period. For example, if you choose a project of 5 years, you will have to estimate the expected cash flow in year one, year two, year three, year four, and year five. It is also vital to analyze any uncertainties and risks associated with each project.
2. Measure projects’ profitability:
The second step is about estimating each project’s net cash flow. Now that we have an idea of the expected cash expenses and cash revenue for each period, we can calculate the net cash flow, which is equal to cash revenue minus cash expenses.
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3. With the above results,
you can rank the projects and select the most profitable, given the objective of the company, using different capital budgeting tools.
Capital Budgeting Tools
To determine whether a project is worth executing, analysts will use these primary methods of capital budgeting:
1. DCF (Discounted Cash Flow) Analysis:
Before you invest money in a new project, you have to anticipate how much money it will generate in the future. The DCF valuation method will help you estimate the present value of an investment’s future cash flows. To determine the profitability of an investment, analysts have to discount all future cash flows back into today’s value. Discounting consist of smashing down future values and learn what they are worth today.
DCF method has two key components, including:
Free Cash Flow (CF): the money the company is making or is expecting to make.
Time (t): How long until you get the anticipated results. It can be months, one year, ten years, and even more.
Discount rate (r):To determine the present value of expected cash flows, you need to use a discount rate. The company is ready to give up money that it could use right now and put it into future projects. However, they have any idea of what could happen to the money or whether the project is viable. In that logic, they have to put the price on the time it will take to get to the anticipated cash flows. That price is called a discount rate, and it reflects the risk of the cash flows. Analysts use the rate to smash future cash flows back to their current value.
DCF Formula: PV= Cash flow/(1+r)t
As you discount future cash flows their value decrease. Discounting depends on how far you expect the money to come in and how big is the interest rate.
For example, you plan to invest $100 to buy a new machine and expect to make $200 in the next year. To determine the feasibility of the investment, you need to discount the first-year cash flow to its current value using a discount rate of your choice. If the result obtained through DCF is higher than the initial investment ($100), then the project is worth considering.
2. Net Present Value (NPV):
The NPV calculates the difference between an investment’s initial cost and its market value. This method adds up the present values of all future cash flows and weighs it against the initial investment.
Using the first example, let's assume that the machine is expected to bring in $150 in the first year and $210 in the second. You will then need to calculate the PV of each cash flow. After, add up the results and compare them to the initial cost ($100). If the result is positive, you can proceed with the project.
NPV= Cash flow/(1+r)t-Initial Cost.
3. Internal Rate of Return (IRR):
it referrs to the discount rate that makes NPV equal to zero. The higher the IRR, the more beneficial the project.Its main role is to measure the resiliency of the cash flows. IRR is also the rate of growth investment is expected to achieve. To determine the IRR, you have to set the NPV equal to zero and calculate the new discount rate.
0= CF/(1+IRR)t-Initial Cost.
You can calculate the IRR easily using the Excel built-in formula. The IRR is a useful and intuitive capital budgeting tool. However, it can sometimes give a misleading judgment, which is why it is better to compare it to the NPV.
DCF, NPV, and IRR are some of the best capital budgeting tools as they take into consideration all the metrics, including cash flows, time, and risk.
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4. Payback Analysis:
Payback methods reveals how long it takes to earn back the initial investment. A project with shorter payback is more attractive to investors. You can compare different projects by checking which one pays back soon enough.
For instance, a project with a duration of four necessities $500 expects to earn $250 each year. In that case, the investor makes back his money in the second year. Therefore, the payback period equals to two.
The benefit of the Payback method is that you get your money sooner and use it for other purposes. However, it doesn’t consider the cash flows generated after the payback period.
Examples of accounting ratios:
- The quick ratio measures a company's liquidity.
- Quick ratio= (Current Assets- Inventory- Prepaid Expenses)/Current Liabilities.
- Debt-to-equity (D/E) ratio provides analysts insight on how risky a project or a company is. If the ratio is high, it means that the company uses more debt than equity to finance its operations. The contrary means that it uses more equity.
- Gross margin: Company Gross Profit/Net Sales.
- Return on Assets: Net Income/Total Assets.
- Return on Equity: Net Income/Shareholder’s equity.
- Payout ratio: It determines the share of earnings to be paid out as dividends. Payout ratio= Total dividends/Net Income.
6. Average Rate of Return:
This method reveals the percentage rate of return expected from a project. ARR is a quick and easy process to evaluate multiple projects’ degree of profitability. However, it completely ignores the cash flows and the value of time.
ARR= Average annual profit/Initial investment.
To determine the Average Annual Profit, you need to forecast the net revenue from your investment minus all the costs. You can now compare your projects and choose the one with a higher percentage.
7. Profitability Index (PI):
Also referred to as Profit Investment Ratio, PI determines the relationship between initial cost and the benefits. The higher the PI, the more attractive the project gets.
PI= PV of Future Cash Flows/Initial cost.
Any PI>1 indicates that the discounted future cash inflows are higher than the discounted future cash inflows. It also means that the NPV is positive.