Budgeting is creating an estimation of expense and income over a period of time. It is allocation of income.
A budget is created by individuals and families to manage their expenses and save for their future needs and wants.
When businesses do the same thing it is known as capital budgeting. It is a process through which an organization plans its capital projects/capital expenditure on projects which have a life of a year or more.
Importance of capital budgeting
Capital budgeting is a process which helps a company decides the advantages of accepting an investment project. It helps a company decide which project to choose from the various options available based on the rate of return any such project will generate.
It is a process which helps to increase the value of the firm to the shareholders. It helps to understand risk and return involved and determine the long term economic profit of any project.
Through capital budgeting a company can:
- Strategize long term goal
- Select the best investment project
- Forecast and estimate the probable future cash flow
- Keep a check on the expenses
Capital budgeting process:
Normally, the capital budgeting process depends on the organization’s size, policy and the project that is being evaluated. The steps involved in capital budgeting are:-
- Generating Ideas: The first step in capital budgeting is generating ideas. It can come from anywhere, within the organization or from an outside consultant, vendor or customer.
- Analyze the proposal: Gather all the information available and use it to forecast the cash flows for the project and then evaluate the profitability.
- Planning the capital budget: After the forecast and profitability is evaluated, the next step is considering the time line. A project may look desirable in isolation but may not be feasible strategically. So it’s necessary to compare it against other projects and schedule it properly.
- Keeping check and post-auditing: The actual results are compared with the forecasted results. Any difference needs to be verified and explained.
Important terms to know while doing capital budgeting
- Sunk cost: It is a cost that has already been incurred which cannot be recovered
- Opportunity cost: It is a cost borne when we let go of an opportunity to pursue another opportunity. It is the cost of alternative forgone choice. This choice has to be made when we have limited resources. Ex: I chose to grow carrots over water melon, so not growing water melon is my opportunity cost
- Externality: It is the effect of the investment decision on other things besides itself. It can affect the other parts of the company. It can either be positive or negative. It should be considered as a part of investment decision.
- Independent v/s mutually exclusive projects: Independent projects are those projects whose cash flow doesn’t get affected by any other project while mutually exclusive projects are those which are dependent on each other, like you can either chose project A or project B but not both.
- Capital rationing: When a company has fixed amount of funds and has to allocate resources in a way they achieve maximum shareholder value.
Investment decision criterion:
- Net Present Value (NPV)
It is the difference between the present value of cash inflow and the present value of cash outflow. It is used to analyze the profitability of any business.
It tells you how much return a project will generate at a given rate of return. A zero NPV means the company is paying the back the amount invested + the required rate of return. A positive NPV means the project is generating additional cash flow while a negative NPV means the project is making losses.
Formula:
Ct = net cash inflow during the period t
Co = total initial investment costs
r = discount rate, and
t = number of time periods
Image source: Investopedia
Internal Rate of Return:
Internal rate of return is the discount rate that makes the net present value of the cash flow equal to zero.
IRR is the discount rate that makes the present value of the future after tax cash flow equal to investment outlay (out flow).
Simply put, it is the rate of growth that a project is expected to generate. Normally, the actual growth will differ from the IRR. Higher the IRR more chances of a stronger growth. It helps the organization determine the probable return rate.
Issues with IRR:
- The first IRR should be used to value only standalone project and not projects that are mutually exclusive (either one of the project can be selected)
- IRR does not consider the cost of capital, so if a project has different durations, IRR cannot be used to compare.
- In case the project has fluctuating cash flow (Say positive in year 1, negative in year 2 and again positive in year 3) IRR can have multiple values.
- IRR overstates the rate of return for projects whose temporary cash flow would be reinvested at a lower rate.
This is where we end this article. The next tutorial will give you an insight into other budgeting tools like NPV v/s IRR and capital budgeting in real world.
So stay tuned for Part II!