Capital Budgeting is the process of evaluating the projects to be invested in the company and how to finance them. Due to the limited fund, we cannot accept all projects proposals. We will filter and select only the most profitable project to maximize our return. The projects includes both self-construction asset, buying machinery, develop a new product line, and purchase a new subsidiary.
The criteria of accepting projects depend on the lifetime cash outflow and inflow which depend on the estimated return or cost-saving. It also depends on the requirement of our business operation such as new product development or new specialist from a subsidiary.
Capital Budgeting Methods
There are many methods which can be used to assist the management to select the investment project such as:
Accounting rate of return
It is the average profit that expects to generate from investment divide by the cost of investment. The accounting rate of return will express in percentage per annual. It represents the return from the investment which expects to generate each year. This method dose not take into account the time value of money.
Average accounting return
Average accounting return is the profit generate from investment after-tax and depreciation expense, and divide by the initial cost.
The payback period is the amount of time which take to recover the initial cost of investment. It is the time spend to reach the break-even point. This method ignore the life time profit but focus on how fast the initial investment is recovered.
Net present value
Net present value is the present value of all future cash flow over the entire life of the investment. It includes both cash inflow and outflow. It is the different between present value of cash inflow and cash outflow over project life time.
The profitability index is the profit ratio calculated by the present value of future cash flow and initial investment. The company will select the project with higher PI and the project greater than 1 is considered as a good investment.
Internal rate of return
IRR is the interest rate which makes the total net present value of all both in and outflows equal to zero in any project. It shows the project’s break-even point interest rate which indicates the project profitability.
Modified internal rate of return
MIRR is closely related to IRR but MIRR assumes the cash inflow is reinvested at the same rate.
Equivalent annual cost
EAC is the annual cost of owning, maintaining, and operating the asset over its entire lifetime. The company uses EAC to evaluate each asset cost-effectiveness of assets and select the best one to invest. It allows the company to compare the assets which have a different useful life.
Capital Budgeting Process
Identify the opportunity
First, we need to identify the investment opportunity which is available for us. These investments must be related to our business and add some value to us such as increase sales, expand operations, and lower the cost. In this stage, we need to list down all these available investments.
Obtain an investment proposal
After identifying the available project, the company needs to collect all the proposals. The proposal should be included the projected cash flow, initial cost, and associated risk. This information must be reviewed by the relevant department such as sales, production, and accounting in order to reduce the error.
In this process, the management needs to select the most valuation project which can bring more benefits to the company.
It should be time to start the investment process. The purchasing department may require to collect quotes or bidding to find the appropriate supplier. The finance department will start to seek loans from banks or issue bonds to the capital market. The management needs to assign the appropriate people to charge of the project.
The investment should be reviewed annually or monthly basis in order to monitor the progress with the proposal. We may require to adjust as the actual situation may differ from our plan.
Important of Capital Budgeting
The amount spent on a fixed asset can be large and impact the company liquidity, it even leads to bankruptcy if the project fails generate enough cash for operation. So capital budgeting is very important to ensure that the company use the fund precisely and manage the source of fund in order to minimize the cost.