Meaning of Capital Budgeting or Investment Decision
The term capital budgeting or investment decision means planning for capital assets. Capital budgeting decision means the decision as to whether or not to invest in long-term projects such as setting up of a factory or installing a machinery or creating additional capacities to manufacture a part which at present may be purchased from outside and so on. It includes the financial analysis of the various proposals regarding capital expenditure to evaluate their impact on the financial condition of the company for the purpose to choose the best out of the various alternatives.
According to Milton “Capital budgeting involves planning of expenditure for assets and return from them which will be realized in future time period”.
According to I.M Pandey “Capital budgeting refers to the total process of generating, evaluating, selecting, and follow up of capital expenditure alternative”
Capital budgeting decision is thus, evaluation of expenditure decisions that involve current outlays but are likely to produce benefits over a period of time longer than one year. The benefit that arises from capital budgeting decision may be either in the form of increased revenues or reduced costs. Such decision requires evaluation of the proposed project to forecast likely or expected return from the project and determine whether return from the project is adequate.
Nature / Features of Capital budgeting decisions
a) Long term effect: Such decisions have long term effect on future profitability and influence pace of firms growth. A good decision may bring amazing returns and wrong decision may endanger very survival of firm. Hence capital budgeting decisions determine future destiny of firm.
b) High degree of risk: Decision is based on estimated return. Changes in taste, fashion, research and technological advancement leads to greater risk in such decisions.
c) Huge funds: Large funds are required and sparing huge funds is problem and hence decision to be taken after proper care .
d) Irreversible decision: Reverting back from a decision is very difficult as sale of high value asset would be a problem.
e) Most difficult decision: Decision is based on future estimates/uncertainty. Future events are affected by economic, political and technological changes taking place.
f) Impact on firms future competitive strengths: These decisions determine future profit or cost and hence affect the competitive strengths of firm.
g) Impact on cost structure – Due to this vital decision, firm commits itself to fixed costs such as supervision, insurance, rent, interest etc. If investment does not generate anticipated profit, future profitability would be affected.
Techniques used in Investment decision making
Most commonly used technique in investment decision making are given below:
1) Payback period Method: It is one of the simplest methods to calculate period within which entire cost of project would be completely recovered. It is the period within which total cash inflows from project would be equal to total cash outflow of project. Here, cash inflow means profit after tax but before depreciation.
Merits of Payback period Method
a) This method of evaluating proposals for capital budgeting is simple and easy to understand, it has an advantage of making clear that it has no profit on any project until the payback period is over i.e. until capital invested is recovered. This method is particularly suitable in the case of industries where risk of technological services is very high.
b) In case of routine projects also, use of payback period method favours projects that generates cash inflows in earlier years, thereby eliminating projects bringing cash inflows in later years that generally are conceived to be risky as this tends to increase with futurity.
c) By stressing earlier cash inflows, liquidity dimension is also considered in selection criteria. This is important in situations of liquidity crunch and high cost of capital.
d) Payback period can be compared to break-even point, the point at which costs are fully recovered but profits are yet to commence.
e) The risk associated with a project arises due to uncertainty associated with cash inflows. A shorter payback period means that uncertainty with respect to project is resolved faster.
Limitations of payback period
a) It stresses capital recovery rather than profitability. It does not take into account returns from the project after its payback period.
b) This method becomes an inadequate measure of evaluating 2 projects where the cash inflows are uneven.
c) This method does not give any consideration to time value of money, cash flows occurring at all points of time are simply added.
d) Post-payback period profitability is ignored totally.
2) Accounting rate of return (Average rate of return – ARR): ARR is a financial ratio used in capital budgeting. The ratio does not take into account the concept of time value of money. ARR calculates the return, generated from net income of the proposed capital investment. The ARR is a percentage return. Say, if ARR = 7%, then it means that the project is expected to earn seven cents out of each dollar invested. If the ARR is equal to or greater than the required rate of return, the project is acceptable. If it is less than the desired rate, it should be rejected. When comparing investments, the higher the ARR, the more attractive the investment. Over one-half of large firms calculate ARR when appraising projects. It is calculated with the help of the following formula:
ARR=Average Profit / Investment
Merits of ARR
a) It is simple, common sense oriented method.
b) Profits of all years taken into account.
c) It considers actual net profit of the project.
Demerits of ARR
a) Time value of-money is not considered
b) Risk involved in the project is not considered
c) Annual average profits might be same for different projects but accrual of profits might differ having significant implications on risk and liquidity
d) The ARR has several variants and that it lacks uniform understanding.
3) Net present value (NPV) method: The best method for evaluation of investment proposal is net present value method or discounted cash flow technique. This method takes into account the time value of money. The net present value of investment proposal may be defined as sum of the present values of all cash inflows as reduced by the present values of all cash outflows associated with the proposal. Each project involves certain investments and commitment of cash at certain point of time. This is known as cash outflows. Cash inflows can be calculated by adding depreciation to profit after tax arising out of that particular project.
Merits of NPV method:
1) NPV method takes into account the time value of money.
2) The whole stream of cash flows is considered.
3) NPV can be seen as addition to the wealth of shareholders. The criterion of NPV is thus in conformity with basic financial objectives.
4) NPV uses discounted cash flows i.e. expresses cash flows in terms of current rupees. NPV's of different projects therefore can be compared. It implies that each project can be evaluated independent of others on its own merits.
Limitations of NPV method:
1) It involves different calculations.
2) The application of this method necessitates forecasting cash flows and the discount rate. Thus accuracy of NPV depends on accurate estimation of these 2 factors that may be quite difficult in reality.
3) The ranking of projects depends on the discount rate.