Capital budgeting technique

Long-term investment decisions are made through capital budgeting. It is most certainly a company’s most important financial decision and it is selecting projects and investments that increase a company’s worth.

In this article, you will understand capital budgeting and its five techniques with examples. This article will also give you an in-depth insight into the advantages and disadvantages of capital budgeting techniques.

Table of contents

• Meaning of capital budgeting.
• What is a technical budgeting technique?
• Techniques of capital budgeting with example.
• Advantages and disadvantages of capital budgeting techniques.
• conclusion

Meaning of capital budgeting

It is a combination of two words capital and budgeting. Capital is the primary asset used in the production process and budgeting is a financial/economic plan which includes a list of all planned income and expenditures. So we can say that it is a method of making the decision of the long-term investments either initiative is profitable for a company and will give the appropriate return in the coming years or not.

What is a capital budgeting technique?

The capital budgeting technique is a method that is used to describe the process of making investment decisions, it is finding out whether or not to invest money in a project. Capital budgeting strategies aid in determining the profitability of investments that must be made inside a company. There are several methods/ techniques for calculating capital budgeting like the profitability index, payback period, net present value, internal rate of return, and modified rate of return.

Techniques of capital budgeting with example

There are five techniques to calculate capital budgeting

1- Profitability indexing

The profitability index is one of the most crucial techniques of capital budgeting, which represents a ratio between the project’s investment and its payout. It can be calculated by dividing the present value of future cash flows by the present value of the initial investment.

The formula of profitability indexing;

Example of profitability indexing

If a company gets a project A and its initial investment is $5,000, the present value of future cash flow is  $50,000. Then how can we calculate the profitability indexing of project A of a company?

Given;

• Initial investment of project A = $5,000
• Cash flow = $50,000
• Profitability indexing = ?

Solution; 

Profitability indexing = PV of future cash flows / PV of the initial investment

PI = $50,000/$5,000

PI = $10.

2- The payback period(PP)

 It is used to identify how long it requires to recover the project’s initial costs and expenses as well as an investment’s cost. It can be calculated by dividing the initial investment made by the net annual cash inflow.

The formula of the payback period;

Example of payback period

Let’s suppose a company gets a project and its initial cost is $5,000 and it is expected to generate a cash flow of $1,500 for the next four years.

Given;

• Initial cost of a project =$5,000
• Expected cash flow = $1,500
• Time period = 4 years

Solution; 

Payback period = number of years – (cumulative cash flow / annual cash flow)

PP                       = 4 – ( $1000/$1,500)

PP                       = 4 – $0.66

Payback period   = $3.34

As a result, we can say that the investment will be recovered in 3.34 years.

3- Net present value(NPV)

It is the difference between the present value of cash inflow and outflow at a specific time period. It is used in capital budgeting to find out a project’s profitability.

The formula of net present value;

• The discount rate is denoted by (i).
• The number of years is denoted by (n).

Example of net present value

Let’s suppose a manufacturing company gets a project B and its initial investment is -$1,200and assume the discount rate is 15% and cash flow for the four years are as follow

• Year 1 = $200
• Year 2 = $400
• Year 3 = $500
• Year 4 = $600

Find the NPV of project B.

Given; 

• Initial investment of project B = -$1,200
• Discount rate =7%
• Number of years = 4
• Cash flow = year 1($200), year 2($400), year 3($500), year 4($600).

Solution;

Net present value = [ cash flow / (1+i)ⁿ]- initial investment

NPV                     = -$1,200/(1+0.07)^0 + $200/(1+0.07)^1 + $400/(1+0.07)^2 + $500/(1+0.07)^3 + $600/(1+0.07)^4

NPV                     = -$1,200 + $186.916 + $349.375 + $408.149 + $457.737

Net present value = $202.177

As a result of the positive value of NPV, it is suggested to continue project B.

4- Internal rate of return(IRR)

It is also considered a fundamental technique of capital budgeting where the discount rate of projects cash inflow is equal to cash outflow. This means that the discount rate of the net present value is equal to zero. 

The formula for internal rate of return;

Example of the internal rate of return;

Let’s suppose a company gets a project and its initial investment is -$103.75, it generates a cash flow for three years is $39.50, $42.49, and $50.55. The discount rate of the project is 13%. Find the internal rate of return.

Given; 

• IN = -$103.75
• CF = $39.50, $42.49, $50.55
• No of years = 3
• r(discount rate) = 13%

Solution;

NPV                  = [cash flow / (1+i)ⁿ] – initial investment = 0

 NPV                 = -$103.75 + 39.50 / (1+0.13)^1 + $42.49 / (1+0.13)^2 + $50.55 / (1+0.13)^3 = 0

Net present value = -$103.75 + $34.96 + $33.76 + $35.03 = 0

NPV                   = -$103.75 + $103.75 = 0

Net present value = 0

As a result we can say taht NPV = 0

5- Modified internal rate of return(MIRR)

MIRR is a financial term that is used to calculate the project’s profitability and cost. It is the ratio between the future value of positive cash flow and the present value of negative cash flow.

The formula of the modified internal rate of return;

Example of modified internal rate of return;

A company spends/invest $1,000 and expected a cash flow of $200, $400, and $600 for three years. The rate of return is 10% find the MIRR.

Given; 

• PV= $1,000
• CF= $200, $400, $600
• Rate of return = 10%
• FV= ?

Solution;

MIRR = PV(cash outflow) = PV(terminal value of the cash inflow)

FV = FV1 + FV2 + FV3

= 200 * (1+0.1)^2 + 400 * (1+0.1)^1 + 600(1+0.1)^0

= 200 * 1.21 + 400 * 1.1 + 600

= 242 + 440 + 600

= 1,282

PV = 1,000

1000 = 1282 / (1+r)^4

(1+r)^4 = 1282 / 1000

(1+r)^4 = 1.282

Now let’s take the 4th root on both side

1+r = 1.064

r = 1.064 – 1

r = 0.064

r = 6.4%

So now we can say that the modified internal rate of return is 6.4%.

Advantages and disadvantages of capital budgeting technique

Conclusion

In this article, I have discussed the five important techniques of capital budgeting with examples. Moreover, it helps you how to calculate the capital budgeting of the company’s project.