Capital budgeting techniques

CAPITAL BUDGETING TECHNIQUES 6

Capitalbudgeting techniques

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Capitalbudgeting refers to the planning process that most companies use indetermining which long term investment projects are worth pursuing.This also entails a budget for crucial capital expenditures (Wilkes,2011). These investments include new products, machinery, researchprojects and machinery replacement among others. Capital is a scarceresource and hence careful consideration is put in place whenconsidering the type of investments to undertake. Capital projectsare evaluated using qualitative and quantitative analysis so as toidentify the most viable venture (Wilkes, 2011).

Differentcompanies adopt different methods in analyzing these investments.Most of these analyses use cash inflows and outflows approaches whileothers use estimated cash inflows by reducing costs and adding anyproceeds from the sale of any company asset, and cash outflows onoperating costs, overhauls of machines and capital investment. It isof importance to note that a capital budgeting analysis performs atest to identify whether the cash inflows from the investment willmeet particular demands (Wilkes, 2011). This investment must be in aposition to repay the initial cost of the asset, meet the costincurred to finance it and finally the risk premium. The most commontechniques used for analyzing capital budgeting include Paybackperiod, Net Present Value, Profitability index and Internal rate ofreturn (Wilkes, 2011).

First,payback period is a simple capital budgeting technique that is usedto calculate the time investment will take to repay the originalamount. This approach is explained as the time an investment takes togenerate income that equals the project thus paying the company back.This is arrived at by dividing the initial investment by annual netincome or its average (Wilkes, 2011). Investments chosen are thosewith shorter, or having equal payback periods. For instance, whenchoosing between two new technology investments, the chosentechnology will be the one that has a quicker payback time on thecost to acquire it. It is of important to state that the otherinvestment not chosen can provide greater returns in the long run.

Themethod of payback period faces various limitations as compared toother techniques. One of the criticisms is that this approach doesnot consider the value of money, financing, risk and opportunity costamong other considerations. This technique is assumed as it ignorestiming differences of cash flows and the project period (Wilkes,2011). For instance, a number of projects may have the same cashflows but differ in the extent of their timings. Similarly, projectscould have the same payback period, where one of the projects takesthree years, and the other one lasts two years.

Thesecond technique used in capital budgeting analysis is the NetPresent Value approach. This method is used in the evaluation ofprojects with different cash flows, costs and period. The essentialdata needed in this approach include cash inflow, outflow and thecompany’s rate of return on the investment being evaluated (Wilkes,2011). Choosing the best rate of return is important as the netpresent value is dependent on it. The best way in determining theappropriate rate of return is by using weighted average cost ofcapital.

Underthis technique, the company evaluates cash inflows and outflows,revenues and costs involved in undertaking a certain project, atpresent and future. Further, it adjusts the future cash inflows toascertain what they are worth now using a discount rate taking intoconsideration risk associated with the project, inflation and cost.The Net present value is arrived at after an addition of all the cashflows both positive and negative. The decision rule is that theproject with a positive net present value qualifies. Also select theproject with a higher net present value (Wilkes, 2011).

Majorityof companies combine a number of techniques when analyzing capitalbudgeting decision. For instance, a business can use payback periodmethod to cut down some alternatives, and then adapt the net presentvalue technique to establish the best decisions among the remainingalternatives (Wilkes, 2011). Likewise, it can apply net present valueapproach to reduce the number of projects and then use payback periodmethod to identify the project that repay back in the shortest time.

Theother technique is by using the internal rate of return. This is arate that results to a negative net present value. IRR measures theefficiency of investment. The internal rate of return is derived by aformula whereby the proposed capital investment is divided by the netcash inflow of that particular year (Wilkes, 2011). The net presentvalue and internal rate of return yield the same results fornon-mutually exclusive projects in an uncontrolled environment andthe cash flow at the initial stage is negative. On the other side,for mutually exclusive investments, choosing a project with a highinternal rate of return, gives rise to selection of a project with alower net present value. Further, the decision rule is to select aproject with a higher internal rate of return as compared to thecompany`s rate of return.

Profitabilityindex is another method used in capital budget analysis. This is alsoreferred to as a benefit-cost ratio. It is useful in ranking ofprojects as one can measure the value per unit of the investment. Itis in most case referred to as profit investment or value investmentrate. It is defined using a formula that divides the current value offuture cash flows by the amount of initial investment needed for theproject (Wilkes, 2011). This technique has been delivered from thenet present value method. These techniques differ in that Net presentvalue portrays a quantifiable figure for the investment whileprofitability ratio gives the outcome as a ratio. The decision ruleof this method is to accept a plan when the index is more than onereconsider if the index is zero and reject if the index is less thanone (Wilkes, 2011).

Reference

Wilkes,F. M. (2011). Capitalbudgeting techniques.Chichester: J. Wiley.