There are many different sources of finance that businesses can use to meet their needs. These sources of finance may include capital invested by the owners or debt received from third parties. In the case of companies, it also includes any equity finance raised through the issue of shares and equity instruments. Businesses need to use a combination of different sources of finance to meet their needs.
All types of finance come at different costs. Businesses need to use these finances efficiently. This means that a business will have to properly allocate its resources in a way that can generate the highest returns for the business using the least amount of resources or with their limited resources. For this purpose, businesses need to properly plan their activities. However, sometimes, planning these activities will not be as straightforward. Businesses may need to choose between different options all of which may provide returns to the business.
These decisions can have critical consequences for a business. If there are any errors during this decision-making process, then the business can suffer in the future. Therefore, the business needs to carry out a proper capital budgeting process to ensure proper and efficient use of its resources and generate the maximum returns possible.
Table of contents
What is Capital Budgeting?
Capital budgeting is a part of the decision-making process of a business. Capital budgeting is the process of evaluating different potential projects or investments of a business. As discussed above, this is done to ensure that the resources of the business are used to their full potential. When a business decides between different projects to undertake in the future with limited resources, it will need to evaluate all the projects and choose the one that suits the needs of the business the most.
The capital budgeting process of a business can combine different investment appraisal techniques to help in the decision-making process. For example, when presented with a capital budgeting decision, the business will have to calculate the payback period (PB), the net present value (NPV), the internal rate of return (IRR), the discount payback period (DPB), etc. of the different projects to use for comparison. Once a comparison is made, the business can decide which project can be the most beneficial for the business.
However, the use of different capital budgeting techniques may also be a problem for the business. Different techniques will give different results for each project. For example, a project that has a high net present value may not have an ideal payback period. On the other hand, a project with an ideal internal rate of return may not present the business with an ideal discounted payback period. Therefore, businesses need to understand what the results obtained from each of these techniques represent.
Importance of Capital Budgeting
There are several reasons why capital budgeting is important for businesses.
Help in the Decision Making Process
The first reason why capital budgeting is important has already been discussed above. Capital budgeting helps in the decision-making process of a business. This is because it allows the business to evaluate different projects easily and make decisions on which one suits the need of the business the most.
Help to Efficiently Allocate Resources
Similarly, it can help the business efficiently allocate its resources to ensure maximum possible returns.
A Forward-Looking for Long-Term Growth
Capital budgeting is also important for the long-term growth of a business. It can help the business make decisions in line with the long-term strategies or plans of the business to ensure that short-term objectives aren’t prioritized. Capital budgeting is a forward-looking process. In case of absence of a robust capital budgeting process, the long-term objectives of a business may be compromised which can lead to losses for the business.
Help to Ascertain the Usage of Resources and Finance Properly
Similarly, capital budgeting is important in a business to ascertain that its resources and finances are used properly. The bigger the size of a business is, the more important it is for the business to properly manage its resources. For example, companies are the largest form of businesses and, therefore, have a lot of resources. Without a proper capital budgeting process, companies cannot properly manage their resources. This puts the long-term sustainability of the business into doubt.
Capital Budgeting Techniques
There are many capital budgeting techniques that businesses can use. These techniques are also known as investment appraisal techniques. Below are some of the techniques that are used by businesses for capital budgeting with their respective advantages and disadvantages.
Return On Capital Employed (ROCE)
The first capital budgeting technique is Return on Capital Employed (ROCE). ROCE is one of the most basic investment appraisal techniques. This technique isn’t as commonly used for capital budgeting purposes. ROCE is used as an investment appraisal technique because it is easy to calculate and understand. This is mainly because a business does not need to have any extra information to calculate the ROCE for a project. All the information that is used to calculate it is readily available. To calculate the ROCE of a project, the following formula can be used:
ROCE = Profits before interest and tax / Initial capital cost of project x 100%
The formula can also be modified for more advanced calculations as follows:
ROCE = Average profits before interest and tax / Average capital investment x 100%
The ROCE of a project will produce a percentage of the expected returns from a project. However, the ROCE will not give a business a decision about whether to accept or reject the project in question. The business must establish some standards regarding the acceptance rule for this technique. For example, a business may decide that it will only accept projects that have a ROCE of greater than 10%.
Advantages of ROCE
ROCE has some advantages for businesses. As discussed above, the main advantage of ROCE as an investment appraisal tool is that it is easy to calculate and simple to understand. It can be easily calculated using readily available information. Furthermore, it is the most basic investment appraisal technique and, therefore, understandable for all levels of management. Similarly, the ROCE of a project can easily be linked with other accounting ratios, thus, allowing for better analysis of projects.
Disadvantages of ROCE
The disadvantages of ROCE are also due to its simplicity. Being the most basic investment appraisal tool, ROCE does not consider the life of a project in question. This means that even though, it may take a business 10 years to recover its investment on a project if the ROCE on the project is acceptable, the project will be accepted. This may not be acceptable to businesses that are looking for the fastest possible recovery of their investments. Similarly, it does not consider the timing of cash flows and the time value of money.
Furthermore, the acceptance decision based on ROCE may differ according to different businesses. For some businesses, 5% ROCE may be acceptable while for others it may not be ideal. This also means that it does not provide a definitive investment signal to the business. The business will still need other techniques to make more advanced decisions. Similarly, as compared to other techniques, ROCE also does not consider the working capital of a business.
ROCE is also an investment technique that is based on profits rather than cash flows. The profits of a project are easily susceptible to manipulation. Using profits instead of cash flows also makes the results obtained from this technique less comparable with other investment appraisal techniques.
Payback Period
Another capital budgeting technique or investment appraisal technique used by many businesses is the payback period. The payback period gives the time in which a business can recover its initial investment in a project. The payback period is based on the expected cash flows of a project rather than its profits. To calculate the payback period of an investment, the following formula can be used:
Payback Period = Initial Capital Investment / Total Annual Cash Flow
Please note that this formula assumes that the annual cash flows of the business from the project will be constant. To calculate the payback period for projects with inconsistent cashflows, the business will have to reduce its yearly cash flows from the initial investment of the project every year. The year in which the cash flows of the business exceed the initial investment required for the project or the year in which the overall cash flows of the business from the project become positive is considered the payback period of the project.
Advantages of Payback Period
The advantage of the payback period as a capital budgeting technique is that it is simple to understand. It also is very easy to calculate if the cash flows of a project are constant every year. The payback period method of investment appraisal can be useful for investment appraisal in the technology industry where rapid changes happen or when the investment conditions are improving.
Payback period also promotes quick return for projects. This allows businesses to easily grow and minimizes the risks associated with the projects while maximizing liquidity. Payback periods are also better than other investment appraisal techniques that use profits to conclude. This is because profits can easily be manipulated and do not represent the liquidity position of a business.
Disadvantages of Payback Period
There are also a few disadvantages of payback period. Payback period is only used to find the time at which the initial investment of the business will be recovered. It ignores any returns after the payback period. Payback period also does not consider the timing of the cashflows or time value of money. Also, similar to ROCE, the payback period does not give a definite answer about whether the project should be accepted or not. The business will have to set standards for what an acceptable payback period is.
Net Present Value
The Net Present Value (NPV) technique of investment appraisal calculates the discounted present value of an investment. This capital budgeting technique is calculated by discounting all the cash flows a project to their present value. The discount rate used is the cost of capital or the required rate of return of a business. At the end of the appraisal, the total value of cash inflows is subtracted from the initial investment requirement and any further outflows during the period. All outflows after the initial year of the investment are also discounted to their present values.
The acceptance rules for projects based on their NPVs are very simple. Any project that has a positive NPV will be financially viable for a business. Any project with an NPV of zero will be considered a break-even. While projects with negative NPV will be considered as financially unviable. However, a business may still have some standards for the NPV of a project although it is rare. For example, a business may only accept projects that have an NPV of more than $5,000.
The NPV method of project appraisal is also more helpful when a business is deciding on two different projects. For example, if a project has an NPV of $1,000 while another project has an NPV of $2,000, then the business can easily choose the project that has the higher NPV.
Advantages of Net Present Value
The NPV method of investment appraisal is one of the more advanced investment appraisal techniques. There are many advantages that this technique provides. First of all, unlike the previous two techniques, the NPV technique considers the timing of cash flows and the time value of money. This is because the cash flows are discounted before being used for the calculation of NPV.
Similarly, NPV like the two other investment appraisal techniques does not give an indefinite investment signal. The result of NPV appraisal is used by all businesses in the same manner. If a project gives a positive NPV then it is considered financially feasible. Although some businesses may have their extra requirements from the NPV of a project, the NPV technique does not provide a subjective result.
Similar to payback period, NPV appraisal is based on cash flows rather than profits which makes it more objective and less prone to manipulation. Similarly, unlike payback period, NPV appraisal considers the whole life of a project. This means that regardless of when the initial investment of a project is recovered, the whole NPV of the project is calculated. This allows the business to consider all the cash flows from a project.
The NPV method of investment appraisal is based on the maximization of the wealth of owners. This is because using the NPV of projects to make decisions ensures that only projects with the highest positive NPVs are selected. This ensures that the projects will generate income in the future, thus, increasing owners’ wealth. Moreover, the NPV of a project can also be used as a basis for the calculation of the Internal Rate of Return (IRR) of a project.
Finally, the NPV method of investment appraisal also supports advanced calculations by considering working capital requirements and tax implications of projects. This allows a business to consider all the benefits from a project for the best possible estimate of the NPV of a project. These concepts are generally ignored by other investment appraisal techniques.
Disadvantages of Net Present Value
While there are many benefits of NPV method of investment appraisal, it may have some disadvantages as well. First of all, the NPV method for investment appraisal is not as simple as the other previously mentioned methods. This capital budgeting techniques can be difficult to explain to anyone in the business who does not have technical knowledge.
While the method supports working capital and tax implications of projects, it makes the calculations more complex. Similarly, as compared to the previous two techniques, the NPV method for investment appraisal also considers the time value of money when making calculations. To do so, a business needs to calculate the cost of capital. This can make the calculation of NPV even more complex. Even a slight miscalculation can cause the business to take wrong decisions and may cost the business in the long run.
Internal Rate of Return (IRR)
The IRR method of investment appraisal is also one of the more advanced capital budgeting techniques used for investment appraisal. The calculation of the IRR of a project is based on the calculation of NPV of the project using different rates for the cost of capital or rate of return. IRR is a rate where the NPV equal zero. To calculate IRR, we commonly use trial and error technique or sometimes is called interpolation. Usually, a business must calculate the NPV of a project first at a rate of return that will result in a positive NPV for the project and then at a rate of return at which the NPV of the project is negative. This ensures a more accurate result. However, businesses can also calculate NPVs at two rates both of which return positive NPVs. Finally, using both the NPVs, the IRR of the project can be calculated.
The NPV of a project will be lower or negative at a higher rate of return and will be higher or positive at a lower rate of return. Once the NPV of a project at different rates is calculated, the following formula can be used to calculate its IRR:
IRR = Lower rate of return + [(NPV at lower rate of return / (NPV at lower rate of return – NPV at higher rate of return)) x (Higher rate of return – Lower rate of return)]
This formula will return an internal rate of return of the project in percentage. If the IRR of the project is greater than the cost of capital of the project, then the project is deemed financially feasible for the business. If the IRR is lower than the cost of capital of the project, then the project is deemed financially unfeasible. Therefore, projects with IRR below the cost of capital of a business are rejected.
Advantages of Internal Rate of Return
The IRR method of investment appraisal has some advantages. Some of these advantages may also relate to its use of the NPV method of investment appraisal. The first advantage of IRR is that it considers the timing of cash flows and the time value of money. This advantage is due to its use of the NPV of projects. Similarly, due to the use of NPVs of projects, the IRR method of investment appraisal also uses cash flows of a project rather than profits.
Similarly, due to its reliance on the NPV of projects, IRR also considers the whole life of the project rather than just considering the payback period. Furthermore, since the NPV method is based on maximizing the wealth of owners, the IRR method is also based on the same principle. However, instead of considering projects with a positive NPV, the IRR method considers projects with an IRR above the cost of capital of the business.
However, unlike the NPV method of investment appraisal, the IRR method is easier to understand. Since the result of the IRR method is obtained as a percentage, it is easier to comprehend. The decision rule of the IRR method is also straightforward. Any project with an IRR above the cost of capital or required rate of return of business is acceptable.
Disadvantages of Internal Rate of Return
The IRR method of investment appraisal may also have some disadvantages. The first disadvantage is that the IRR method of investment appraisal is that it does not give an absolute measure of the profitability of the project. While it does allow a business to understand whether the project will be profitable or not, it does not give the business an absolute measure of how profitable it will be. Furthermore, the calculation of IRR can be very complex as it requires the NPV of a project to be calculated at two different rates and put in a complex formula.
Similarly, as discussed above, calculating the IRR of a project requires the NPV of the project to be calculated at two different cost of capital rates. The IRR produces more accurate results when one of the NPVs of the project is negative and the other is positive. However, some times it may not be possible to calculate a positive and a negative IRR. Similarly, the closer the cost of capital used in the calculation of both NPVs are to the IRR, the more accurate result the business will get. This may require many calculations, and trial and error before an accurate IRR can be calculated.
Types of Capital Budgeting Decisions
There are many different types of capital budgeting decisions that a business can make. These decisions can be taken with the help of the techniques discussed above. While all methods can give a business different types of results, the business must use a combination of these techniques to ensure the best decision is taken for the business. Some of the types of capital budgeting decisions are as follows.
Accept-Reject Decision
The most common type of decision made using capital budgeting is an accept or reject decision. In this type of a decision, the business must decide whether a project should be accepted or not. A business can use different standards with the tools above to make a decision. For example, given the choice to accept or reject a project, the business can check whether the ROCE of the project meets the expectations of the business. Similarly, the business can evaluate whether it can recover its initial investment in the project within a specified time which is the payback period of the project.
For more advanced calculations, the business can use the NPV of the project to decide whether the project should be undertaken or not. As discussed above, the decision will be based on whether the project will have a positive NPV or not. The business can also set an expected NPV to ensure that only worthwhile projects are undertaken. Furthermore, the business can calculate the IRR of the project and see if it is above the expected rate of return of the business.
These projects can only be accepted or rejected by a business based on the results of the investment appraisal process. For example, a company evaluating whether to invest in a subsidiary or not. Usually, these projects don’t come with any alternative options.
Mutually Exclusive Project
The second type of capital budgeting decision that businesses have to make is regarding mutually exclusive projects. Mutually exclusive projects are two or more different projects from which only one project can be selected by the business. These are projects of a business that compete for the same resources or investments.
The decision rule for mutually exclusive projects is different than accept or reject projects. In accept or reject decisions, projects were selected based on standards set by the business. However, in mutually exclusive projects decisions, all projects may meet the standards of the business. If any project does not meet the standards set by the business, it is removed from the decision-making process to make the decision-making process easier.
For mutually exclusive projects all the above-mentioned investment appraisal tools can be used. However, these are used comparatively rather than on their own. This means that a business can check the ROCE of the projects among each other and select projects with the highest ROCE. Similarly, businesses can compare the payback periods of different projects and choose the project that allows for the quickest recoverability of the initial investment.
Similarly, for further comparisons, the business can compare the NPVs of both projects and select the project that returns a higher NPV. Likewise, the business can select the project that has a higher IRR as compared to the other.
While the decision-making for mutually exclusive projects may seem straightforward, it can sometimes be very complicated. For example, one project may have a better payback period while another project may have a better NPV. Ultimately, the decision to choose between different projects is for the business to make. Apart from these tools, businesses also consider whether they want faster recoverability or higher profits which may play an important role in the selection of these projects.
For example, a business that wants to invest $20,000 in projects may come up with 2 different projects to invest in. These projects are mutually exclusive because both projects need the same amount of investment. However, one project allows for faster recoverability while the other offers higher returns. Ultimately, it is for a business to decide which project is more feasible for it.
Capital Rationing Decision
While mutually exclusive projects require capital to be exclusively allocated to a single project, capital rationing consists of dividing capital between different projects. For businesses where resources are not limited, which is very rare, there is no need for capital rationing. The problem arises when businesses have limited resources and must decide how much resources should be allocated to each project being considered. It is one of the most important parts of decision-making for every business.
The capital rationing decision rules are different from mutually exclusive projects. With capital rationing decisions, businesses will want to focus on faster recoverability more than higher returns. This is because the quicker these businesses recover their capital from one project, they can invest the capital in another project.
The capital rationing decision can start by comparing the ROCE of all the projects available. These projects are sorted by highest ROCEs. Projects with higher ROCEs are considered first for investment before other projects. Similarly, the most important decision rule may come with payback periods of projects. Projects with shorter payback periods are preferred and invested into before projects with longer payback periods.
Likewise, projects with higher NPVs and higher IRRs are preferred and invested in first. However, the business must also calculate the annual return from each project. Usually, this is done by calculating the average NPV of the project over its life. This allows the business to maximize its profitability while also ensuring quick recoverability.
Example and Explanation
In order to understand clearly about each of the capital budgeting technique, let’s see the example below. In this example, we will calculate all those techniques as mentioned in the above section.
A company, ABC Co., wants to invest in a new asset for the future. The company wants to know whether the investment should be undertaken or not. Currently, ABC Co. estimates that the project will require an investment of $100,000 in the current year. From next year forward, the asset will generate cash flows of $25,000 for the next 8 years. ABC Co. has also calculated the total profit from the project to be $15,000 after 8 before any interest and tax. ABC Co. has calculated its cost of capital to be 10%.
To evaluate whether the project is feasible or not, ABC Co. must use different investment appraisal techniques. This is a simple example of an accept or reject decision.
ROCE
First of all, the company can calculate the ROCE of the project. The company believes that any project with a ROCE of 10% or above is acceptable. The formula to calculate the ROCE of the project is:
ROCE = Profits before interest and tax / Initial capital cost of project x 100%
ROCE = $15,000 / $120,000 x 100%
Thus, ROCE = 12.5%
According to the ROCE of the project, the project is acceptable since ABC Co. will accept projects with ROCE equal to or above 10%.
Payback Period
ABC Co. must also calculate the payback period of the project. The company believes that any project that has a payback period of 5 years or less is acceptable. Since the project will have a constant stream of annual cashflows, the following formula can be used to calculate the payback period of the project:
Payback period = Initial Capital investment / Total Annual cash flow
Payback period = $120,000 / $25,000
Thus, Payback period = 4.8 years or 4 years and 10 months
From the calculation above, the payback period of the project is 4.8 years. This means that ABC Co. will recover the initial investment in 4.8 years or 4 years and 10 months. ABC Co. also has a standard rule for payback period which is 5 years or below. Therefore, the project qualifies as a feasible project using the payback period method.
A payback period of below 5 years not only means that the project qualifies as feasible for ABC Co. but also means that the initial investment can be recovered before its end date of 8 years. ABC Co. can either make a decision solely based on the payback period or can use further evaluation to check if the project is feasible.
Net Present Value
The NPV calculation is a bit more complex as compared to the above techniques. ABC Co. must discount the cash flows before using them in NPV calculation. The NPV calculation using a discount factor calculated at a cost of capital of 10% is as below:
| Description | Cash flow | Discount factor | Discounted cashflow |
| Initial investment | $ (120,000) | 1 | $ (120,000) |
| Year 1 | $ 25,000 | 0.909 | $ 22,725 |
| Year 2 | $ 25,000 | 0.826 | $ 20,650 |
| Year 3 | $ 25,000 | 0.751 | $ 18,775 |
| Year 4 | $ 25,000 | 0.683 | $ 17,075 |
| Year 5 | $ 25,000 | 0.621 | $ 15,525 |
| Year 6 | $ 25,000 | 0.564 | $ 14,100 |
| Year 7 | $ 25,000 | 0.513 | $ 12,825 |
| Year 8 | $ 25,000 | 0.467 | $ 11,675 |
| Total | $ 80,000 | $ 13,350 |
The NPV of the project at the end of 8 years is $13,350 and positive. This means that the project overall is feasible and will help ABC Co. generate wealth for its shareholders. If the NPV was negative, then the project would have been unfeasible.
Internal Rate of Return
Finally, the internal rate of the project must be calculated to evaluate whether the project is feasible. Generally, a business won’t need to perform further calculations if the ROCE, payback period and NPV of a project are all favourable.
To calculate the IRR of the project, ABC Co. must use the NPV calculation as well. The NPV of the project at a 10% cost of capital is $13,350. Now ABC Co. must calculate the NPV of the project at a cost of capital that will generate a negative NPV.
Since the NPV will decrease as the cost of capital goes up, the next possible cost of capital to use can be 15%. The NPV calculation at a cost of capital of 15% is as follows:
| Description | Cash flow | Discount factor | Discounted cashflow |
| Initial investment | $ (120,000) | 1 | $ (120,000) |
| Year 1 | $ 25,000 | 0.87 | $ 21,750 |
| Year 2 | $ 25,000 | 0.756 | $ 18,900 |
| Year 3 | $ 25,000 | 0.658 | $ 16,450 |
| Year 4 | $ 25,000 | 0.572 | $ 14,300 |
| Year 5 | $ 25,000 | 0.497 | $ 12,425 |
| Year 6 | $ 25,000 | 0.432 | $ 10,800 |
| Year 7 | $ 25,000 | 0.376 | $ 9,400 |
| Year 8 | $ 25,000 | 0.327 | $ 8,175 |
| Total | $ 80,000 | $ (7,800) |
Now the IRR of the project can be calculated using the following formula:
IRR = Lower rate of return + [(NPV at lower rate of return / (NPV at lower rate of return – NPV at higher rate of return)) x (Higher rate of return – Lower rate of return)]
IRR = 10% + [$13,350 / ($13,350 – (-$7,800)) x (15% – 10%)]
= 10% + [$13,350 / $21,150 x 5%]
= 10% + 3.16%
Hence, IRR = 13.16%
In the above calculation, the IRR of the project is higher than the cost of capital of ABC Co., which is 10%. Therefore, the project is deemed financially feasible.
Final Analysis
The project meets all of the requirements of ABC Co. while also providing favourable NPV and IRR for the company. This means that the project is financially feasible for the company and will ultimately generate wealth for the shareholders of the company. This project should be undertaken by ABC Co. as proved by the calculations and analysis above.
Conclusion
Capital budgeting is an important process for any business. Capital budgeting is the process of evaluating different projects to ensure maximum returns are generated using the least amount of resources. There are different capital budgeting techniques such as Return On Capital Employed (ROCE), Payback period, Net Present Value (NPV) and Internal Rate of Return (IRR) that a business can use. Each of these capital budgeting techniques has its advantages and disadvantages. When a business evaluates different projects, it must use a combination of these techniques to ensure the best decision is made. There are different types of capital budgeting decisions that a business can make such as accept or reject decisions, mutually exclusive projects decisions and capital rationing decisions.
