Understanding Capital Budgeting

Accountancy Resources

Understanding Capital Budgeting

Budgeting Author: Admin


Historically, the role of accountants have been limited to office work where they were used to manage the affairs of daily accounting and record keeping. When the economic horizon broadened and expanded business operations beyond the borders of their homeland and sustained investment in long-term projects and companies wrap for many years the role of typical counters became worthless and new approaches emerged in the field of accounting and finance. Despite great strides made many new techniques were adopted in the reporting mechanism for the financial period generally limited to one year or less, but they were not familiar with the practicalities, financial viability and assess the economic benefits of large firms duration. To address the shortage of this material a very comprehensive technical materialized in the community of financial managers called capital budgeting.

Capital budget or valuation of investments as the name suggests refers to capital investments that determine the financial viability of a long-term project. Capital budgeting is an issue deep enough and is part of the curriculum finance and financial management worldwide. This technique of determining the financial viability attracts investors due to the fact that it takes into account the cash flow streams over the life of the project and to exclude non-cash expenses, depreciation etc. Also cash flows discounted present value of investors’ required rate of return therefore, taking into account the time value of money. The exceptional qualities above the capital budget do more than any other approach to the criterion of acceptance or rejection of a project.

Investment appraisal is essential for the understanding of financial management. Planning process involves decisions on capital spending based on the concept of maximization of shareholder wealth. This process requires:

• Ability to classify investment projects of a significant order of profitability
• Ability to provide a cutoff point beyond which it is not worth further investment
• consistency with corporate objectives

In business effectively managed this is a fundamental requirement that decisions should be based on knowledge and efficiency. Countless decisions on the nature of capital have to be taken by management as the replacement of worn and obsolete equipment, acquisition of fixed assets, and evaluating proposals for strategic investment. Capital budgeting decisions are of two types:

The revenue growth

The decisions in order to expand operations with the intention of increasing the revenue of the company. Usually companies buy new assets, expand operations and invest in new projects to increase the revenue base. The additional income compared to the additional costs and assessed using the techniques of capital budgeting.

Cost reduction

Sometimes companies have to face the dilemma of rising costs of production. To reduce the cost of the companies have to make decisions to replace the old plant and machinery. They must decide whether to continue with or replace existing assets to reduce costs. The benefits of the new assets are evaluated through extensive use of capital budgeting techniques.

The above two types of decisions are fundamentally different in that the level of uncertainty is concerned. decisions to reduce costs are less uncertain, compared with revenue improvement decisions because the decisions of a cost reduction reliable past data is available for comparison with future profits. On the other hand the improvement of future income compared to revenue decisions of future costs that increase the level of uncertainty greatly.

Relevant cash flows

It has been mentioned that the capital budgeting decisions depend on future cash flows and future benefits including non-cash expenses and income. To determine the relevant cash flows high level of professional skills are mandatory for the judge relevant or irrelevant cash or noncash expenses. Relevant cash flows are of two types of outputs that is, cash and cash inflows. Cash outflows are relatively easy to determine, including initial capital costs plus the cost of installation of plant and machinery. You can also include the reversal of initial working capital repayment after project completion. Cash inflows are more technical in nature and is determined by adding depreciation to profits after tax for each year. Besides residual value of an asset and the recovery of working capital are also added at the end of the project.

Assessment Techniques

There are two broad categories of capital budgeting techniques ie, traditional, and the set time. The later are more popular and techniques are commonly known as discount cash flows. The first category includes the average rate of return and payback period method. The second category includes the following:

• Net Present Value
• Internal Rate of Return
• Rate of return

Average rate of return
It is based on accounting information rather than cash flows. The formula is:

RRA = (profit after tax annual Ave. / avg. Investment over the life of project) x 100

Return on investment/Payback
It is the most widely used technique, which assesses the capital investment project during the period or number of years required to receive cash benefits to recover the initial capital investment. Payback period is calculated from the

PBP = Investment / constant annual cash flow

Net Present Value
The most reliable and comprehensive tool for the evaluation of investment capital. It discounts the annual net cash flows for the year present value and compared with the cost of initial investment.

Internal Rate of Return
Another important and widely used technique for the investment decisions of capital in the capital budget is the internal rate of return. IRR is the discount rate that equates the present value of expected cash flows to present value of anticipated expenses. If the IRR exceeds the required rate of return the project is accepted, otherwise rejected.

Profitability index
The measure of rate of return for the benefit of the return for each dollar invested. This method is also called benefit-cost analysis of rationing. Symbolically,

PI = Present value cash inflows / Present value of cash outflows

If the resulting figure is more than one project is acceptable to the contrary should be rejected.