What is Capital Budgeting?
Capital budgeting entails the process of selecting projects that add value to an organization. Before investing in any major project, companies must evaluate whether the potential returns meet a certain target benchmark. The capital budgeting process involves investments such as purchasing new land, setting up a factory, or acquiring a fixed asset such as machinery. Corporations are recommended to undertake projects that enhance shareholders’ value through increased profitability. The process of capital budgeting involves assessing a prospective investment’s lifetime cash outflows and outflows to determine whether the desired returns will be achieved.
The need for capital budgeting arises due to constrained resources, making it hard for businesses to invest in any project. Often, organizations have more than one opportunity or project that requires resource allocations to pursue, but the firms’ resources are limited (Kengatharan, 1). Consequently, the management is forced to use capital budgeting techniques to identify projects that can yield the highest returns. The rate of return deemed acceptable or otherwise by the management is influenced by a couple of factors specific to a company or the project. For instance, while a for-profit organization would approve a project almost entirely based on returns on investments, a charitable project may approve an investment based on its ability to foster community goodwill.
At times, hospitals make huge investments, especially purchasing healthcare equipment that may cost millions of dollars, and in such situations, capital budgeting becomes essential as it creates measurability and accountability. The organization in question must understand the risks and returns involved in an investment. If the hospital lacks a way of measuring the effectiveness of its investment decisions, it may fail to survive in the competitive market. Capital budgeting will, therefore, act as both an investment and financial commitment.
Capital Budgeting Techniques
Broadly, capital budgeting techniques are classified into two; discounted and non-discounted methods. The former uses cash flows that have been adjusted to incorporate the time value of money. The most commonly used budgeting techniques that utilize discounted cash flow models include the net present value (NPV), internal rate of return (IRR), and profitability index (PI) (Marchioni and Magni, 2). On the other hand, the latter are not adjusted for the time value of money. Accounting rate of return (ARR) and Payback period (PB) are the frequently used discounted capital budgeting techniques. Generally, the three most utilized budgeting techniques are NPV, IRR, and PB methods.
Net Present Value (NPV)
The net present value (NPV) technique is used to estimate a project’s potential value using a discounted cash flow (DCF) valuation model. NPV is the most commonly used capital budgeting technique in many organizations. The technique acknowledges that money does not retain the same value over time. The difference between discounted cash flows and asset cost is calculated when appraising an investment (Sarwary, 5). If the discounted future cash flows exceed the cost of an asset, a project is deemed profitable. therefore, future cash flows drop in value, hence the use of the term ‘present value.’ Since NPV is greatly affected by the discounting rate, selecting the most appropriate rate is central to making the right investment decision. Typically, the rate should reflect the investment risks as measured by the volatility of future cash flows.
Advantages and Disadvantages of NPV
This approach has several advantages. Foremost, it considers the time value of money. Future cash flows are therefore discounted to the present to estimate their worth. Secondly, it takes into account all cash flows emanating from the investment, unlike other methods, such as the payback period that ignores any cash flows generated after the payback. Thirdly, it is not affected by conventional cash flow patterns since the future cash flows are discounted to the present before the project is appraised. The use of discount rates when calculating NPV ensures that all risks of undertaking a project are factored in.
Despite being the most commonly used capital budgeting technique, NPV has serious setbacks. For instance, the technique ignores sunk costs, such as research and development (R&D), which are often substantial. As a result, an organization may invest in a loss-making project without knowing since huge cost components are not considered during investment appraisal. Additionally, the technique estimates future cash flows, which may prove too optimistic or even unrealistic, hence providing misleading recommendations. Lastly, the method is difficult to apply when appraising projects of different sizes and life spans.
Internal Rate of Return (IRR)
The internal rate of return (IRR) compares the returns of an investment to its cost. IRR is the rate at which the NPV of an investment equals to zero, and the discounted cash inflows equal discounted cash outflows (Agbeye 4). Since the technique uses discounted cash flows, the method acknowledges the time value of money. Typically, the process seeks to arrive at the interest rate at which the funds invested in a project would be repaid out by expected cash inflows. The IRR is not affected by any factors outside the project, thus the use of the term ‘internal rate’.
Advantages and Disadvantages of IRR
The approach is advantageous for various reasons but has some drawbacks. For example, just like NPV, IRR takes into account the time value of money, hence the use of discounted cash flows. Similarly, timings of future cash flows are weighted equally using the time value of money. IRR is also advantageous as it does not require the use of a discounting rate, hence eliminating the risk of using a wrong rate which might lead to wrong recommendations. On the other hand, IRR ignores reinvestment rates by assuming that cash flows can always be re-invested at the same rate as IRR. However, this supposition not practical since IRR is sometimes higher than the actual rates of returns. The method also ignores future costs that may affect profits.
Payback Period (PB)
The payback period technique of appraising capital investments determines the time period required for a project to fully recoup the initial investment outlay. Generally, the quicker the company can recover costs, the better the investment (Siziba and Hall, 4). The technique does not consider the time value of money, and emphasis is placed on cash inflows and the project’s economic life.
Advantages and Disadvantages of Payback Period
Like the other approaches, the payback period has various pros and cons. For example, the method is advantageous because it is simple to use. Additionally, focusing on an early payback period can enhance liquidity, consequently ensuring that a company does not fall into a cash flow crisis. The major limitation of the PB method is that it does not consider time value for money. Similarly, other important factors, such as opportunity costs and financial risks, are not considered, which may lead to misleading recommendations, hence investing in less profitable projects.
Why NPV has been Chosen
NPV has been selected as the most appropriate technique to appraise the investment because it considers all future cash inflows. Additionally, the method considers the time value of money as well as business risks associated with the future projected cash flows. When compared to the PB method, which ignores the time value of money, and the IRR method, which only concentrates on cash flows that equalize future cash flows to initial cash outflow, the NPV method is the most realistic.
Results of the NPV Calculation
- The estimated cost of the ultrasound machine is $10 million
- Expected cash inflows for the next eight years are $1.6 million annually.
- Estimated useful life is 5 years
- Current investment rate (discounting rate) is 7%
The NPV will therefore be calculated as below;
NPV= X0-a1/ (1+r) +a2/ (1+r) 2+….az/ (1+r) z
Where; a= Future cash flows
r= discount rate
n= Number of periods
x0=Initial cash outflow
The presented value for the discounted cash flows is as shown in table 1 below;
|Undiscounted Cash Flow||1,600,000||1,600,000||1,600,000||1,600,000||1,600,000||1,600,000||1,600,000||1,600,000|
Table 1. Present Value for Discounted Cash Flows (Source, self)
Total Present Value for the Cash Inflows= $ 9,554,078.
NPV for the project = 10,000,000-9,554,078
= – $445,922.39
Table 2 below shows cash flow movements over the eight years and comparison to the initial cash outlay of $10 million.
Table 2. Cash Flow Movement over the 8 years (source: self)
Both the discounted and non-discounted cash flows are portrayed in the chart 1 below;
Figure 1. Discounted and Non-Discounted Cash Flows (Source: self)
The equipment should not be purchased since the net present value of the investment is negative. Negative NPV means that the project promised a lower return than the minimum required rate of return.
Limitation of the NPV Model Used
All sunk costs that may be associated with the purchase of ultrasound equipment have been ignored. For instance, initial costs on market research have not been considered. Similarly, the method has assumed that the cash flows will remain steady in the future, which may not be realistic. Qualitative factors that should be considered in the decision and that may go beyond the NPV calculations include gaining a competitive advantage by purchasing the machine, and the need to improve patient care over profits.
- Kengatharan L. Capital budgeting theory and practice: a review and agenda for future research. Applied Economics and Finance. 2016 Feb 3;3(2):15-38.
- Marchioni A, Magni CA. Investment decisions and sensitivity analysis: NPV-consistency of rates of return. European Journal of Operational Research. 2018 Jul 1;268(1):361-72.
- Agbeye SJ. Capital Budgeting Techniques: Estimation of Internal Rate of Returns. Asian Journal of Economics, Business, and Accounting. 2019 Dec 16:1-0.
- Siziba S, Hall JH. The evolution of the application of capital budgeting techniques in enterprises. Global Finance Journal. 2019 Nov 27:100504.
- Sarwary Z. Capital budgeting techniques in SMEs: A literature review. Journal of Accounting and Finance. 2019 Jun 29;19(3).