Capital Budgeting Techniques in Financial Appraisal

Capital budgeting is a method of generating, evaluating and analyzing substantial future investments and expenditures to determine which ones are most worthwhile. In other words, it’s a process that facilitates the usage of Capital or funds in the most efficient manner in anticipation of  generating returns over a series of years. Each project is ranked by its potential future return, so the company management can choose which one to invest in first. Thus, Capital budgeting is a process of evaluating investments and huge expenses in order to obtain the best returns on investment.

An organization is often faced with the challenges of selecting between two projects/investments or the buy vs replace decision. Ideally, an organization would like to invest in all profitable projects but due to the limitation on the availability of capital an organization has to choose between different projects/investments. Capital budgeting as a concept affects our daily lives.

What are the objectives of Capital budgeting?

Capital expenditures are huge and have a long-term effect. Therefore, while performing a capital budgeting analysis an organization must keep the following objectives in mind:

Selecting profitable projects

An organization comes across various profitable projects frequently. But due to capital restrictions, an organization needs to select the right mix of profitable projects that will increase its shareholders’ wealth.

Capital expenditure control

Selecting the most profitable investment is the main objective of capital budgeting. However, controlling capital costs is also an important objective. Forecasting capital expenditure requirements and budgeting for it, and ensuring no investment opportunities are lost is the crux of budgeting.

Finding the right sources for funds

Determining the quantum of funds and the sources for procuring them is another important objective of capital budgeting. Finding the balance between the cost of borrowing and returns on investment is an important goal of Capital Budgeting.

The process of capital budgeting is as follows:

Identifying investment opportunities

An organization needs to first identify an investment opportunity. An investment opportunity can be anything from a new business line to product expansion to purchasing a new asset. For example, a company finds two new products that they can add to their product line.

Evaluating investment proposals

Once an investment opportunity has been recognized an organization needs to evaluate its options for investment. That is to say, once it is decided that new product/products should be added to the product line, the next step would be deciding on how to acquire these products. There might be multiple ways of acquiring them. Some of these products could be:

• Manufactured In-house

• Manufactured by Outsourcing manufacturing the process, or

• Purchased from the market

• Choosing a profitable investment

Once the investment opportunities are identified and all proposals are evaluated an organization needs to decide the most profitable investment and select it. While selecting a particular project an organization may have to use the technique of capital rationing to rank the projects as per returns and select the best option available. In our example, the company here has to decide what is more profitable for them. Manufacturing or purchasing one or both of the products or scrapping the idea of acquiring both.

Capital Budgeting and Apportionment

After the project is selected an organization needs to fund this project. To fund the project it needs to identify the sources of funds and allocate it accordingly. The sources of these funds could be reserves, investments, loans or any other available channel.

Performance Review

The last step in the process of capital budgeting is reviewing the investment. Initially, the organization had selected a particular investment for a predicted return. So now, they will compare the investments expected performance to the actual performance.

In our example, when the screening for the most profitable investment happened, an expected return would have been worked out. Once the investment is made, the products are released in the market, the profits earned from its sales should be compared to the set expected returns. This will help in the performance review.

Capital Budgeting Techniques

The most popular models used in Capital Budgeting are:

Payback Period, Payback Reciprocal & Post Payback Profitability

Average Rate of Return

Net Present Value(NPV)

Profitability Index(PV Index)

Internal Rate of Return(IRR)

Discounted Payback Period