8 Steps to Capital Budgeting

Capital budgeting is a technique used for some of the most crucial decisions of a firm. It relates to the selection of an asset or investment proposal or course of action whose benefits are likely to be available in the future over the lifetime of the project. The long-term assets can be new or old/ existing ones. It is usually related to the company’s physical assets. The machinery and equipment used to manufacture products or transform the raw materials to finished products.

The first aspect of capital budgeting decisions relates to the choice of the new asset out of the alternatives available or the reallocation of capital when an existing asset fails to justify the funds committed. Whether an asset will be accepted or not will depend upon the relative benefits and returns associated with it. The measurement of the worth of the investment proposal is therefore a major element in the capital budgeting exercise. This implies a discussion of the methods of appraising investment proposals.

The second element of the capital budgeting decision is the analysis of risk and uncertainty. Since, the benefits from the investment proposals extend into the future, their accrual is uncertain. They must be estimated under various assumptions of the physical volume of sale and the level of prices. An element of risk in the sense of uncertainty of future benefits is thus involved in the exercise. The returns from capital budgeting decisions should, therefore, be evaluated in relation to the risks associated with it.

The third element, the evaluation of the worth of a long term project implies a certain norm or standard against which the benefits are to be judged. The requisite norm is known by different names such as cut-off rate, hurdle rate, required rate, minimum rate of return and so on. This standard is broadly expressed in terms of the cost of capital. The concept and measurement of the cost of capital is, thus, another major aspect of capital budgeting decisions

In brief the main elements of capital budgeting decisions are:

1. The long-term assets and their composition.

2. The business risk complexion of the firm.

3. The concept and measurement of cost of capital.

8 Steps to Capital Budgeting

Step 1: Determine the Total Cash Outlay

For example: If you want to buy new equipment, we shouldn’t just run the analysis on purchase price of the equipment.?But on the total cost including installation, training etc.

Step 2: Project the Future Cash Flows

• We should identify appropriate reference classes (E.g.: past purchases of similar machines by another division, location, or competitor).
• Next, we gather the data about the cash flows generated by the cases in the referenced class.
• We use judgement and develop the future cash flows on? a realistic basis.

Step 3: Ascertain the Required Rate of Return

Most companies add the risk-free rate of return and the weighted average cost of capital (WACC) together to obtain this required rate of return.

Also, known as the discount rate as it is the interest rate that managers consider as a reference to evaluate the attractiveness of the project.??

In other words, it’s the interest rate below which managers would disapprove of the project unless they have clear guidance from the board of the company to go ahead.

Step 4: Determine the Payback Period

• The payback period is the time required to recoup the cash outlay through the projected cash flows.
• Payback period = Investment / (Total Cash Flow / Total Period in years)
• Payback is the simplest method and results in a fast assessment.?

Step 5: Calculate the NPV of Future Cash Flows

While calculating the NPV, the cash outflows regarding the investment, and also the cash inflows originated by the project are both projected in the time horizon.??

A Discount Rate is applied on the resulting cash flow, and the Net Present Value of the project is calculated.??

The calculation is based on the formula:??

NPV =??????????????? ????????????????????+[????1/(1+??1 ) +????2/(1+??2 )+CF3/(1+??3 )+…??????/(1+???? )]?

Where r is the Discount Rate.?

CF stands for Cash Flow for periods 1, 2 and so on.?

n represents the periods of investment?

Step 6: Determine the IRR (Internal Rate of Return)

• We calculated the NPV in the previous step where we may learn that our capital expenditure has a rate of return greater than or less than the company's hurdle rate.
• However, we don’t know the actual annualized rate of return (hurdle rate) for the capital investment.
• To calculate the hurdle rate (IRR) we must solve the same equation for "r" so that NPV is Zero.

Step 7: Determine the Profitability Index (PI)

• Pl clearly shows what $1 invested today returns in today's dollars.?
• The formula is PI = Present Value of all Future Cash flows /Investment.

Step 8: Make your recommendations

• We use all 4 methods (NPV, Payback Period IRR and Pl) and compare the proposed investments.
• Each of the above methods provides a slightly different angle on the potential attractiveness of the proposed investment.

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