Capital Budgeting

Briefly discuss the process of Capital Budgeting and various discounting and non-discounting techniques for the selection of investment proposals by financial managers.

CAPITAL BUDGETING PROCESS:

Project identification and generation: The first step towards capital budgeting is to generate a proposal for investments. There could be various reasons for taking up investments in a business. It could be addition of a new product line or expanding the existing one. 

Project Screening and Evaluation: This step mainly involves selecting all correct criteria to judge the desirability of a proposal. This has to match the objective of the firm to maximize its market value.

Project Selection: There is no such defined method for the selection of a proposal for investments as different businesses have different requirements.

Implementation: Money is spent and thus proposal is implemented. The different responsibilities like implementing the proposals, completion of the project within the requisite time period and reduction of cost are allotted.

Performance review:  The final stage of capital budgeting involves comparison of actual results with the standard ones. 

various discounting and non-discounting techniques for the selection of investment proposals.

• Discounted cash flow method:

The discounted cash flow technique calculates the cash inflow and outflow through the life of an asset. These are then discounted through a discounting factor. The discounted cash inflows and outflows are then compared. This technique takes into account the interest factor and the return after the payback period.

• Payback period method:

As the name suggests, this method refers to the period in which the proposal will generate cash to recover the initial investment made. It purely emphasizes on the cash inflows, economic life of the project and the investment made in the project, with no consideration to time value of money. Through this method selection of a proposal is based on the earning capacity of the project.

• Accounting rate of return method (ARR):

This method helps to overcome the disadvantages of the payback period method. The rate of return is expressed as a percentage of the earnings of the investment in a particular project. It works on the criteria that any project having ARR higher than the minimum rate established by the management will be considered and those below the predetermined rate are rejected.

This method takes into account the entire economic life of a project providing a better means of comparison.

• Internal Rate of Return (IRR):

This is defined as the rate at which the net present value of the investment is zero. The discounted cash inflow is equal to the discounted cash outflow.

• Net present Value (NPV) Method:

This is one of the widely used methods for evaluating capital investment proposals. In this technique the cash inflow that is expected at different periods of time is discounted at a particular rate. The present values of the cash inflow are compared to the original investment. If the difference between them is positive (+) then it is accepted or otherwise rejected.