Capital Budgeting

Before arriving at any decisions related to huge capital investment, every finance manager / analyst tries to evaluate the project on various parameters and at last selects between different available proposals / options. This process of evaluation of multiple proposals which has life of more than a year forms part of capital budgeting process. Thus it plays a vital role in decision making process and is generally used in decisions related to replacement & modernization of machinery, expansion of project and diversification of product line or services..

Assumptions

1) Capital rationing: 

Managers / analyst start with the thought that there is no scarcity of funds and the firm isn't faced with capital rationing.

a) Decisions are based on cash flows, not on accounting net income. 

b) After tax cash flows are considered for evaluation.

c) Cash flows are based upon opportunity costs. An opportunity cost is what a resource is worth in its next best use.

d) Despite uncertainties while making projections about cash flows, it is assumed that accurate forecast of cost and benefits of proposals are available for entire economic life of the proposal.

3) Financing costs: 

This cost is ignored to avoid double counting as we had already considered the financing cost in calculation of discount rate.

Steps in Capital budgeting process

1. Generating ideas

2. Analyzing individual proposals

3. Planning the capital budget

4. Monitoring and post auditing  

Evaluation Process

1) Project after tax cash flows for the economic life of the project for all proposals.

2) Estimate WACC (Weighted average cost of capital) for discounting.

3) Choose the proper technique for evaluation purpose.

4) Evaluate the proposals and choose the best amongst all.

Capital Budgeting Techniques of evaluation

1) Traditional approach or Non discounting techniques

a) Payback period

b) Accounting rate of return (ARR)

2) Discounted cash flows approach

a) Net present value (NPV)

b) Internal rate of return (IRR)

c) Profitability Index

d) Terminal value