Capital Budgeting-I: Evaluating Investment Proposals
Capital budgeting is the process businesses use to evaluate potential major investments or expenses, such as acquiring new machinery, expanding operations, or launching a new product. The goal is to ensure that investments yield long-term financial benefits and align with the company’s strategic objectives.
Types of Investment Projects
Investment projects can be categorized into several types:
-
Profit-Oriented and Legally Binding Projects
- Projects aimed at revenue generation while complying with legal and regulatory requirements.
- Example: Setting up a power plant to generate electricity and sell it to the government.
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Mutually Exclusive and Accept-Reject Proposals
- Mutually exclusive projects require choosing one among multiple options.
- Accept-reject decisions involve whether a project meets minimum investment criteria.
- Example: A company choosing between solar and wind energy projects.
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Contingent vs. Independent Proposals
- Contingent projects depend on other projects being accepted.
- Independent projects do not affect each other.
- Example: A retail chain investing in a new outlet (independent) versus an online sales portal requiring a digital marketing campaign (contingent).
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Research and Not-for-Profit Projects
- Projects with societal benefits rather than direct financial gain.
- Example: Pharmaceutical companies investing in vaccine research.
Feasibility Study: Ensuring Project Viability
Before approving an investment, feasibility studies assess multiple aspects:
- Economic Feasibility – Analyzes the project's macroeconomic impact, such as job creation and GDP contribution.
- Commercial Feasibility – Assesses the demand, competition, and potential profitability.
- Technical Feasibility – Evaluates technological requirements, such as machinery and skilled labor.
- Legal Feasibility – Ensures compliance with government regulations and legal requirements.
- Organizational Feasibility – Examines whether the company has the right structure and skills to execute the project.
- Strategic Analysis – Aligns the project with long-term business goals.
- Financial Appraisal – Evaluates cash flows, investment requirements, and funding sources.
Project Appraisal: The Key Metrics
Project appraisal is critical in determining financial viability. It includes:
- Cash Flows – Inflow and outflow of money over the project's life.
- Incremental Costs and Benefits – Additional costs and benefits from the project.
- Total Investment Consideration – Initial investment, working capital, and additional investments.
- Depreciation and Interest Expenses – Affects profitability and tax liabilities.
- Opportunity Costs – The potential returns lost from alternative investments.
Accounting Rate of Return (ARR) – A Simple Evaluation Method
Example
A company is evaluating two proposals, X and Y:
| Particulars | Proposal X | Proposal Y |
|---|---|---|
| Initial Investment | ₹1,00,000 | ₹1,00,000 |
| Expected Life | 5 years | 5 years |
| Depreciation per Year | ₹20,000 | ₹20,000 |
| Income Tax | 30% | 30% |
| Scrap Value | ₹0 | ₹0 |
Profit Estimates (in ₹ '000):
| Year | Proposal X | Proposal Y |
|---|---|---|
| 1 | 90 | 30 |
| 2 | 30 | 30 |
| 3 | 30 | 30 |
| 4 | 30 | 30 |
| 5 | 30 | 30 |
ARR Calculation:
ARR = (Average Annual Profits / Initial Investment) × 100
For Proposal X: ARR = (15,400 / 1,00,000) × 100 = 15.4%
For Proposal Y: ARR = (15,400 / 50,000) × 100 = 30.8%
Payback Period Method – Measuring Investment Recovery
The payback period represents the time required to recover the initial investment.
| Year | Beginning Balance | Net Cash Inflow | Year-End Unrecovered Amount |
|---|---|---|---|
| 1 | ₹1,00,000 | ₹69,000 | ₹31,000 |
| 2 | ₹31,000 | ₹27,000 | ₹4,000 |
| 3 | ₹4,000 | ₹27,000 | ₹0 |
Payback Period = 2 Years + (₹4,000 / ₹27,000) = 2.15 Years
Effect of Salvage Value and Working Capital in Decision Making
Consider a project with:
- Initial Investment: ₹1,00,000
- Annual EBDT: ₹35,000 for 5 years
- Salvage Value: ₹10,000
- Working Capital: ₹25,000 (recovered after 5 years)
- Required Rate of Return: 12%
- Income Tax Rate: 25%
Key Calculations
Average Investment
Average Investment = (1,16,000 + 98,000 + 80,000 + 62,000 + 44,000) / 5 = ₹80,000
Revised Payback Period
| Year | Beginning Balance | Net Cash Inflow | Unrecovered Amount |
|---|---|---|---|
| 1 | ₹1,25,000 | ₹30,750 | ₹94,250 |
| 2 | ₹94,250 | ₹30,750 | ₹63,500 |
| 3 | ₹63,500 | ₹30,750 | ₹32,750 |
| 4 | ₹32,750 | ₹30,750 | ₹2,000 |
| 5 | ₹2,000 | ₹65,750 (Including Salvage & Working Capital) | ₹0 |
Evaluating investment proposals through capital budgeting techniques ensures optimal decision-making for long-term growth. By using feasibility studies, project appraisals, ARR, and payback period calculations, businesses can determine the profitability and risks of projects.
By incorporating real-world factors like working capital and salvage value, companies can make better financial decisions that align with strategic objectives.
