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What Is Capital Budgeting?

How capital budgeting works, discounted cash flow analysis, payback analysis.

• Throughput Analysis
• Capital Budgeting FAQs

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Capital Budgeting: Definition, Methods, and Examples

Capital budgeting is a process that businesses use to evaluate potential major projects or investments. Building a new plant or taking a large stake in an outside venture are examples of initiatives that typically require capital budgeting before they are approved or rejected by management.

As part of capital budgeting, a company might assess a prospective project's lifetime cash inflows and outflows to determine whether the potential returns it would generate meet a sufficient target benchmark. The capital budgeting process is also known as investment appraisal.

Key Takeaways

• Capital budgeting is used by companies to evaluate major projects and investments, such as new plants or equipment. 
• The process involves analyzing a project's cash inflows and outflows to determine whether the expected return meets a set benchmark.  
• The major methods of capital budgeting include discounted cash flow, payback analysis, and throughput analysis.

Investopedia / Lara Antal

Ideally, businesses could pursue any and all projects and opportunities that might enhance shareholder value and profit. However, because the amount of capital any business has available for new projects is limited, management often uses capital budgeting techniques to determine which projects will yield the best return over an applicable period.

Although there are a number of capital budgeting methods , three of the most common ones are discounted cash flow, payback analysis, and throughput analysis.

Discounted cash flow (DCF) analysis looks at the initial cash outflow needed to fund a project, the mix of cash inflows in the form of revenue , and other future outflows in the form of maintenance and other costs.

These cash flows, except for the initial outflow, are discounted back to the present date. The resulting number from the DCF analysis is the net present value (NPV) . The cash flows are discounted since present value assumes that a particular amount of money today is worth more than the same amount in the future, due to inflation.

In any project decision, there is an opportunity cost , meaning the return that the company would have received had it pursued a different project instead. In other words, the cash inflows or revenue from the project need to be enough to account for the costs, both initial and ongoing, but also to exceed any opportunity costs.

With present value , the future cash flows are discounted by the risk-free rate such as the rate on a U.S. Treasury bond , which is guaranteed by the U.S. government, making it as safe as it gets. The future cash flows are discounted by the risk-free rate (or discount rate ) because the project needs to at least earn that amount; otherwise, it wouldn't be worth pursuing.

In addition, a company might borrow money to finance a project and, as a result, must earn at least enough revenue to cover the financing costs, known as the cost of capital . Publicly traded companies might use a combination of debt—such as bonds or a bank credit facility —and equity , by issuing more shares of stock. The cost of capital is usually a weighted average of both equity and debt. The goal is to calculate the hurdle rate or the minimum amount that the project needs to earn from its cash inflows to cover the costs. To proceed with a project, the company will want to have a reasonable expectation that its rate of return will exceed the hurdle rate.

Project managers can use the DCF model to decide which of several competing projects is likely to be more profitable and worth pursuing. Projects with the highest NPV should generally rank over others. However, project managers must also consider any risks involved in pursuing one project versus another.

Payback analysis is the simplest form of capital budgeting analysis, but it's also the least accurate. It is still widely used because it's quick and can give managers a " back of the envelope " understanding of the real value of a proposed project.

Payback analysis calculates how long it will take to recoup the costs of an investment. The payback period is identified by dividing the initial investment in the project by the average yearly cash inflow that the project will generate. For example, if it costs $400,000 for the initial cash outlay, and the project generates $100,000 per year in revenue, it will take four years to recoup the investment.

Payback analysis is usually used when companies have only a limited amount of funds (or liquidity ) to invest in a project, and therefore need to know how quickly they can get back their investment. The project with the shortest payback period would likely be chosen. However, the payback method has some limitations, one of them being that it ignores the opportunity cost.

Also, payback analysis doesn't typically include any cash flows near the end of the project's life. For example, if a project that's being considered involves buying factory equipment, the cash flows or revenue generated from that equipment would be considered but not the equipment's salvage value at the conclusion of the project. As a result, payback analysis is not considered a true measure of how profitable a project is, but instead provides a rough estimate of how quickly an initial investment can be recouped.

Salvage value

Salvage value is the value of an asset, such as equipment, at the end of its useful life .

Throughput Analysis 

Throughput analysis is the most complicated method of capital budgeting analysis, but it's also the most accurate in helping managers decide which projects to pursue. Under this method, the entire company is considered as a single profit-generating system. Throughput is measured as an amount of material passing through that system.

The analysis assumes that nearly all costs are operating expenses , that a company needs to maximize the throughput of the entire system to pay for expenses, and that the way to maximize profits is to maximize the throughput passing through a bottleneck operation. A bottleneck is the resource in the system that requires the longest time in operations. This means that managers should always place a higher priority on capital budgeting projects that will increase throughput or flow passing through the bottleneck.

What Is the Primary Purpose of Capital Budgeting?

Capital budgeting's main goal is to identify projects that produce cash flows that exceed the cost of the project for a company.

What Is an Example of a Capital Budgeting Decision?

Capital budgeting decisions are often associated with choosing to undertake a new project that will expand a company's current operations. Opening a new store location, for example, would be one such decision for a fast-food chain or clothing retailer.

What Is the Difference Between Capital Budgeting and Working Capital Management?

Working capital management is a company-wide process that evaluates current projects to determine whether they are adding value to the business, while capital budgeting focuses on expanding the current operations or assets of the business.

Capital budgeting is a useful tool that companies can use to decide whether to devote capital to a particular new project or investment. There are several capital budgeting methods that managers can use, ranging from the crude but quick to the more complex and sophisticated.

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What is Capital Budgeting? Process, Methods, Formula, Examples

‘Expansion and Growth’ are the two common goals of an organization's operations. In case a company does not possess enough capital or has no fixed assets , this is difficult to accomplish. It is at this point that capital budgeting becomes essential.

The capital budget is used by management to plan expenditures on fixed assets. As a result of the budgets, the company's management usually determines which long-term strategies it can invest in to achieve its growth goals. For instance, management can decide if it needs to sell or purchase assets for expansion to accomplish this.

The purpose of capital budgeting is to make long-term investment decisions about whether particular projects will result in sustainable growth and provide the expected returns.

We shall learn about Capital Budgeting and all the details related to it in this article:

• What is Capital Budgeting in detail
• Features of capital budgeting
• Understanding capital budgeting and how it works
• Techniques/Methods of capital budgeting with Examples
• Process of capital budgeting
• Factors affecting capital budgeting
• Limitations of capital budgeting

What is Capital Budgeting?

Capital Budgeting is defined as the process by which a business determines which fixed asset purchases or project investments are acceptable and which are not. Using this approach, each proposed investment is given a quantitative analysis, allowing rational judgment to be made by the business owners.

Capital asset management requires a lot of money; therefore, before making such investments, they must do capital budgeting to ensure that the investment will procure profits for the company. The companies must undertake initiatives that will lead to a growth in their profitability and also boost their shareholder’s or investor’s wealth.

Features of Capital Budgeting

Capital Budgeting is characterized by the following features:

• There is a long duration between the initial investments and the expected returns.
• The organizations usually estimate large profits.
• The process involves high risks.
• It is a fixed investment over the long run.
• Investments made in a project determine the future financial condition of an organization.
• All projects require significant amounts of funding.
• The amount of investment made in the project determines the profitability of a company.

Understanding Capital Budgeting

While companies would like to take up all the projects that maximize the benefits of the shareholders, they also understand that there is a limitation on the money that they can employ for those projects. Therefore, they utilize capital budgeting strategies to assess which initiatives will provide the best returns across a given period. Owing to its culpability and quantifying abilities, capital budgeting is a preferred way of establishing if a project will yield results.

To measure the longer-term monetary and fiscal profit margins of any option contract, companies can use the capital-budgeting process. Capital budgeting projects are accepted or rejected according to different valuation methods used by different businesses. Under certain conditions, the internal rate of return (IRR) and payback period (PB) methods are sometimes used instead of net present value (NPV) which is the most preferred method. If all three approaches point in the same direction, managers can be most confident in their analysis.

How Capital Budgeting Works

It is of prime importance for a company when dealing with capital budgeting decisions that it determines whether or not the project will be profitable. Although we shall learn all the capital budgeting methods, the most common methods of selecting projects are:

• Payback Period (PB)
• Internal Rate of Return (IRR) and
• Net Present Value (NPV)

It might seem like an ideal capital budgeting approach would be one that would result in positive answers for all three metrics, but often these approaches will produce contradictory results. Some approaches will be preferred over others based on the requirement of the business and the selection criteria of the management. Despite this, these widely used valuation methods have both benefits and drawbacks.

Investing in capital assets is determined by how they will affect cash flow in the future, which is what capital budgeting is supposed to do. The capital investment consumes less cash in the future while increasing the amount of cash that enters the business later is preferable.

Keeping track of the timing is equally important. It is always better to generate cash sooner than later if you consider the time value of money. Other factors to consider include scale. To have a visible impact on a company's final performance, it may be necessary for a large company to focus its resources on assets that can generate large amounts of cash.

In smaller businesses , a project that has the potential to deliver rapid and sizable cash flow may have to be rejected because the investment required would exceed the company's capabilities.

The amount of work and time invested in capital budgeting will vary based on the risk associated with a bad decision along with its potential benefits. Therefore, a modest investment could be a wiser option if the company fears the risk of bankruptcy in case the decisions go wrong.

Sunk costs are not considered in capital budgeting.  The process focuses on future cash flows rather than past expenses .

Techniques/Methods of Capital Budgeting

In addition to the many capital budgeting methods available, the following list outlines a few by which companies can decide which projects to explore:

#1 Payback Period Method

It refers to the time taken by a proposed project to generate enough income to cover the initial investment. The project with the quickest payback is chosen by the company.

Example of Payback Period Method:

An enterprise plans to invest $100,000 to enhance its manufacturing process. It has two mutually independent options in front: Product A and Product B. Product A exhibits a contribution of $25 and Product B of $15. The expansion plan is projected to increase the output by 500 units for Product A and 1,000 units for Product B.

Here, the incremental cash flow will be calculated as:

(25*500) = 12,500 for Product A

(15*1000) = 15,000 for Product B

The Payback Period for Product A is calculated as:

Product A = 100,000 / 12,500 = 8 years

Now, the  Payback Period for Product B is calculated as:

Product B = 100,000 / 15,000 = 6.7 years

This brings the enterprise to conclude that Product B has a shorter payback period and therefore, it will invest in Product B.

Despite being an easy and time-efficient method, the Payback Period cannot be called optimum as it does not consider the time value of money. The cash flows at the earlier stages are better than the ones coming in at later stages. The company may encounter two projections with the same payback period, where one depicts higher cash flows in the earlier stages/years. In such as case, the Payback Period may not be appropriate.

A similar consideration is that of a longer period, potentially bringing in greater cash flows during a payback period. In such a case, if the company selects the projects based solely on the payback period and without considering the cash flows, then this could prove detrimental for the financial prospects of the company.

#2 Net Present Value Method (NPV)

Evaluating capital investment projects is what the NPV method helps the companies with. There may be inconsistencies in the cash flows created over time. The cost of capital is used to discount it. An evaluation is done based on the investment made. Whether a project is accepted or rejected depends on the value of inflows over current outflows.

This method considers the time value of money and attributes it to the company's objective, which is to maximize profits for its owners. The capital cost factors in the cash flow during the entire lifespan of the product and the risks associated with such a cash flow. Then, the capital cost is calculated with the help of an estimate.

Example of Net Present Value (with 9% Discount Rate ):

For a company, let’s assume the following conditions:

Capital investment = $10,000

Expected Inflow in First Year = $1,000

Expected Inflow in Second Year = $2,500

Expected Inflow in Third Year = $3,500

Expected Inflow in Fourth Year = $2,650

Expected Inflow in Fifth Year = $4,150

Discount Rate = 9%

Net Present Value achieved at the end of the calculation is:

With 9% Discount Rate  = $18,629

This indicates that if the NPV comes out to be positive and indicates profit. Therefore, the company shall move ahead with the project.

#3 Internal Rate of Return (IRR)

IRR refers to the method where the NPV is zero. In such as condition, the cash inflow rate equals the cash outflow rate. Although it considers the time value of money, it is one of the complicated methods.

It follows the rule that if the IRR is more than the average cost of the capital, then the company accepts the project, or else it rejects the project. If the company faces a situation with multiple projects, then the project offering the highest IRR is selected by them.

We shall assume the possibilities exhibited in the table here for a company that has 2 projects: Project A and Project B.

Here, The IRR of Project A is 7.9% which is above the Threshold Rate of Return (We assume it is 7% in this case.) So, the company will accept the project. However, if the Threshold Rate of Return would be 10%, then it would be rejected as the IRR would be lower. In that case, the company will choose Project B which shows a higher IRR as compared to the Threshold Rate of Return.

#4 Profitability Index

This method provides the ratio of the present value of future cash inflows to the initial investment. A Profitability Index that presents a value lower than 1.0 is indicative of lower cash inflows than the initial cost of investment. Aligned with this, a profitability index great than 1.0 presents better cash inflows and therefore, the project will be accepted.

Assuming the values given in the table, we shall calculate the profitability index for a discount rate of 10%.

So, Profitability Index with 10% discount = $15,807/$10,000  = 1.5807

As per the rule of the method, the profitability index is positive for the 10% discount rate, and therefore, it will be selected.

Process of Capital Budgeting

The process of Capital Budgeting involves the following points:

Identifying and generating projects

Investment proposals are the first step in capital budgeting. Taking up investments in a business can be motivated by a number of reasons. There could be the addition or expansion of a product line. An increase in production or a decrease in production costs could also be suggested.

Evaluating the project

It mainly consists of selecting all criteria necessary for judging the need for a proposal. In order to maximize market value, it has to match the company's mission. It is crucial to consider the time value of money here.

In addition to estimating the benefits and costs, you should weigh the pros and cons associated with the process. There could be a lot of risks involved with the total cash inflows and outflows. This needs to be scrutinized thoroughly before moving ahead.

Selecting a Project

Since there is no ‘one-size-fits-all’ factor, there is no defined technique for selecting a project. Every business has diverse requirements and therefore, the approval over a project comes based on the objectives of the organization.

After the project has been finalized, the other components need to be attended to. These include the acquisition of funds which can be explored by the finance department of the company. The companies need to explore all the options before concluding and approving the project. Besides, the factors like viability, profitability, and market conditions also play a vital role in the selection of the project.

Implementation

Once the project is implemented, now come the other critical elements such as completing it in the stipulated time frame or reduction of costs. Hereafter, the management takes charge of monitoring the impact of implementing the project.

Performance Review

This involves the process of analyzing and assessing the actual results over the estimated outcomes. This step helps the management identify the flaws and eliminate them for future proposals.

Factors Affecting Capital Budgeting

So far in the article, we have observed how measurability and accountability are two primary aspects that achieve the center stage through capital budgeting. However, while on the path to accomplish a competent capital budgeting process, you may come across various factors that may affect it.

Let us move on to observing the factors that affect the capital budgeting process.

Objectives of Capital Budgeting

The following points present the objectives of the capital budgeting:

• Capital Expenditure Control : Organizations need to estimate the cost of investment as it allows them to control and manage the required capital expenditures.
• Selecting Profitable Projects : The company will have to select the most appropriate project from the multiple possibilities in front of it.
• Identification of Source of funds : The businesses need to locate and select the most viable and apt source of funds for long-term capital investment. It needs to compare the various costs like the costs of borrowing and the cost of expected profits.

Limitations of Capital Budgeting

Although capital budgeting provides a lot of insight into the future prospects of a business, it cannot be termed a flawless method after all. In this section, we learn about some of the limitations of capital budgeting.

It is a simple technique that determines if an enhanced value of a project justifies the required investment. The primary reason to implement capital budgeting is to achieve forecasting revenue a project may possibly generate. The problem could be the estimate itself. All the upfront costs or the future revenue are all only estimates at this point. An overestimation or an underestimation could ultimately be detrimental to the performance of the business.

Time Horizon

Usually, capital budgeting as a process works across for long spans of years. While the shorter duration forecasts may be estimated, the longer ones are bound to be miscalculated. Therefore, an expanded time horizon could be a potential problem while computing figures with capital budgeting.

Besides, there could be additional factors such as competition or legal or technological innovations that could be problematic.

The payback period method of capital budgeting holds a lot of relevance, especially for small businesses. It is a simple method that only requires the business to repay in the predecided timeframe. However, the problem it poses is that it does not count in the time value of money. This is to say that equal amounts (of money) have different values at different points in time.

Discount Rates

The accounting for the time value of money is done either by borrowing money, paying interest, or using one’s own money. The knowledge of discount rates is essential. The proper estimation and calculation of which could be a cumbersome task.

Even if this is achieved, there are other fluctuations like the varying interest rates that could hamper future cash flows. Therefore, this is a factor that adds up to the list of limitations of capital budgeting.

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Key Takeaways

Before we wrap up the post, let us peep into the important points with context to Capital Budgeting:

• Capital Budgeting is defined as the process by which a business determines which fixed asset purchases are acceptable and which are not.
• Capital budgeting leads to calculating the profitable capital expenditure.
• Determining if replacing any existing fixed assets would yield greater returns is a part of capital budgeting
• Selecting or denying a given project is based on its merits.
• The process of capital budgeting requires calculating the number of capital expenditures.
• An assessment of the different funding sources for capital expenditures is needed.
• Payback Period, Net Present Value Method, Internal Rate of Return, and Profitability Index are the methods to carry out capital budgeting.
• The process of capital budgeting involves the steps like Identifying the potential projects, evaluating them, selecting and implementing the projects, and finally reviewing the performance for future considerations.
• Capital return, accounting methods, structures of capital, availability of funds, and working capital are some of the factors that affect the process of capital budgeting.

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All you need to know about Capital Budgeting

Checked : Vallary O. , Curtis H.

Latest Update 20 Jan, 2024

Table of content

What is Capital budgeting?

Pay-back period, net present value (npv), internal rate of return (irr) or internal rate of return (tir), average accounting yield, the focus of the investment evaluation, the economic-financial evaluation, the ingredients:, the capital budget in a nutshell.

The modern CFO knows how to govern the process and the tools that allow him to evaluate economic and financial sustainability. The evaluation of investments is not an exclusively strategic judgment but concerns the entire process of creating corporate economic value. This is a reflection shared by managers, aware that the starting point of the creation of economic value for a company is placed in the allocation of capital between the different investment alternatives. Here’s everything you need to know about   capital budgeting .

As part of the planning and control process, a capital budget is a central tool with which management establishes the optimal allocation of financial resources. In short, it is a matter of evaluating alternative   investment projects   to achieve profit levels consistent with the assumed risk profile. It is evident that capital budgeting decisions represent one of the main responsibilities of management, being able, if not taken correctly, to undermine corporate competitiveness. Furthermore, it should be considered that investment analysis is something that does not focus exclusively on industrial projects only, but concerns investment decisions such as the launch of new products, the purchase of shares, shares or securities of different nature or research and advertising projects that impact on the corporate image. Capital budgeting is nothing more than "analysis and evaluation" of the economic returns that could be obtained from the financing of investment projects.

Some classic examples of corporate capital budgeting:

• acquire a new plant that increases business productivity
• finance customers by giving them more credit
• finance a research project
• buy equity securities
• acquire a company
• acquire a corporate brand

For the evaluation of the economic returns of the investments, there are mainly four techniques:

Evaluate the period of time that elapses between the capital advance and the financial return of the same. For example, I spend 100 thousand dollars for a piece of more technologically advanced machinery, and the new productivity allows me a profit increase of 33 thousand dollars per year. In this case, with a bit of approximation, we can say that the payback period is three years.

Adds the incoming and outgoing cash flows in the various years of evaluation of the investment and updates its value by applying a discount rate. It is the most used and reliable one of the four methods.

It derives from the previous method but reasons in reverse. It does not start from a specific discount rate but calculates the discount rate that generates a discounted cash flow zero. The investment is accepted or refused if the discount rate calculated in this way is respectively lower or higher than the degree of risk assigned to the activity to be financed.

The average book yield is calculated by dividing the average annual profits by the value of the average annual book investment.

The possible investment analysis profiles concern the following areas of assessment:

• STRATEGIC, in which consistency with the company competitive profile is verified through the impact on the competitive strength or attractiveness of the business;
• TECHNIQUE, through which the various technological or commercial options are analyzed in terms of effectiveness and efficiency of operations;
• ECONOMIC, which verifies the relationship between the resources absorbed (investment) and those released by the project over time (future benefits) through synthetic indicators;
• FINANCIAL, through which the compatibility of the investment flows with the income and expenses profile is assessed, both from a dimensional and temporal point of view.

A great chef, to make a delicacy, must have first quality ingredients and a recipe that distinguishes him. In the same way, the CFO, to carry out an eco-fin effective evaluation, must have the correct "ingredients" and the right "recipe" with which to combine them.

The ingredients represent the elements to make a choice among the investment alternatives. It is necessary to know them thoroughly. On the other hand, the recipes also indicate the operating methods with which to combine the investment alternatives to reach a synthetic parameter of classification of investment opportunities.

The CFO has five tools that can help him in the choices:

• The invested capital, broken down into three subcategories: ● The declination of the individual types of investment, in the case of a significant articulation of the project, for example, in the construction of the factories; ● This is necessary to have a detail of the useful life of the investments in which the project is divided, so as to be able to derive the depreciation; ● The temporal distribution of investmentsThe secondary costs to be incurred immediately or over the period, so that the investment guarantees its performance during its useful life or within the identified time horizon
• The duration of the investment (time horizon), which leads us to define: ● The time horizon of the investment analysis, which is affected by the sector in which the company operates the type of investment taken into consideration, the predictability of the results, and the economic life of the project. ●  The duration of the periods in which the periodic financial events are to be distributed
• The metric to be used to evaluate the investment. Taking into account that the economic evaluation of investment has as its object, the analysis of the resources absorbed (investment). The project releases them over time (future benefits), the practice uses cash flows, which in this case are identified by the Cash Flow Operating (Operating Free Cash Flow)
• The financial value of time: In finance, it is always associated with the concept of interest rate, which is intended as a "reward" for giving up immediate consumption.
• When evaluating the investments, it must be considered that the cash flows of the project, divided into sub-periods (Fcn), belong to different moments and cannot be added together. Through the discounting process. Therefore, the various amounts will be normalized according to the logic of the financial value of time, thus being able to determine the present value of the profile of future cash flows.
• The discount rate: The theory and practice refer to the opportunity cost of the project, i.e., the return achievable with an equivalent investment in the amount, in the distribution of flows, and in the risk profile. Cost/opportunity that is based on the concept behind finance: the correlation between risk and return.

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From this, we understand how, to determine the value created/destroyed, it is necessary to identify the determinants of the cost of capital, understood as cost/opportunity. Briefly, the key elements through which the cost of corporate capital is determined are:

• the cost of the individual sources of financing, i.e., the cost/opportunity of the shareholders (Ke) and the cost of the interest rate paid to the banks for the credit lines received (Kd)
• the weight of the sources of financing, i.e., the weight as a percentage of the capital contributed by the shareholders (Net Equity / Net Invested Capital) and the weight as a percentage of the capital contributed by the banks (Net Financial Position / Net Invested Capital)

By combining the highlighted elements, we obtain that the cost of capital is determined by the weighted average cost of capital (WACC).

In recent times, many companies are implementing capital budget processes with which to select and monitor investment options. Given that the focus of the capital budget is, under the direction of the CFO, to develop a process of sharing between the management of the rationale for economic-financial sustainability and its feasibility. It is clear that the role of the CFO is to offer its own skills at the service of management.

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Essay on Capital Budgeting | Functions | Financial Management

Here is an essay on ‘Capital Budgeting’ for class 11 and 12. Find paragraphs, long and short essays on ‘Capital Budgeting’ especially written for school and college students.

Essay on Capital Budgeting

Essay Contents:

• Essay on the Techniques of Capital Budgeting

Essay # 1. Definition of Capital Budgeting:

Capital budgeting refers to the process a firm uses to make decisions concerning investments in the long-term assets of the firm. The general idea is that the capital, or long-term funds raised by the firms are used to invest in assets that will enable the firm to generate revenues several years into the future.

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Some of the definitions of capital budgeting are:

Capital budgeting is the process by which the financial manager decides whether to invest in specific capital projects or assets.

Capital budgeting (or investment appraisal) is the planning process used to determine whether a firm’s long-term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing.

Capital budgeting is a method of evaluating investment proposals to determine whether they are financially sound, and to allocate limited capital resources to the most attractive proposals.

Essay # 2. Meaning of Capital Budgeting:

The term ‘capital budgeting’ is used interchangeably with capital expenditure decisions, capital expenditure managements, long-term investment decision, management of fixed assets and so on.

The budget provides a guidance as to the amount of capital that may be needed for procurement of capital assets during the budget period. The budget is prepared after taking into account the available productive capacities, probable reallocation of existing assets and possible improvement in production techniques. If necessary, separate budgets may be prepared for each item of assets, such as a building budget, a plant and equipment budget, etc.

The capital budgeting decision, therefore, involves a current outlay or series of outlays of cash resources in return for an anticipated flow of future benefits. In other words, the system of capital budgeting is employed to evaluate expenditure decisions which involve current outlays but are likely to produce benefits over a period of time longer than one year.

Capital expenditure management includes addition, disposition, modification and replacement of fixed assets.

Following are the basic features of capital budgeting:

(a) It has potentially large anticipated benefits.

(b) It has a relatively high degree of risk.

(c) It has a relatively long-time period between the initial outlay and the anticipated return.

Essay # 3. Importance of Capital Budgeting :

1. Capital budgeting decisions are of paramount importance in financial decision-making. Such decisions affect the profitability of a firm. They also have a bearing on the competitive position of the enterprise. Capital budgeting decisions determine the future destiny of the company.

An opportune investment decision can yield spectacular returns. On the other hand, an ill-advised and incorrect investment decision can endanger the very survival even of the large-sized firms. A few wrong decisions and the firm may be forced into bankruptcy.

2. A capital expenditure decision has its effect over a long time-span and inevitably affects the company’s future cost structure.

3. Capital investment decisions, once made are not easily reversible without much financial loss to the firm. It is because there may be no market for second­hand plant and equipment and their conversions to other uses may not be financially feasible.

4. Capital investment involves costs and the majority of the firms have scarce capital resources this underlines the need for thoughtful, wise and correct investment decisions, as an incorrect decision would not only result in losses but also prevent the firm from earning profits from other investments which could not be undertaken for want of funds.

Essay # 4. Difficulties in Capital Budgeting :

Capital expenditure decisions are of considerable significance to the firm as the future success and growth of the firm depends heavily on them. Unfortunately, they are not easy to take.

There are a number of factors responsible for this:

1. The benefits from investments are received in some future period. The future is uncertain. Therefore, an element of risk is involved. A failure to forecast correctly will lead to serious errors which can be corrected only at considerable expense.

2. Problems also arise because costs incurred and benefits received from the capital budgeting decisions occur in different time periods. They are not logically comparable because of the time value of money.

3. It is not often possible to calculate in strictly quantitative terms all the benefits or the costs relating to a particular investment decision.

Capital budgeting decisions can be of two types :

(i) Those which expand revenues;

(ii) Those which expand costs;

A fundamental difference between the above two categories of investment decisions lies in the fact that cost-reduction investment decisions are subject to less uncertainty in comparison to the revenue-affecting investment decisions.

Thus, capital budgeting refers to the total process of generating, evaluating, selecting and following up on capital expenditure alternatives. The firm allocates or budgets financial resources to new investment proposals. Capital budget is a statement of expenditure on fixed assets or long-term projects and the benefits of which are likely to accrue in future.

The process of capital budgeting involves:

(a) Evaluating investment proposals;

(b) Measuring the benefits, and

(c) Selecting a project on the basis of a pre-determined criterion.

Essay # 5. Techniques of Capital Budgeting :

The prime task of the capital budgeting is to estimate the requirements of capital investment of a business. There are a number of techniques/methods of capital budgeting available.

i. Traditional Methods:

a. Payback Period.

b. Average rate of Return.

ii. Discounted Methods:

a. Net Present Value.

b. Internal Rate of Return.

c. Profitability Index.

a. Pay Back Period:

Payback period is the most widely used measure for evaluating potential investments. Payback period focuses on recovering the cost of investments. Payback period is the time required (months or years) for a company to recover its original investment in project.

There are two ways of calculating the payback period:

1. The first method can be applied when the cash inflows are uniform for each year of project’s life.

The formula for Payback Period (PP) is:

Capital Budgeting: Important Problems and Solutions

Written by True Tamplin, BSc, CEPF®

Reviewed by subject matter experts.

Updated on January 30, 2024

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Table of Contents

The cost of a project is $50,000 and it generates cash inflows of $20,000, $15,000, $25,000, and $10,000 over four years.

Required: Using the present value index method, appraise the profitability of the proposed investment, assuming a 10% rate of discount.

The first step is to calculate the present value and profitability index.

Total present value = $56,175

Less: initial outlay = $50,000

Net present value = $6,175

Profitability Index (gross) = Present value of cash inflows / Initial cash outflow

= 56,175 / 50,000

Given that the profitability index (PI) is greater than 1.0, we can accept the proposal.

Net Profitability = NPV / Initial cash outlay

= 6,175 / 50,000 = 0.1235

N.P.I. = 1.1235 - 1 = 0.1235

Given that the net profitability index (NPI) is positive, we can accept the proposal.

A company is considering whether to purchase a new machine. Machines A and B are available for $80,000 each. Earnings after taxation are as follows:

Required: Evaluate the two alternatives using the following: (a) payback method, (b) rate of return on investment method, and (c) net present value method. You should use a discount rate of 10%.

(a) Payback method

24,000 of 40,000 = 2 years and 7.2 months

Payback period:

Machine A: (24,000 + 32,000 + 1 3/5 of 40,000) = 2 3/5 years.

Machine B: (8,000 + 24,000 + 32,000 + 1/3 of 48,000) = 3 1/3 years.

According to the payback method, Machine A is preferred.

(b) Rate of return on investment method

According to the rate of return on investment (ROI) method, Machine B is preferred due to the higher ROI rate.

(c) Net present value method

The idea of this method is to calculate the present value of cash flows.

Net Present Value = Present Value - Investment

Net Present Value of Machine A: $1,04,616 - $80,000 = $24,616

Net Present Value of Machine B: $1,03,784 - 80,000 = $23,784

According to the net present value (NPV) method, Machine A is preferred because its NPV is greater than that of Machine B.

At the beginning of 2024, a business enterprise is trying to decide between two potential investments .

Required: Assuming a required rate of return of 10% p.a., evaluate the investment proposals under: (a) return on investment, (b) payback period, (c) discounted payback period, and (d) profitability index.

The forecast details are given below.

It is estimated that each of the alternative projects will require an additional working capital of $2,000, which will be received back in full after the end of each project.

Depreciation is provided using the straight line method . The present value of $1.00 to be received at the end of each year (at 10% p.a.) is shown below:

Calculation of profit after tax

(a) Return on investment

(b) Payback period

Payback period = 2.9 years

Payback period = 3.5 years

(c) Discounted payback period

(d) Profitability index method

Capital Budgeting: Important Problems and Solutions FAQs

What are some examples of capital budgeting.

Examples of capital budgeting include purchasing and installing a new machine tool in an engineering firm, and a proposed investment by the company in a new plant or equipment or increasing its inventories.

What is the process of capital budgeting?

It involves assessing the potential projects at hand and budgeting their projected cash flows. Once in place, the present value of these cash flows is ascertained and compared between each project. Typically, the project that offers the highest total net present value is selected, or prioritized, for investment.

What are the primary capital budgeting techniques?

The primary capital budgeting techniques are the payback period method and the net present value method.

What are the capital budgeting sums?

The capital budgeting sums are the amounts of money involved in capital budgeting.

What are the capital budgeting numericals?

The capital budgeting numericals are the various types of numbers used in applying different capital budgeting techniques.

About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide , a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University , where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website or view his author profiles on Amazon , Nasdaq and Forbes .

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Capital Budgeting essay

Capital budgeting comprises an integral part of the effective business development because companies have to focus on the most prospective and profitable projects with the balanced risk-returns ratio. Capital budgeting is the process, which determines whether the particular project is worth pursuing. Investing too much into capital budgeting leads to the narrow development of the company with the focus on a few secure and profitable projects, while others projects may remain under-estimated and the company can fail to invest into a risky but potentially successful project. Investing too little into capital budgeting can raise the problem of the low effectiveness of company’s investments, if the company fail to determine priority projects which are the most prospective and beneficial for its further business development.

Sunk costs are costs that cannot be changed and are irrelevant to the decision making process because they are the past costs that have been already spent but currently the equipment, machinery or other items purchased are virtually useless. Opportunity costs are costs involving the alternative chosen that has brought profits to the company. In contrast to sunk costs, which brought financial losses to the company, opportunity costs bring profits. However, both opportunity and sunk costs have ceased their impact and cannot be used anymore.

Capital budgeting is associated with three types of risks, including stand-alone risk, corporate risk, and market risk. Stand-alone risk is the risk associated with a particular project and means that the company faces a high risk of the failure of completing the particular project successfully. The corporate risk implies that the entire company is at risk and its business operations are under a threat. Therefore, the company may face a risk of losing its marketing position or even run bankrupt. As for the market risk, this is the risk associated with the possible downturn or crisis within the market, as was the case of the housing market in the US in 2007-2008. Each type of risk is necessary to assess and control because the failure to identify either risk may lead to the failure of the project.

The qualitative risk focuses on the assessment of actual risks associated with a particular project or company. However, the qualitative risk is subjective because it relies on the assessment of qualitative attributes and does not involve quantitative ones. Nevertheless, this risk is essential to assess to understand prospects and risks associated with a particular project to the full extent. The qualitative risk focuses on the assessment of the particular project and related risks from the qualitative standpoint that means that the assessment involves the analysis of the qualitative information related to the project and associated risks. As a result, the company conducting the assessment of the qualitative risk can determine whether the project is worth implementing or not. For example, the introduction of a new product is accompanied by the qualitative risk assessment. The company monitors the customer behavior and conducts interviews of a group of customers to assess the qualitative risk. On the ground of their responses, the company makes conclusion concerning the risk. Obviously, such risk assessment is subjective because it is grounded on subjective responses of customers. Nevertheless, such risk assessment helps to understand better real world prospects of a particular project.

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60 Important Capital Budgeting Questions and Answers [With PDF]

The 6th chapter of our finance learning course is “ Capital Budgeting .” In this article, we’ll learn the 60 most important capital budgeting questions and their answers.

It will help you quickly understand the important capital budgeting terms and their explanations.

By reading this post, you may quickly prepare for “finance” courses and for any competitive tests such as school and college exams, vivas, job interviews, and so on.

So let’s get started…

Capital Budgeting Questions and Answers   

The 60 important capital budgeting questions and answers are as follows:

Question 01: What is capital budgeting?

Answer: Capital budgeting is the process of finding, analyzing, and choosing investment projects with returns that are expected to last longer than one year. 

It is the process by which a company determines whether projects like building a new plant or investing in a long-term venture are worthwhile. 

Ideally, companies should pursue all projects and opportunities that increase shareholder value.

Question 02: What is another name for capital budgeting?

Answer: Another name for capital budgeting is “investment appraisal.”

Question 03: What is a project?

Answer: A project is a planned piece of work that has a distinct objective.

Question 04: What are the types of projects?

There are generally three types of projects that businesses will take on:

•  Independent Project
• Dependent Project
• Mutually Exclusive Project

Question 05: What are the steps in the capital budgeting process?

Answer: The five steps of capital budgeting are as follows:

• Generating Ideas
• Analyzing individual proposals
• Planning the capital budget
•  Implementation
•  Monitoring and follow up

Question 06: What are the fundamental principles of capital budgeting?

Answer: The following are the fundamental principles of capital budgeting:

•  Cash flows are used to make decisions.
• The timing of cash flow is critical.
• Cash flows are calculated using opportunity costs.
• After-tax cash flows are examined.
• Financing costs (such as interest) are ignored.
•  Sunk costs are not considered.
•  Only incremental flows are taken into account.
•  Inflationary effects are taken into account.

Question 07: What are the objectives of capital budgeting?

Answer: The following are the primary objectives of capital budgeting:

• Select the most profitable project for the business enterprise.
•  Assists the business in determining the most rational project for a business venture.
• Aids businesses in forecasting their future revenue, cash flows, present value status of future investments, and net earnings.
• Demonstrate the justification for new investment and abandon older investment projects.

Question 08: What are the benefits or importance of capital budgeting?

Answer: The following are the benefits or importance of capital budgeting:

• Capital budgeting assists in selecting the best project from a pool of potential investments.
•  Analyzing capital budgeting techniques allows an investor to forecast future cash flows.
• Capital budgeting allows a company to control costs and other unnecessary expenditures.
• Capital budgeting assists businesses in calculating the venture’s future financial risks. It is cautious steeping to avoid future investment risk.
• It is beneficial to choose a project investment that is not frequently changed.

Question 09: What are the features or characteristics of capital budgeting?

Answer: The following are the five most important features or characteristics of capital budgeting:

• Cash flows are used to make capital budgeting decisions.
• The timing of cash flows is critical in capital budgeting decisions.
•  Cash flows are calculated using opportunity costs.
• Capital budgeting ignores financing and sunk costs.
• The cash flows are examined after taxes.

Question 10: What are the constraints or limitations of capital budgeting?

Answer: The top five constraints of capital budgeting are as follows:

• Because major project decisions are based on forecasting, there is a chance that important project information will be overlooked.
• This budgeting technique does not allow for the estimation of probable future risk.
• Sometimes a country’s economic turmoil can have an impact on capital budgeting decisions for a future project.
• Estimating the economic life of an investment is perhaps the most difficult task.
• There are numerous unknown factors that cannot be predicted and cannot be controlled or avoided.

Question 11: What is the application of capital budgeting?

Answer: Capital budgeting is used in all aspects of long-term investment decisions. The following are some examples of popular capital budgeting applications:

• Purchase of a fixed asset.
• Business expansion with the goal of increasing production capacity.
• Product differentiation
• Modernization and replacement.

Question 12: What are the factors affecting capital budgeting decisions?

Answer: The following factors influence capital budgeting decisions:

• Maturity of Project
•  Cash flows
• Present value factor

Question 13: What are the major cash flow components?

Answer: The following are the major cash flow components:

• Initial cash outflow
• Interim Incremental Net Cash Flows
• Terminal Year Incremental Net Cash Flow

Question 14: What is an initial cash outflow?

Answer: The amount of money paid out or received at the start of a project or investment is referred to as the “initial cash outflow.”

Question 15: How do you calculate the initial cash outflow?

Answer: The initial cash flow is calculated in the following manner:

Initial cash flow = cost of the new asset – capitalized expenditures +/- increased or decreased level of net working capital +/- net proceeds from the sale of old assets +/- taxes (tax savings) from the sale of old assets

Question 16: What are the interim incremental net cash flows?

Answer: Interim incremental net cash flows are the extra operating cash flows that a company gets because it started a new project.

Question 17: How do you calculate the interim incremental net cash flows?

Answer: The interim incremental net cash flows are calculated as follows:

Incremental Net Cash Flow for the Period = Net increase (decrease) in operating revenue -/+ any net increase or decrease in operating expenses, excluding depreciation +/- Net increase or decrease in tax depreciation charges +/- Net increase or decrease in taxes +/- Net increase or decrease in tax depreciation charges

Question 18: How do you calculate the terminal-year incremental net cash flow?

Answer: The terminal year incremental net cash flow is calculated as follows:

Terminal year incremental net cash flow = Net increase or decrease in operating revenue -/+ any net increase or decrease in operating expenses, excluding depreciation +/- Net increase or decrease in tax depreciation charges +/- Net increase or decrease in taxes +/- Net increase or decrease in tax depreciation charges +/- initial salvage value of new assets -/+ Taxes or Tax savings due to sale or disposal of new assets +/- decreased or increased level of net working capital

Question 19: What are the types of capital budgeting decisions?

Answer: The following are the different types of capital budgeting decisions:

•  Accept or reject decision
• Mutually exclusive decision
• Capital rationing decision
• Ranking method
• Non-discounted methods of capital budgeting
• Discounted methods of capital budgeting

Question 20: What is an “accept or reject” decision?

Answer: This is an important decision in capital budgeting. The farm would invest in the project if it were accepted, but not if it were rejected. 

Most project proposals are accepted if their rates of return are higher than a certain minimum rate of return. 

Under the accept or reject decision, all separate products that meet the minimum investment criteria should be put into place.

Question 21: What are mutually exclusive decisions?

Answer: Projects that compete with each other but don’t affect each other’s chances of getting approved are said to be “mutually exclusive.” Only one of the options is allowable because they are mutually exclusive.

Question 22: What is a capital rationing decision?

Answer: If the business has no limits on how much money it can spend, any independent investment proposal with a return higher than a certain level could be accepted.

In reality, a business’s budget for project implementation is limited. There are many investment proposals competing for those limited funds. As a result, the business must ration them. 

The business allocates funds to projects in such a way that long-term returns are maximized. Capital rationing is a term for a business’s financial situation in which it only has a small amount of money to spend on capital investments.

Question 23: What is the ranking method?

Answer: Using different capital budgeting techniques, this method starts by figuring out how likely each project is to happen. 

The project with the highest return is then ranked first, followed by the project with the lowest return. The project with the highest ranking is chosen, and the investment decision is made.

Question 24: What are the non-discounted methods of capital budgeting?

Answer: The non-discounted methods of capital budgeting are as follows:

• Payback Period (PBP)
• Average Rate of Return (ARR)
• Pay Back Reciprocal (PBR)

Question 25: What are the discounted methods of capital budgeting?

Answer: The discounted methods of capital budgeting are as follows:

• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Profitability Index (PI)
• Modified Internal Rate of Return (MIRR)
• Discounted Pay Back Period (DPBP)

Question 26: What is a payback period (PBP)?

Answer: The payback period is the number of years it takes to get back the money you put into a project at the beginning.

The payback period is one of the most common and widely accepted ways to judge investment proposals. The PBP figures out how long it will take to get back the initial cash investment based on the expected cash flows.

Question 27: What is the average rate of return (ARR)?

Answer: When you divide the average annual net income after taxes by the average investment, you get the average rate of return. It considers both the amount invested and the profit generated. 

Question 28: What is the net present value (VPV)?

Answer: The net present value of a project is the sum of the present values of all expected future cash flows over the project’s life, less the initial cash outlay.

The net present value is the traditional economic method for assessing investment proposals. It is one of the most important ways to discount money that takes into account the value of time. 

It makes the right assumption that future cash flows from different time periods have different values and can’t be compared until their equivalent present values are known.

Question 29: What is an internal rate of return (IRR)?

Answer: Another method for discounting is the internal rate of return. A project’s IRR is the discount rate that equals its NPV.

It is the discount rate at which the present value of future cash flows is equal to the initial investment.

Question 30: What is a profitability index (PI)?

Answer: The profitability index is the ratio you get when you divide the present value of all future cash inflows by the present value of all cash outflows.

Question 31: What are the techniques or methods of capital budgeting?

Answer: The following are capital budgeting techniques or methods:

• Discounted Payback Period (DPBP)

Question 32: What is the formula for NPV, and how do you calculate NPV?

Answer: The formula for calculating NPV is as follows:

CFt = After-tax cash flow at time t

R = Required rate of return for the investment

Outlay = Initial cash outflow or investment 

Calculation:

Let’s calculate the net present value (NPV) using a straightforward example.

ABC Corporation is thinking about investing $30,000 in a project that will generate after-tax cash flows of $12,000 per year for the next three years and an additional $20,000 in the fourth year. The required rate of return is 13%.

The NPV for ABC Corporation would be as follows, using the above formula:

NPV= 12/1.13+12/(1.13)+12/1.13+20/1.13-30

       =10.62+9.4+8.32+12.27-30

       =40.61-30

       =10.61

Since the NPV is positive, the investment will therefore be accepted.

Question 33: What are the NPV decision criteria?

Answer: The following are the NPV decision criteria:

• Invest: If the NPV is greater than or equal to zero.
• Do not make an investment: If the NPV is less than zero.

Question 34: What are the benefits of using the Net Present Value (NPV) method?

Answer: The net present value (NPV) method has the following benefits:

• It recognizes the time value of money.
• It calculates the project’s worth based on all cash flows that occur over the course of the project’s life.
• The discounting process allows you to calculate cash flows in terms of present value.
• The NPV Method can be modified to account for risk.
• It took into account the risk of future cash flows (through the cost of capital).
• The NPV method is always in line with the goal of maximizing shareholder wealth.

Question 35: What are the disadvantages of using the Net Present Value (NPV) method?

Answer: The following are the disadvantages of the net present value (NPV) method:

• In comparison to PBP or ARR, it is difficult to understand, calculate, and use. 
• The problem associated with NPVs involves calculating the required rate of return or cost of capital to discount the cash flows.
• When comparing alternative projects with unequal life, use caution when using the NPV.

Question 36: What is the formula for IRR?

Answer: The internal rate of return (IRR) formula is: 

IRR = r = the discount rate that makes the net present value of the investment equal to zero.

Question 37: What are the IRR decision criteria?

Answer: The IRR decision criteria are as follows:

• Invest: If the IRR is greater than or equal to the required rate of return.
• Don’t invest: If the IRR is less than the required rate of return.

Question 38: What are the benefits of using the Internal Rate of Return (IRR) method?

Answer: The following are the benefits of using the Internal Rate of Return (IRR) method:

• It takes into account the time value of money.
• It considers total cash inflows and outflows.
• For business executives, the IRR is simpler to grasp.
• It is consistent with the overall goal of increasing shareholder wealth.
• It takes into account the risks associated with future cash flows.

Question 39: What are the disadvantages of using the Internal Rate of Return (IRR) method?

Answer: The following are the disadvantages of the Internal Rate of Return (IRR) method:

• It entails arduous and time-consuming calculations.
• It may generate multiple rates, which can be perplexing.
• IRR does not account for scale or amount.
• If the project has a long duration, the trial and error process used to calculate the IRR can become unmanageable.

Question 40: What is the PBP formula?

Answer: The following is the formula for calculating the payback period (PBP):

PBP= a+((ICO-c)/d)

a= the year of the cumulative inflow closest to the year of the initial cash outflow

ICO= Initial Cash Outlay

c=Cumulative inflow of a year

d= Inflow of the year of recovery

Question 41: What are the PBP decision criteria?

Answer: The payback period decision criteria are as follows:

• The proposal is accepted if the calculated payback period is less than some maximum acceptable payback period.
• The project is rejected if the payback period exceeds the acceptable payback period.

Question 42: What are the benefits of using the Pay Back Period (PBP) method?

Answer: The Pay Back Period (PBP) method has the following benefits:

• It is very simple to compute.
• The method provides some information about the investment’s risks. When the payback period exceeds an acceptable payback period, the project becomes more uncertain.
• This method does not provide a rough estimate of the project’s liquidity.

Question 43: What are the disadvantages of using the Payback Period (PBP) method?

Answer: The Payback Period (PBP) method has the following disadvantages:

• There are no concrete decision criteria for determining whether an investment increases the firm’s value.
• The method disregards cash flows that occur after the payback period.
• It ignores the concept of the time value of money.
• It also takes no account of the risk of future cash flows.
• This method is an ineffective predictor of profitability.

Question 44: What is the Discounted Pay Back Period (DPBP) formula?

Answer: The following is the formula for calculating the discounted payback period (DPBP):

DPBP= a+((ICO-c)/d)

Question 45: What are the benefits of the Discounted Pay Back Period (DPBP) method?

Answer: The following are the benefits of the discounted payback period (DPBP) method:

• The primary benefit of a discounted payback period is that it takes into account the time value of money.
• It also takes into account the riskiness of the project’s cash flows (through the cost of capital).

Question 46: What are the disadvantages of using the Discounted Payback Period (DPBP) method?

Answer: The following are the disadvantages of the Discounted Pay Back Period (DPBP) method:

• This method, like the payback period method, ignores cash flows after the discounted payback period is reached.
• This method is still not a reliable indicator of profitability.
• The maximum acceptable discounted payback period is entirely arbitrary.

Question 47: What is the formula of an average or accounting rate of return (ARR)?

Answer: The formula for figuring out an average or accounting rate of return (ARR) is as follows:

ARR = Average net income/Average Investment

Average Investment=(Initial Investment +Salvage Value)/2

Question 48: What are the ARR decision criteria?

Answer: The following are the ARR decision criteria:

• Accept: If the actual ARR exceeds or equals the projected ARR.
• Don’t accept: If the actual ARR is less than or equal to the projected ARR.

Question 49: What are the benefits of calculating the average rate of return (ARR)?

Answer: The following are the benefits of using the Average Rate of Return (ARR) method:

• It is simple to comprehend, calculate, and apply.
• The ARR method is easy to figure out from accounting data, and unlike the NPV and IRR methods, it doesn’t require any adjustments to get to the cash flows of the project.
• It considers benefits over the project’s entire life cycle.
• The ARR rule considers the entire income stream when calculating the project’s profitability.

Question 50: What are the disadvantages of using the Average Rate of Return (ARR) method?

Answer: The following are the disadvantages of the Average Rate of Return (ARR) method:

• It is calculated using accounting profit rather than cash flow.
• It does not account for the time value of money.
• The ARR does not account for any benefits that may accrue after the project is completed.
• The ARR makes no distinction between the sizes of the investments needed for each project.

Question 51: What is the PI formula, and how is it calculated?

Answer: The following is the formula for calculating PI:

PI = PV of future cash flows/Initial investment

PI= 1+(NPV/Initial Investment)

The example below will show you how to calculate the Profitability Index (PI).

Assume ABC Corporation is considering a $42,000 investment in a capital project that will generate after-tax cash flows of $14,000 per year for the next five years. The cost of capital is 10%.

The estimated present value of future cash flows is $53,071.

PV of Future cash flows=$53,071

Initial Investment = $42,000

Profitability Index (PI)= (53,071/42000)= 1.26

Question 52: What are the PI Decision Criteria?

Answer: The following are the PI decision criteria:

• If PI is greater than or equal to one, invest.
• If the PI is less than one, do not invest.

Question 53: What are the advantages of the Profitability Index (PI) method?

Answer: In capital budgeting decision-making, the Profitability Index has the following advantages:

• The PI meets almost all of the criteria for a sound investment.
• It assesses all of the project’s cash flows.
• It indicates whether or not an investment increases the firm’s value.

Question 54: What are the disadvantages of using the Profitability Index (PI) method?

Answer: The following are the Profitability Index’s disadvantages:

• The calculation necessitates an estimate of the capital cost.
• When used to compare mutually exclusive projects, it may not provide the correct decision.

Question 55: What is the difference between capital budgeting and capital rationing?

Answer: The three important differences between capital budgeting and capital rationing are as follows:

• Capital budgeting is the process of generating, analyzing, and allocating long-term investments to the capital budget. “Capital rationing,” on the other hand, is a situation in which the amount of funding available is limited to the point where projects cannot be accepted.
• Capital budgeting functions include project evaluation, selection, and implementation. On the other hand, the goal of capital rationing is to choose projects that will make the most money out of the limited amount of money.
• To analyze projects, capital budgeting is used. Capital rationing, on the other hand, is used to accept or reject projects.

Question 56: What is the distinction between Net Present Value (NPV) and Internal Rate of Return (IRR)?

Answer: The following are the three important distinctions between the net present value (NPV) and the internal rate of return (IRR):

• NPV is the present value of future cash flows discounted at the required rate of return minus the project’s initial investment. Whereas IRR is the rate of return that equates the present value of a series of cash inflows with the initial investment.
• The NPV method’s goal is to compute the net value. The goal of the IRR method is to calculate the required rate.
• The project is profitable if the NPV is positive. The project is profitable if the IRR is greater than the cost of capital.

Question 57: What is the distinction between Net Present Value (NPV) and Profitability Index (PI)?

Answer: The following are the three important distinctions between net present value (NPV) and profitability index (PI):

• NPV is the present value of future cash flows discounted at the required rate of return minus the project’s initial investment. Whereas PI is the present value of future cash flows discounted at the required rate of return divided by the project’s initial investment.
• The NPV method’s goal is to compute the net value. The goal of the PI method is to calculate the ratio.
• The project is profitable if the NPV is positive. The project is profitable if the PI is greater than one.

Question 58: Which technique, NPV or IRR, is preferred and why?

Answer: It is difficult to choose between approaches. It is smart to look at NPV and IRR methods from both a theoretical and a practical point of view.

The theoretical point of view:  

Answer: NPV is the superior approach to capital budgeting for the following reasons:

• The NPV user assumes that any intermediate cash inflows from an investment are reinvested at the firm’s cost of capital. whereas the use of IRR assumes that the IRR will reinvest any of these cash inflows. The cost of capital, on the other hand, is the realistic investment rate.
• A project with an unusual cash flow may produce multiple IRR, whereas NPV does not have this issue.

The practical point of view: 

Answer: Even though the NPV method is better in theory, financial managers prefer the IRR method for the following reasons:

• Rates of return are preferred by businesspeople over dollar returns. In this regard, IRR is preferable.
• NPV is less intuitive to financial decision-makers because it does not measure benefits in relation to the amount invested.
• There are several methods for avoiding the difficulty of the IRR.

Question 59: When is the profitability index better than the NPV?

Answer: In the following situations, it is thought that the profitability index is better than the net present value (NPV).

• In terms of capital rationing decisions, the profitability index is thought to be better than the NPV.
• If the initial investment is unequal and I am asked to accept or reject a decision, the profitability index will be a better technique than the NPV.
• In the profitability index method, the net present value of the cash flows is calculated first, followed by the profitability index. As a result, the profitability index becomes preferable.

Question 60: What is the best way to figure out how much a capital expenditure or investment is worth?

Answer: There are two types of capital budgeting methods: traditional and discounted cash flow. The discounted cash flow method is the better option of the two.

I hope that by the end of this post, you will have a good understanding of the “ capital budgeting ” chapter.

You will gain a better understanding of the “ capital budgeting ” chapter if you read these “60 important capital budgeting questions and answers” on a regular basis.

You can read the first five chapters of our finance learning course here:

• 25 Important Introduction to Finance Questions and Answers [With PDF]
• 30 Important Time Value of Money Questions and Answers [With PDF]
• 35 Important Short-Term and Mid-Term Financing Questions and Answers [With PDF]
• 35 Important Long-Term Financing Questions and Answers [With PDF]
• 35 Important Cost of Capital Questions and Answers [With PDF]

1 thought on “60 Important Capital Budgeting Questions and Answers [With PDF]”

Well researched and written, short and pricise, straight to the point notes. Very understandable when studying them.

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How capital expenditure management can drive performance

One of the quickest and most effective ways for organizations to preserve cash is to reexamine their capital investments. The past two years have offered a fascinating look into how different sectors have weathered the COVID-19 storm: from the necessarily capital expenditure–starved airport industry to the cresting wave of public-sector investments in renewable infrastructure and anticipation of the next mining supercycle. Indeed, companies that reduce spending on capital projects can both quickly release significant cash and increase ROIC, the most important metric of financial value creation (Exhibit 1).

This strategy is even more vital in competitive markets, where ROIC is perilously close to cost of capital. In our experience, organizations that focus on actions across the whole project life cycle, the capital project portfolio, and the necessary foundational enablers can reduce project costs and timelines by up to 30 percent to increase ROIC by 2 to 4 percent. Yet managing capital projects is complex, and many organizations struggle to extract cost savings. In addition, ill-considered cuts to key projects in a portfolio may actually jeopardize future operating performance and outcomes. This dynamic reinforces the age-old challenge for executives as they carefully allocate marginal dollars toward value creation.

Companies can improve their odds of success by focusing on areas of the project life cycle— capital strategy and portfolio optimization , project development and value improvement, and project delivery and construction—while investing in foundational enablers.

Cracking the code on capital expenditure management

Despite the importance of capital expenditure management in executing business strategy, preserving cash, and maximizing ROIC, most companies struggle in this area for two primary reasons. First, capital expenditure is often not a core business; instead, organizations focus on operating performance, where they have extensive institutional knowledge. When it comes to capital projects, executives rely on a select few people with experience in capital delivery. Second, capital performance is typically a black box. Executives find it difficult to understand and predict the performance of individual projects and the capital project portfolio as a whole.

Across industries, we see companies struggle to deliver projects on time and on schedule (Exhibit 2). In fact, cost and schedule overruns compared with original estimates frequently exceed 50 percent. Notably, these occur in both the public and private sectors.

The COVID-19 pandemic has accelerated and magnified these challenges. Governments are increasingly viewing infrastructure spending as a tool for economic stimulus, which amplifies the cyclical nature of capital expenditure deployments. At the same time, some organizations have had to make drastic cutbacks in capital projects because of difficult economic conditions. The reliance on just a few experienced people when travel restrictions necessitated a remote-operating model further increased the complexity. As a result, only a few organizations have been able to maintain a through-cycle perspective.

In addition, current inflation could put an end to the historically low interest rates that companies are enjoying for financing their projects. As the cost of capital goes up, discipline in managing large projects will become increasingly important.

Improving capital expenditure management

In our experience, the organizational drivers that impede capital expenditure management affect all stages of a project life cycle, from portfolio management to project execution and commissioning. Best-in-class capital development and delivery require companies to outperform in three main areas, supported by several foundational enablers (Exhibit 3).

Recipes for capturing value

Companies can transform the life cycle of a capital expenditure project by focusing on three areas: capital strategy and portfolio optimization, project development and value improvement, and project delivery and construction. While the savings potential applies to each area on a stand-alone basis, their impact has some overlap. In our experience, companies that deploy these best practices are able to save 15 to 30 percent of a project’s cost.

Capital strategy and portfolio optimization

The greatest opportunity to influence a project’s outcome comes at its start. Too often, organizations commit to projects without a proper understanding of business needs, incurring significant expense to deliver an outcome misaligned with the overall strategy. Indeed, a failure to adequately recognize, price, and manage the inherent risks of project delivery is a recurring issue in the industry. Organizations can address this challenge by following a systematic three-step approach:

Assess the current state of capital projects and portfolio. It’s essential to identify strengths, areas of improvement, and the value at stake. To do so, organizations must build a transparent and rigorously tested baseline and capital budget, which should provide a clear understanding of the overall capital expenditure budget for the coming years as well as accurate cost and time forecasts for an organization’s portfolio of capital projects.

Ensure capital allocation is linked to overall company strategy. This step involves reviewing sources and uses of cash and ensuring allocated capital is linked to strategy. Companies must set an enterprise-wide strategy , assess the current portfolio against the relevant market with forward-looking assessments and cash flow simulation, and review sources and uses of cash to determine the amount of capital available. Particular focus should be given to environmental, social, and governance (ESG) considerations—by both proactively managing risks and capturing the full upside opportunity of new projects—because sustainability is becoming a real source of shareholder value (Exhibit 4). With this knowledge, organizations can identify internal and external opportunities to strengthen their portfolio based on affordability and strategic objectives.

Optimize the capital portfolio to increase company-wide ROIC. Executives should distinguish between projects that are existing or committed, planned and necessary (for legal, regulatory, or strategic requirements), and discretionary. They can do so by challenging a project’s justification, classifications, benefit estimates, and assumptions to ensure they are realistic. This analysis helps companies to define and calibrate their portfolios by prioritizing projects based on KPIs and discussing critical projects not in the portfolio. Executives can then verify that the portfolio is aligned with the business strategy, risk profile, and funding constraints.

For example, a commercial vehicle manufacturer recently undertook a rigorous review of its project portfolio. After establishing a detailed baseline covering several hundred planned projects in one data set, the manufacturer classified the projects into two categories: must-have and discretionary. It also considered strategic realignment in light of a shift to e-mobility and the implications on investments in internal-combustion-engine vehicles. Last, it scrutinized individual maintenance projects to reduce their scope. Overall, the manufacturer uncovered opportunities to decrease its capital expenditure budget by as much as 20 percent. This strict review process became part of its annual routine.

Project development and value improvement

While value-engineering exercises are common, we find that 5 to 15 percent of additional value is typically left on the table. Too often, organizations focus on technical systems and incremental improvements. Instead, executives should consider the full life cycle cost across several areas:

Sourcing the right projects with the right partners. Companies must ensure they are sourcing the right projects by aligning on prioritization criteria and identifying the sectors to play in based on their strategy. Once these selections are made, organizations can use benchmarking and advanced-analytics tools to accelerate project timelines and improve planning. Building the right consortium of contractors and partners at the outset and establishing governance and reporting can have a huge impact. Best-in-class teams secure the optimal financing, which can include public and private sources, by assessing the economic, legal, and operational implications for each option.

A critical success factor is a strong tendering office, which focuses on choosing better projects. It can increase the likelihood of winning through better partnerships and customer insights and enhance the profitability of bids with creative solutions for reducing cost and risk. Best-in-class tendering offices identify projects aligned with the company’s strategy, have a clear understanding of success factors, develop effective partnerships across the value chain, and implement a risk-adjusted approach to pricing.

Achieve the full potential of the preconstruction project value. Companies can take a range of actions to strengthen capital effectiveness. For example, they should consider the project holistically, including technical systems, management systems, and mindsets and behaviors. To ensure they create value across all stages of the project life cycle, organizations should design contract and procurement interventions early in the project. An emphasis on existing ideas and proven solutions can help companies avoid getting bogged down in developing new solutions. For instance, a minimum-technical-solution approach can be used to identify the highest-value projects by challenging technical requirements once macro-elements are confirmed.

Companies should also seek to formalize dedicated systems and processes to support decision making and combat bias. We have identified five types of biases to which organizations should pay close attention (Exhibit 5). For instance, interest biases should be addressed by increasing transparency in decision making and aligning on explicit decision criteria before assessing the project. Stability biases can also be harmful. We have seen it too many times: companies have a number of underperforming projects that just won’t die and that take up valuable and already limited available resources. Organizations should invest in quickly determining when to halt projects—and actually stop them.

Setting up a system to take action in a nonbiased way is a crucial element of best-in-class portfolio optimization. Changing the burden of proof can also help. One energy company counterbalanced the natural desire of executives to hang on to underperforming assets with a systematic process for continually upgrading the company’s portfolio. Every year, the CEO asked the corporate-planning team to identify 3 to 5 percent of the company’s assets that could be divested. The divisions could retain any assets placed in this group but only if they could demonstrate a compelling turnaround program for them. The burden of proof was on the business units to prove that an asset should be retained, rather than just assuming it should.

An effective governance system ensures that all ideas generated from project value improvements are subject to robust tracking and follow-up. Further, the adoption of innovative digital and technological solutions can enhance standardization, modularization, transparency, and efficiency. A power company recently explored options to phase out coal-powered energy using a project value improvement methodology and a minimum technical solution. The process helped to articulate options to maximize ROI and minimize greenhouse-gas emissions. An analysis of each option, using an idea bank of more than 2,000 detailed ideas, let the company find solutions to reduce investment on features with little value added, reallocate spending to more efficient technologies, and better adjust capacity configurations with business needs. Ultimately, the company reduced capital costs by 30 percent while increasing CO 2 abatement by the same amount.

Designing the right project organization. An open, collaborative, and result-focused environment enabled by stringent performance management processes is critical for success, regardless of the contractual arrangement between owners and contractors. Improving capital project practices is possible only if companies measure those practices and understand where they stand compared with their peers. The organization should be designed with a five-year capital portfolio in mind and built by developing structures for project archetypes and modeling the resources required to deliver the capital plan. A rigorous stage-gate process of formal reviews should also be implemented to verify the quality of projects moving forward. Too many projects are rushed through phases with no formal review of their deliverables, leading to a highly risky execution phase, which usually results in delays and cost overruns.

As successful organizations demonstrate, addressing organizational health in project teams is as important as performance initiatives. McKinsey research has found that the healthiest organizations generate three times higher returns than companies in the bottom quartile and more than 60 percent higher returns compared with companies in the middle two quartiles. 1 Scott Keller and Bill Schaninger, Beyond Performance 2.0: A Proven Approach to Leading Large-Scale Change , second edition, Hoboken, NJ: Wiley, 2019.

Project delivery and construction

Since the root causes of poor performance—project complexity, data quality, execution capabilities, and incentives and mindsets—can be difficult to identify and act on, organizations can benefit from taking the following actions across project delivery and construction dimensions.

Optimize the project execution plan. Organizations should embrace principles of operations science to develop an optimized configuration for the production system, as well as set a competitive and realistic baseline for the project. This execution plan identifies the execution options that could be deployed on the project and key decisions that need to be made. Companies should also break the execution plan into its microproduction systems and visualize the complicated schedule. Approaching capital projects as systems allows companies to apply operations science across process design, capacity, inventory, and variability.

Contract, claims, and change orders management. While claims are quite common on capital projects, proactive management can keep them under control and allow owners to retain significant value. Focusing on claims avoidance when drafting terms and conditions can head off many claims before they arise. In addition, partnering with contractors creates a more collaborative environment, making them less inclined to pursue an aggressive claims strategy. To manage change orders on a project, companies should address their contract management capability, project execution change management, and project closeout negotiation support. A European chemical company planning to build greenfield infrastructure in a new Asian geography recently employed this approach. It reduced risk on the project by bringing together bottom-up, integrated planning and performance management with targeted lean-construction interventions. By doing so, the company reduced the project’s duration by a year, achieved on-time delivery, and stayed within its €1 billion budget.

Enablers of the capital transformation

These three value capture areas must be supported by a capable organization with the right tools and processes—what we call the “transformational chassis.” To establish this infrastructure, organizations should focus on several activities.

Performance management

The best organizations institute a performance management system to implement a cascading set of project review meetings focused on assessing the progress of value-creation initiatives. Building on a foundation of quality data, the right performance conversations must take place at all levels of the organization.

Companies should also be prepared to reexamine their stage-gate governance system to shift from an assurance mindset (often drowning in bureaucracy and needless reporting) to an investor mindset. Critical value-enabling activities should be defined at each stage of the project life cycle, supported by a playbook of best practices for execution and implemented by a project review board. While governance processes exist, they often involve reporting without decision making or are not focused on the right outcomes—for example, ensuring that the investment decision and thesis remain valid through a project’s life. Quite often, companies provide incentives for project managers to execute an outdated project plan rather than deliver against the organization’s needs and goals.

Creating project transparency is also critical. Companies should establish a digital nerve center—or control tower—that collects field-level data to establish a single source of truth and implement predictive analytics. Equally important, companies must address capability building to ensure that the team has a solid understanding of the baseline and embraces data-based decision making.

Companies should stand up delivery teams that integrate owner and contractor groups across disciplines and institute a consistent and effective project management rhythm that can identify risks and opportunities over a project’s duration. Once delivery teams prioritize the biggest opportunities, dedicated capacity should be allocated to solve a project’s most challenging problems. Finally, companies should build and deploy comprehensive programs that improve culture and workforce capabilities throughout the organization, including the front line.

Capital analytics

Many organizations struggle to get a clear view of how projects are performing, which limits the possibility for timely interventions, decision making, and resource planning. By digitalizing the performance management of construction projects using timely and transparent project data, companies can track value capture and leading indicators while making data available across the enterprise. Using a single source of truth can reduce delivery risk, increase responsiveness, and enable a more proactive approach to the identification of issues and the capture of opportunities. The most advanced projects build automated, real-time control towers that consolidate information across systems, engineering disciplines, project sites, contractors, and broader stakeholders. The ability to integrate data sets speeds decision making, unlocks further insights, and promotes collaborative problem solving between the company that owns the capital project and the engineering, procurement, and construction company.

Ways of working

In many cases, executives are unwilling to engage in comprehensive capital reviews because they lack a sufficient understanding of capital management processes, and project managers can be afraid to expose this lack of proficiency. Agile practices can facilitate rapid and effective decision making by bringing together cross-functional project teams. Under this approach, organizations establish daily stand-ups, weekly showcases, and fortnightly sprints to help eliminate silos and maintain a focus on top priorities. Agility must be supported by an organizational structure, well-developed team capabilities, and an investment mindset. Organizations should also build skills and establish a culture of cooperation to optimize their capital investments.

We do recognize that getting capital expenditure management right feels like a lot to do well. And although many of these tasks are somehow done by a slew of companies, pockets of organizational excellence can be undermined instantly (and sometimes existentially) by one big project that goes wrong or a strategic misfire that pushes an organization from being a leader to a laggard in the investment cycle. In some ways, capital expenditure management leaders face similar challenges to those in other functions that have already undergone major productivity improvements: often these challenges are not technical problems but instead relate to how people work together toward a common goal.

Yet we believe organizations have a significant opportunity to fundamentally improve project outcomes by rethinking traditional approaches to project delivery. Sustainable improvements can be achieved by resizing the project portfolio, optimizing the cash flows for individual projects, and improving and reducing individual project delivery risk.

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Capital gains tax legislation coming before summer break, Freeland says

Finance minister accuses conservative leader of ducking questions on proposed tax changes.

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The Liberal government will introduce legislation to implement its proposed changes to the capital gains tax before the House rises for the summer break, Deputy Prime Minister and Finance Minister Chrystia Freeland said Tuesday.

The increase in the "inclusion rate" — from one-half to two-thirds on capital gains above $250,000 for individuals — was first announced in the budget.

"In the coming weeks and certainly before the House rises, we will begin the legislative process to implement our increase in the inclusion rate," she said 

After announcing the increase, the Liberal government  separated the capital gains tax change from its budget implementation bill and promised to introduce a separate bill that will require its own vote.

The change was detailed in the budget's tax annex, which means the Canada Revenue Agency (CRA) can enforce the change provisionally until the legislation passes.

Prime Minister Justin Trudeau said Thursday the tax change will take effect on June 25. 

• Poilievre still won't say if he'll scrap government's capital gains tax hike
• Trudeau dismisses plea from doctors to reconsider capital gains tax change
• Freeland's new federal budget hikes taxes on the rich to cover billions in new spending

Conservative Leader Pierre Poilievre was asked last week whether he supports the tax change.

"There is no such increase," he replied. "They've pulled that out of the budget."

Freeland challenged Poilievre on that answer Tuesday, saying the Conservative leader has been "deflecting when asked about his position on" the capital gains change.

"It is important for Canadians to insist on a clear answer from the Conservatives on tax fairness and, I think, depending on what answer we get, Canadians will know whose side the Conservatives are really on," she added. 

A spokesperson for Poilievre told CBC News Tuesday that because legislation has yet to be introduced to the House, his position has not changed since last week.

"The legislation you are asking about doesn't exist yet due to Justin Trudeau's incompetence, so it's impossible for us to weigh in on the matter," Sebastian Skamski, Poilievre's press secretary, said in an email.

Skamski also said Freeland is making up the policy "on the fly."

"It's obvious that their incompetence will only cost Canadians more," he said.

Freeland has said that the increase will bring in as much as $19 billion in new revenue.

Changes to capital gains for individuals

A capital gain is the difference between the cost of an asset — an investment property, a stock or a mutual fund — and its total sale price. Right now, only 50 per cent of capital gains are taxable.

Once the changes are implemented, 50 per cent of the first $250,000 in capital gains an individual taxpayer earns will be taxed. For every dollar beyond $250,000, two-thirds will be taxable.

The budget proposes to tax all capital gains earned by corporations and trusts at the two-thirds rate.

• Your questions answered about the proposed capital gains tax changes
• Do Ottawa's proposed capital gains tax changes affect inherited properties?

The 2024 budget maintains the existing exemption for capital gains from selling a principal residence. It also retains an existing lifetime capital gains tax exemption on the sale of small business shares, and farming and fishing property.

According to federal government data, 28.5 million Canadians are not expected to have any capital gains income at all. Three million are expected to earn capital gains below the $250,000 annual threshold.

The government data indicates only 0.13 per cent of Canadians — people with an average income of about $1.4 million a year — are expected to pay more in personal income tax on their capital gains as a result of the change.

ABOUT THE AUTHOR

Senior writer

Peter Zimonjic is a senior writer for CBC News. He has worked as a reporter and columnist in London, England, for the Daily Mail, Sunday Times and Daily Telegraph and in Canada for Sun Media and the Ottawa Citizen. He is the author of Into The Darkness: An Account of 7/7, published by Random House.

With files from the CBC's John Paul Tasker and Benjamin Lopez Steven

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Capital Budgeting Techniques Research Paper

Introduction about the topic, introduction about the company, purpose of research, research questions and methodology of collected data.

Capital budgeting is the process by which companies appraise investment decisions, in particular, by which capital resources are allocated to specific projects. It requires firms to give account for the time value of money and project risk using a variety of more or less formal techniques. The decision to invest in fixed assets is one of the major decisions made by managers.

Investments in fixed assets impact a firm’s operations for a very long time because they involve large capital outlays. As a result, a variety of quantitative and analytical techniques are applied by managers in the selection of projects to enable them to make good decisions in the area 1 .

Capital budgeting comprises of a number of techniques based on various concepts emanating from projects and investments such as the concept of incremental cash flows. Accounting rules play a very important role in the basis of some particular techniques.

The management control process requires the services of budgetary planning and control to provide necessary accounting information. Most of the important information is normally provided through variance reports availed by the accountants in charge. Capital budgeting decisions are influenced by certain factors dealing with economic, social, political, as well as cultural diversity 2 .

There has been tremendous increase in the level of foreign direct investment (FDI) in the last two decades. This has been brought about by the spread of business investment activities across countries of the world. Multinational organisations have faced various challenges due to lack of reliable and accurate methods which could be used in making appropriate decisions within the market place. The paper comprises of various parts the first presenting both theoretical as well as practical overview of the given organisation.

The second part of the reports gives the methodology, including data collection techniques as well as design of questionnaire. Then there are the findings from the research and finally conclusions and recommendations. However, capital budgeting techniques provide measures through which capital budgeting requests are analysed. Net Present Value utilizes the aspect of time value of money concepts, Payback period has been discovered to be deficient of time value techniques 3 .

Capital budgeting is applied in the company’s planning process to determine the status of the firm in line with long term investments 4 . The chamber is one of Saudi Arabia’s oldest and well-established organisations. The promotion of the private sector contribution to the economy is the cause The Chamber is most devoted to.

To that end, it has formulated a lot of services that have significantly helped in development and, especially, promotion with the attempt of giving all the possible support to the beginners of the private sector in such spheres of economy as industry, trade craft and services.

The main aim of the company is to have an active and successful development of Eastern Province private sector activities and to be only one service provider and assistant for the business development in the Eastern Province. The main aim is to provide separate and qualitative services that meet all the requirements the expectation of the private sector, and successful association in the social and economic spheres of life.

The Chamber aims to provide unique and high-quality services that meet the aspirations of the private sector, thus ensuring continuous development through the optimal investment in available resources, renewable technologies and effective participation in the economic and social development of the region; thus realising the wishes of our members in light of the values and principles of our society.

The advancement of the economic growth by means of the full mobilisation of the resources of the private sector to assist the economic development is its final goal.

It aims at promoting the private sector’s origin by means of different steps that include detecting all existing possibilities for the business production, searching for all the possible solutions to different problems that may crop up in the process according to the rules of the system and government programs and working out the plan of the international trade in the attempts of getting the main goals.

The branch expansion has also served as a tool of promoting membership.

The Chamber’s products and services centres around provision of distinct products and services of added value to members, provision of unique preparation and training programs, excellence in the segments of research, studies and information for the purposes of supporting business sector within Eastern Province. Also, they indulge in supporting small and medium enterprises and encouraging innovation and creativity and the culture of self-employment.

Within the last fifty years, the Chamber has been devoted to the private sector in such areas as contact between the business association and the government, promotional agency and of fellowship amongst businesspeople. Provision of a medium for the private sector, allowing them to perform social obligations as well as provision of information on investment opportunities and changes in economic and commercial policies.

The study seeks to examine the various capital budgeting techniques used in Saudi Arabia’s chamber and the various factors influencing financial investment practices within the country. The focus is to find out how capital budgeting is used by Saudi Arabia’s chamber.

Various techniques used in optimising the financial cash flows and at the same time, computation of effective financial rates are covered within the study. There is also the determination on the manner in which capital budgeting should be applied by the use of Net Present Value (NPV), Internal Rate of Return (IRR), and Profitability Index (PI).

The use of an appropriate type of research design ensured appropriate resolution of the research problem and at the same time help in improving effective level of marketing research. The designs applicable in financial researches always focus on three types of research design which include exploratory research, descriptive research and casual research 5 .

Exploratory research is applicable where general nature of the problem needs to be established. The alternative decisions need to be verified in consideration of relevant variables.

The research methods are characterised by high flexibility and unstructured means granting application of clues concerning the problem situation. Descriptive research involves the use of speculative hypothesis making the relationships not to appear casual and then finally casual research, which seeks to reveal the relationship existing between variables used within the study 6 .

The study involved the use of both descriptive and explanatory, whereby descriptive helped in identifying the value of capital budgeting within Saudi Arabia chamber. And on the other hand, an explanatory approach used to explain the contributions of capital budgeting towards development of corporations within the country.

The research problem can be solved using various methods such as induction and deduction. Inductive approach focuses on obtaining general conclusions from the observations obtained from empirical investigation. The deductive method, on the other hand, utilised the use of hypothesis and theories subject to testing within the empirical world. However, the more preferable way through this research was the use of abduction method. This method incorporates both empirical and theoretical measures.

The study discussed much on theories and frameworks based on capital budgeting framework used in the analysis of the various corporations within the chamber. The study also required to establish and identify capital budgeting intangibles which need the application of observations from empirical studies for the purposes of deducing some assumptions. Hence most of the study focused on abduction method 7 .

The following procedures were incorporated in the solution of the research problems involved. Secondary literature was obtained from books, journals, internet as well as electronic databases. This provided the required literature used in establishing a theoretical framework necessary for the study.

The empirical study involved the use of mail survey, where the survey was conducted amongst various corporations within the private and public sector through the use of detailed questionnaire. This was done in order to establish the various methods of restructuring and work design the chamber uses for international markets 8 .

It is widely accepted that the best way to evaluate capital budgeting proposals are the discounted cash flow methods. More recent studies suggest that firms are increasingly adopting discounted cash flow analysis, although this was not always the case in the past. Much of the empirical research on capital budgeting practices adopted by corporate managers are always drawn from US data research based on different countries is also done by other authors.

An appraisal in the application of the capital budgeting in the retail sector was undertaken in the Kingdom of Saudi Arabia as a basis for strategic capital budgeting for the purposes of developing this study. The focus of the study was to address the extent of use of capital budgeting in retail sector in the kingdom of Saudi Arabia in terms of using financial and accounting tools, sales forecast, external factors, benchmarking and feedback mechanism.

It also sought to establish the extent to which capital budgeting is applied in retail sector in the Kingdom of Saudi Arabia. This further established employee empowerment, negative effect of branch sales, comparison and application of standard budget for new companies within the SA chamber.

Random sampling was used to obtain data, where both private and public companies within Saudi Arabia were chosen at random for the mail survey. Then the statistical analysis was used to analyse and interpret data from questionnaires.

Empirical results

Capital budgeting of SA chamber presents one of the most important means of making decisions. Capital budgeting is necessary for the purposes of maximising shareholder wealth. The empirical results are presented, and the analysis is given based on the data obtained.

The study provided participants from the chamber with relevant techniques allowing them to tick various importances of capital budgeting techniques from the questionnaire given. The companies from both private and public sector that were sampled added up to 124; however, responses were received from only 60 representing 48% response rate. Good percentage of the questionnaires was answered by intended respondents from the chamber.

Table1: showing the response rate

Respondents were found to be learned since they had considerable academic qualifications. This indicated that they had valuable information concerning the area of study. The size of the capital budget was also identified from each respondent and tabulated as below. The companies within private and public sector differ in terms of size hence vary in annual capital budget.

There were also responses on the frequency of the use of the various budgeting methods. These include; net present value (NPV), profitability index (PI), Internal rate of return (IRR), modified internal rate of return (MIRR) as well as payback. The results were as follows 9 .

Table: Capital Budgeting Techniques

The results indicate that the techniques mostly used in evaluation of projects within Saudi Arabia Chamber are net present value and internal rate of return. This is clearly shown by 94% preferring the use of NPV, 90% of the companies use IRR in most occasions while 70% of the participants use payback period method. This reveals that NPV, payback period, IRR are the most preferred techniques with NPV and IRR forming the most popular methods.

Table showing number of techniques used by companies within chamber

The findings from the table revealed that most companies use multiple budgeting techniques in the process of evaluating their projects. The survey revealed that around 46% of the participants use less than three techniques while the rest utilize more than three techniques.

Table showing significance differences of importance between Capital Budgeting Techniques

The table above represents ranking of techniques based on their importance value attached by the companies. The ranking places NPV, IRR and Payback at the top of the table showing their level of importance. The results reveal some significant differences between participants based on the importance of the capital budget techniques. Most of the companies rank NPV as the most important technique used in evaluating projects.

The objectives of the study were eventually met despite the shortcomings encountered. The results revealed the various capital budgeting techniques and how they are utilized by various companies. This gives vital information to companies concerning the best financial strategies applicable within the current market environment.

Limitations and recommendations

There were various limitations to this study which included the sample group used in the survey which was only 60 companies within the Saudi Arabia Chamber. This means that more data is required so as to establish the exact trend from both lowly ranked and highly ranked companies in private and public sectors.

This would enable adequate understanding on the nature of capital budgeting technique used and the associated impacts on Saudi Arabia chamber. There was high possibility that local meanings of the techniques were lost during the translation process. There were instances where some companies could not allow their capital budgeting practice to be published for the fear of being miss-interpreted.

Based on the study’s findings, the following recommendations are proposed: the owners and management of retail family establishments should use these three elements in the preparation of capital budget; Financial statement or profit and loss statement, Cash flow and Balance sheet. They should also empower employees to help them prepare estimates of their cash flow in terms of sales forecast using data gathered from other reliable sources.

They should employ management tools such as the break-even analysis, payback analysis, net present value and internal rate of return. The organisation at the same time should consider external factors such as government regulations, price increases, stiff competition and customer’s needs. Multiple sales assumptions should be used along with a standard budget. Comparison of different projects within the organisation should also be done.

Adrian B, International Capital Budgeting , 3th edition, Simon, NY, 1996

Dayananda D, R Irons, J Herbohn & P Rowland, Financial appraisal of investment projects. Capital Budgeting . Pitt, New York, 2002

Gray SJ, SB Salter & LH Radebaugh, Global Accounting and Control: A Managerial Emphasis, John Wiley and Sons, London, 2001

Leedy, PD & JE Ormrod, Practical Research Planning and Design . 8th ed. Pearson Prentice-Hall, New Jersey, 2005

Modigliani, F &M Miller, “The Cost of Capital, Corporation Finance and the Theory of Investment”. American Economic American Economic Review , Vol 48 no3, 2003, pp 261–297

1 B Adrian, International Capital Budgeting , 3th edition, Simon, NY, 1996

2 SJ Gray et al, Global Accounting and Control: A Managerial Emphasis, John Wiley and Sons, London, 2001

3 D Dayananda et al, Financial appraisal of investment projects. Capital Budgeting . Pitt, New York, 2002

5 PD Leedy & JE Ormrod, Practical Research Planning and Design . 8th ed. Pearson Prentice-Hall, New Jersey, 2005

8 PD Leedy & JE Ormrod, Practical Research Planning and Design

9 F Modigliani, &M Miller, “The Cost of Capital, Corporation Finance and the Theory of Investment”, American Economic American Economic Review , Vol 48 no.3, 2003, pp 261–297

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IvyPanda. (2019, July 10). Capital Budgeting Techniques. https://ivypanda.com/essays/capital-budgeting-techniques/

"Capital Budgeting Techniques." IvyPanda , 10 July 2019, ivypanda.com/essays/capital-budgeting-techniques/.

IvyPanda . (2019) 'Capital Budgeting Techniques'. 10 July.

IvyPanda . 2019. "Capital Budgeting Techniques." July 10, 2019. https://ivypanda.com/essays/capital-budgeting-techniques/.

1. IvyPanda . "Capital Budgeting Techniques." July 10, 2019. https://ivypanda.com/essays/capital-budgeting-techniques/.

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Ithaca City School District budget, with high tax levy increase, rejected by voters

Ithaca taxpayers overwhelmingly rejected the Ithaca City School District’s budget plan for the 2024-2025 academic year at the polls Tuesday, forcing the district to resubmit a proposal.

The budget was rejected by 70% of the voters, 4,916 to 2,058, according to preliminary results from Tuesday's vote , and showed strong opposition to the district's plan to exceed New York's tax levy limit. The district's proposed 8.42% tax levy increase would have required a 60% supermajority vote.

The district now must resubmit its current proposal or create a revised proposed budget for a June 18 revote, options highlighted in an FAQ on the ICSD website . The district could also adopt a contingency budget. If voters reject the proposed budget a second time, the district would be forced to operate under a contingency budget.

The district's board of education did not immediately reply to a request for comment Wednesday.

According to the district, a contingency budget would have to levy the same amount of taxes as in the current year, which would equal a levy of $107,714,290, an increase of $1,276,141 or 0.8%. According to the district website, a contingency would "identify the expenditures deemed necessary to operate and maintain schools," and would include cuts to athletics, extracurricular activities, non-mandated transportation and more.

Taxpayers also voted to reject the appropriation and expenditure of Capital Reserve Funds, 3,830 votes to 2,980, and the district's proposed 2024 Capital Project also failed, 3,919 votes to 3,014.

Tuesday's vote also decided which three candidates will fill the school board’s open seats. The three leading candidates were Emily Workman, with 4,393 votes, Dr. Adam Krantweiss (3,953) and Todd Fox (2,805).

 For more information on the district’s ongoing budget process, visit its website, and click on budget FAQs or voter information .

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Proposed Granite Quarry budget holds tax rate steady, lays out capital project costs

Published 12:05 am Sunday, May 26, 2024

By Robert Sullivan

GRANITE QUARRY — Granite Quarry Acting Town Manager Jason Hord presented the final budget proposal to the town council during a specially-called meeting on Monday. The new budget proposes to keep the tax rate the same, a conclusion that is based on weeks of discussions among the council and the administration.

Granite Quarry currently sits at a tax rate of 44 cents per $100 of valuation, which is third-lowest among all municipalities in Rowan County, only being greater than Faith at 41 cents and Cleveland at $0.3936 (after calculating the fire rate). In his proposed budget, Hord outlined how the city compares to others in its peer group, which he included as Spencer at 55 cents, China Grove at 50 cents and Landis at 49 cents.

“As one can deduce, the result has often been stretching the workload capabilities of existing resources, the challenge to find or justify funding needed for more proactive goals, an increasing need to tap into fund balance for major (yet anticipated in municipal services) items and projects — if not simply postponing them from year to year,” wrote Hord in the accompanying town manager’s budget message.

The tax rate had been the subject of discussion through several budget workshops and town meetings in the past month. Hord had originally mentioned a tax increase as a possibility to help the town pay for capital projects that included a new fire truck, a new dump truck and park improvements.

“I’d love to see us accomplish everything in this budget without raising taxes,” said council member John Linker during a budget workshop meeting on April 20.

At that point the tax increase stood at a potential three cents, a rate that Hord said would have resulted in $123,525 in additional revenue for the town.

“Why raise the hackles of the whole town by increasing taxes for $125,000?” said council member Rich Luhrs during the April 20 meeting.

Hord’s budget that was presented keeps the tax rate at 44 cents per $100 of valuation.

The budget includes the purchase of a new dump truck for the Public Works Department as a one-time capital need, estimated within the budget as $92,000. Hord’s letter notes that staff performed due diligence to consider the purchase of a used truck, but that the higher mileage and usage that were included in available used trucks made that option not worthwhile.

The fire truck is included in the budget as debt service, as Hord has proposed to finance the estimated $1,075,700 purchase over five years, which would require $215,000 annual payments. The budget also includes funding for three full-time firefighter positions to help the department deal with reduced volunteer participation. The budget presented by Hord, who is also the town’s fire chief, states that the department and town hope to proactively maintain the ISO Class 1 rating.

The park improvements and improvements to the town square and downtown infrastructure are also included in the budget under the contingency and transfers section. Hord proposed that the budget for that be set at $856,621, of which $788,146 comes from American Rescue Plan Act funding.

The proposed budget also includes a four percent increase in the salaries for all town staff, which Hord wrote was a market adjustment to keep the town competitive in hiring. The town administration performed both an organizational culture and climate assessment and a study that compared Granite Quarry’s pay grades to comparable towns as part of a priority the town placed on retention, succession planning and recruitment, according to Hord’s accompanying letter.

After Hord presented the budget to the council, the members voted to set the public hearing for 6 p.m. on June 10. The hearing will be held during the council’s regularly schedule meeting at town hall, located at 143 N. Salisbury Ave.

The budget is available for viewing both at the town hall and on the town’s website, granitequarrync.gov, on the administration department’s page .

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Building apartments for sale becoming less viable as costs rise, pre-Budget papers show

Research suggests state unlikely ever to be more than minority provider of development capital for homes.

The Department of Finance calculates €13.6 billion is needed each year to build 33,000 units. An accompanying chart suggests a cost of more than €20 billion to deliver 50,000 homes. Photograph: Gareth Fuller/PA Wire

The viability of building apartments for sale to owner-occupiers has worsened in recent years as building and financing costs have grown, according to papers setting the scene for the National Economic Dialogue next week.

A paper on housing, written by Department of Finance officials before the annual pre-budget consultation and discussion forum in Dublin on Monday, highlighted that the cost of developing an average two-bed apartment is now €450,000-€550,000. However, the median price for existing apartments is €330,000 in Dublin and €265,000 nationally, it said.

The paper highlighted that the economics of the build-to-rent sector are different, as institutional investors can pay a premium as they look to make returns over an extended period, typically of about 25 years.

[  Two-thirds of developers say Government’s housing plan is not achievable  ]

However, it noted that commercial residential investment fell 75 per cent to below €500 million last year, as larger schemes in particular were affected by rising interest rates.

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The document also pointed out that the State can only remain a minor player in the funding of home delivery in Ireland, especially as the Government’s new target for 250,000 new units to be built by the end of the decade will cost more than €20 billion a year,

It said that that a total of about €5 billion was allocated by the State for home construction this year. This includes exchequer funding, investment by the Land Development Authority (LDA) and loans issued by the Housing Finance Agency (HFA).

“The Department of Finance estimates that annual development financing of €13.6 billion is required to produce 33,000 units. Should the national housing supply target increase, as expected, that funding requirement will grow,” it said. An accompanying chart pointed to a cost of more than €20 billion to deliver 50,000 homes.

[  The Irish Times view on the Housing Commission report: a call to action for policymakers  ]

“In other words, notwithstanding the significant increase in public funding, the scale of housing need means that the State is likely to only ever be a minority provider of development capital,” it said. “Accordingly, tens of billions of euro will need to be invested by the private sector over the coming decade.”

Elsewhere, the papers bring attention to analysis from the Departments of Finance and Enterprise, Trade and Employment, which estimates that the Irish labour market is “marginally more exposed” to the advent of artificial intelligence (AI) than the average advanced economy.

“Nevertheless, while many jobs may be exposed to AI, relatively few are at risk of disappearing completely,” it said. “Indeed, as a ‘digital frontrunner’ with Ireland’s comparative advantage in this sector, the AI rollout may create opportunities for the Irish economy.”

This year’s pre-budget forum – where Taoiseach Simon Harris will deliver the opening address – is focusing on challenges and opportunities for the Republic in a “more shock-prone world”.

[  Costs of social housing construction in Dublin are double those elsewhere  ]

The Government currently forecasts that modified domestic demand – a measure of the underlying Irish economy – is expected to grow by 1.9 per cent this year and accelerate to 2.3 per cent in 2025. It sees headline inflation falling back to 2.1 per cent this year from 5.2 per cent in 2023.

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‘The entire country went red’: Grant Cardone slams Biden's 44.6% capital gains tax proposal, pointing to consequences faced by ‘the last guy who tried it’

P resident Joe Biden's budget proposal for fiscal year 2025 includes significant changes to the capital gains tax. This is the tax on qualified dividends and profits from the sale of assets like stocks, bonds and real estate.

The president’s budget promises to “end one of the most unfair aspects of our tax system.”

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Besides restoring the top marginal income tax rate to 39.6% from the current 37%, Biden wants the country’s wealthiest to pay the same tax rate on their investment income as middle-class families pay on their wages.

For the highest earners — those with taxable income above $1 million and investment income above $400,000 — the long-term capital gains tax rate could reach 44.6% with a combination of proposals.

Real estate mogul Grant Cardone is not a fan of this agenda.

“Biden proposes 44.6% capital gains tax, from current 19%. Can’t even come up with his own ideas taking a page out of Trudeau playbook who raised Canada to 66%,” he wrote in a recent post on X .

Currently the highest long-term capital gains tax rate is 20%, and high-earning individuals may have to pay an additional 3.8% net investment income tax (NIIT).

Cardone also cautioned about the potential political ramifications of such a change.

“And he ignored how that played out for the last guy who tried it … the entire country went red,” he added, sharing an image displaying the 1980 presidential election results, where Ronald Reagan won in a landslide with 489 Electoral College votes compared to Jimmy Carter’s 49.

Copying Trudeau?

Cardone’s mention of Trudeau relates to recent developments in Canada, particularly Prime Minister Justin Trudeau’s 2024 federal budget proposal, which raises the capital gains inclusion rate from 50% to 66.67% for certain high earners.

Currently, only 50% of capital gains are subject to tax in Canada. However, effective June 25, Canadians earning over $250,000 in capital gains in a year will see 66.67% of that gain subject to taxation. Accounting firm Grant Thornton estimates that individuals in the top marginal tax bracket could experience an approximately 8% to 9% rise in capital gains taxes due to this change.

Biden’s plan is a bit different — but it’s also targeting high-income investors.

Read more: Jeff Bezos and Oprah Winfrey invest in this asset to keep their wealth safe — you may want to do the same in 2024

The figure Cardone shared on X is found in a footnote of a document called “General Explanations of the Administration’s Fiscal Year 2025 Revenue Proposals.”

Biden’s main proposal is to have long-term capital gains and qualified dividends of individuals with taxable income of over $1 million “be taxed at ordinary rates, with 37 percent generally being the highest rate (40.8 percent including the net investment income tax).”

The footnotes detail how this rate could be increased even further.

“A separate proposal would first raise the top ordinary rate to 39.6 percent (43.4 percent including the net investment income tax). An additional proposal would increase the net investment income tax rate by 1.2 percentage points above $400,000, bringing the marginal net investment income tax rate to 5 percent for investment income above the $400,000 threshold. Together, the proposals would increase the top marginal rate on long-term capital gains and qualified dividends to 44.6 percent,” it explains.

Carter vs. Reagan again?

Cardone’s reference to “the last guy who tried it” is also quite intriguing.

The last time the capital gains tax approached such a high level in the U.S. was in the late 1970s during President Carter's administration. However, while President Carter subsequently lost the 1980 presidential election, the outcome was likely influenced by multiple factors.

The election occurred during a time of economic challenges, including high inflation and unemployment rates, as well as the Iran hostage crisis. President Reagan's campaign focused on themes of economic revitalization, reduced government regulation, and a more assertive foreign policy, resonating with many voters.

Right now, the election between President Biden and former President Donald Trump still appears to be a tossup. In an April Marist National poll , respondents were asked to choose between Trump and Biden if the election were held today. The results showed that 48% of voters favored Trump, 51% chose Biden, and 1% remained undecided.

However, an Emerson College poll also conducted in April found that 46% of voters supported Trump, 43% supported Biden, and 12% were undecided.

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