So, imagine as a CFO of a company, you had to decide between three options; Invest in a new product, increase the capacity of production or acquire a company. How would you decide which one to choose? That’s exactly, the nature of capital budgeting. In this article we shall discuss the above point and also the limitations of capital budgeting.
Let me take you through the nature of capital budgeting and also the limitations of capital budgeting using simple examples. I mean, what better way then understanding this, than using examples.
Nature of capital Budgeting: Examples
Example 1: Payback Period
So, there is a company which has invested INR 100 Cr, in a phased manner across three years.Now, you are expecting as a CFO, to get cashflows(FCFF), in the following manner
- Year 1-3 , investments for 50, 25, & 25 respectively.
- Year 4-7, cashflows of 25,50,75,120 Cr.
What would be the pay back period. Which in other words is also asking, when do you recover the investments of 100 cr.
Solution:
Hence, here when the question of recovering the initial investment arrives.Which also means that the nature of capital budgeting is in answering the time related question.
So, notice that the cumulative cashflow goes from -25 to 50 between year 5 & 6. Which also means, that the payback period is somewhere between 5 and 6th year.So, how do you calculate the exact time period? Its very simple;
All you need to do is calculate 5th year + ( Cashflow to be recovered/ Cashflow in 6th year) x 12 months. Which is 5 years+(25/50)*12, or 5.5 Years to be precise.
Example 2: Net Present Value
Now, let me discuss another nature of capital budgeting which is the net present value. So, the right question which portrays this concept, is the following question. What would be the present value of all the future cash flows that you generated, minus the investment that you have done.
Now, consider the same example above; but the question now is how much profit you generated in present value terms. However, if you know or remember, the present value formula; which is PV= Future value/(1+r)^n. So we know the future cashflows, however what about the r? r is nothing but the discount rate, which is the opportunity cost. In other words, how much return in percentage would you generate elsewhere, if you don’t invest here. Let’s say that number is 12%.
Solution: Net Present value
So, before you check the calculation below, understand what you need to do. Which is you have to bring all the cashflows, irrespective of whether it is investment or returns to today. Which is nothing but present, the present is always 0.
So you can conclude that at the net level, by executing this project we would end up with 54.2 INR Cr.
Example 3: Nature of capital Budgeting
Now, let me discuss the last example in the context of capital budgeting, which is IRR( Internal rate of return). Again, let me put this in the business context. For eg; if I ask you by investing in the above case, how much return in percentage did you generate on an average year on year compounding? Then the answer you would find out would be called as internal return of return. Another important metric in the nature of capital budgeting.
Solution: Internal Rate of Return
So, the way to understand IRR, is to get this logic. Which is, in the present value formula PV= FV/(1+r)^n. What value of r, would make the net present value =0?. Confusing?
Alright, so let me explain why you want to find that kind of rate.
- Firstly, when we first found the net present value at a rate of 12%, we found the excess return we made.
- Which, means that the return is above 12%, else the NPV would be negative.
- However, the actual level of compounding of cashflows, must be the rate which would leave 0 net present value.
You get that? IRR is the average rate at which the cashflows are compounding, making the net present value zero. Which means it’s an approximation and that is also an important point for the nature of capital budgeting.
Example 4: Accounting Rate of Return
So, accounting rate of return as opposed to internal rate of return, is metric to calculate the ROI year on year. Which is very different compared to IRR.
- IRR measures the average compounding of cashflows.
- Whereas, account rate of return calculates average profit generated over the investment.
Solution
For example; in the above case the accounting rate of return would be as follows; Here you basically take the revenue and reduce any depreciation expense from the revenue. Which you divide it by the initial investment of 100 Cr.
Limitations of Capital Budgeting
So, I know it sounds fancy to do the above calculations, but for a second the assumptions above.Which should point you to think, that it’s hardly an exact science. Let me summarise the limitations of capital budgeting below
Discount Rate
So, one of the biggest limitation of capital budgeting is the discount rate i.e the rate. Whenever, you calculate net present value or internal rate of return, the number is an approximation. Another issue with discount rate, is that it is not an available rate like interest rate or government bond yield. Contrary to this, the rate has a severe disadvantage for the following reasons;
- Firstly, even if I say my existing investments are earning 15%, the next question is can I keep adding capital to earn 15%.
- Secondly, is the risk of my existing investments earning 15%, similar to this new project. Because it turns out its quite possible that the new investment is more risky.
- Thirdly, changing the discount rate even by 1%, has a significant effect on NPV.
Cashflows
So, ultimately your capital budgeting decisions are actually based on your forecasts. Which can never be called as accurate. Either you over forecast or you under forecast, which can make the important metrics swing from positive to negative. Hence, just like any other limitations, cash flows occupy a significant place in the limitations of capital budgeting.
Implicit Assumption of Reinvestment
Another significant limitation of capital budgeting decision making is with metrics like IRR.Which implicitly assume that all the cashflows are getting reinvested at the IRR Rate itself. However, there are ways to counter that by using alternative methods like MIRR(Modified Internal rate of return). But even then the reinvestment rate and amount of reinvestment is again an assumption.
Non Numeric Factors
So, the success and failure of a project or investment, can be as a result of factors which are not financial. For example; regulatory changes, changes in interest rates, pandemics or even industry level changes. So, let’s suppose you started a lithium battery manufacturing unit, however by the time you started selling your batteries. The industry evolved into newer alternatives, leaving your capital budgeting decisions biting the dust. Hence this is the nature of capital budgeting at the same time the limitation of capital budgeting.
Conclusion
So, in conclusion of the nature of capital budgeting and the limitations of it. I hope I was able to shed some context for your understand. However, it also brings me to the question that even with such limitations, is it worth not planning itself? I’ll leave that question for you to decide and reflect.