Historically the role of accountants remained limited to clerical work where they were meant to manage day-to-day accounting matters and record keeping. When the economic horizons expanded and firms stretched out operations beyond the boundaries of their homeland and prolonged their investments in long-term projects and ventures wrapping over many years the role of typical accountants became worthless and new approaches emerged in the field of accounting and finance. Though great many developments were made and new techniques were adopted in the reporting mechanism for the limited financial period typically one year or less but they were not acquainted with the feasibilities, financial viabilities and assessing economic benefits from long lasting undertakings. To cope with the dearth of this matter a very comprehensive technique has been materialized in the community of financial managers called capital budgeting.
Capital budgeting or investment appraisal as the name suggests concerns with the capital investments where the financial feasibility of a long-term project is determined. Capital budgeting is quite a profound subject and forms part of financial curriculum and financial management all over the world.
Investment appraisal is fundamental to an understanding of financial management. It involves the process of planning for decision on capital expenditures based on the concept of wealth maximization for shareholders. This process requires:
• Ability to rank investment projects in a meaningful order of profitability
• Ability to provide a cut off point beyond which no further investment is worthwhile
• Consistency with corporate objectives
In effectively managed firms this is a fundamental requirement that decisions should be based on knowledge and efficiency. Countless decisions of capital nature have to be taken by the management such as replacement of worn and obsolete machinery, acquire fixed assets, and appraise strategic investment proposals. Capital budgeting decisions are of two types:
Expansion of Revenue
Decisions taken for the sake of expanding operations with the intentions to enhance revenues of the firm. Usually the firms purchase new assets, expand operations, and invest in new projects to increase the revenue base. The additional revenues are compared with additional costs and are evaluated using the capital budgeting techniques.
Reduction in Costs
Some times the firms have to face the dilemma of increasing cost of production. To curtail the cost the firms have to take decisions to replace the old plant and machinery. They must decide whether to continue with the existing assets or to replace them to reduce costs. The benefits from new assets are evaluated through the extensive use of capital budgeting techniques.
The above-mentioned two types of decisions are fundamentally different as for as the level of uncertainty is concerned. Cost reduction decisions are less uncertain as compared to the revenue enhancing decisions because in cost reduction decisions a quite reliable past data is available to compare with the future benefits. On the other hand in revenue enhancing decisions future revenues are compared with future costs that increase the level of uncertainty to a great extent.
Relevant Cash Flows
It has already been mentioned that capital budgeting decisions depend upon future cash flows rather future profits that include non-cash expenditures and incomes. To determine the relevant cash flows high level of professional skills are mandatory required to judge the relevant or irrelevant cash or non-cash expenditures. Relevant cash flows are of two types i.e. cash outflows and cash inflows.
There are two broad categories of techniques in capital budgeting i.e. traditional and time-adjusted. The later are more popular and are commonly known as discounted cash flow techniques. The first category include average rate of return method and pay back period. The second category include the following:
• Net Present Value
• Internal Rate of Return
• Profitability Index
Average Rate of Return
It is based on accounting information rather than cash flows. The formula is :
ARR = (Ave. annual profit after tax / avg. investment over the life of project) x 100
It is most widely use technique, which evaluates the capital investment project over the period or number of years required for cash benefits to recover the initial capital investment. Pay back period is calculated from following formula:
PBP = Investment / Constant annual cash flow
Net Present Value
The most reliable and comprehensive tool for the capital investment appraisals. It discounts the annual net relevant annual cash flows to the present value and compared to the initial investment outlay.
Internal Rate of Return
Another important and extensively used technique for capital investment decisions in capital budgeting is Internal rate of return. IRR is the discount rate that equates the present value of the expected cash inflows to the present value of expected cash outflows. If IRR is above the required rate of return the project is accepted otherwise it is rejected.
The profitability index measure the benefit of the return per dollar invested. This method is also called benefit and cost ration analysis. Symbolically,
PI = Present value cash inflows / Present value of cash outflows
If resultant figure is more than one the project is acceptable otherwise should be rejected.