Why is Capital Budgeting Important?

What is capital budgeting?

An organization always faces the challenge of selecting between several projects to invest in. As much as the decision makers would like to pick all profitable projects, due to limited capital the organization has to choose only some of them.

Just like organizations, individuals also choose what to invest in. That’s why capital budgeting affects our daily lives.

How capital budgeting works

The main goal of capital budgeting is to determine whether a project will bring profit to a company or not. There are various methods, including the payback period (PB), internal rate of return (IRR), and net present value (NPV) methods — the most common ones. Additionally, some organizations calculate the profitability index, real options analysis, and equivalent annuity.

In an ideal situation all these methods will point to the same result, but in reality results vary. Depending on management’s preferences and selection criteria, more emphasis will be put on one approach over another. Still, these widely used valuation methods are associated with some common advantages and disadvantages.

Common steps in the capital budgeting process

1. Identify and evaluate potential opportunities

Any company has several investment opportunities to consider. For example, a company that produces a product should choose whether to deliver its product to customers by ship, plane, or train. Each option must be evaluated to see what makes the most financial and logistical sense. Once the most feasible opportunity is identified, a company should determine the right time to pursue it, keeping in mind factors like business need and upfront costs.

2. Estimate operating and implementation costs

The next step is to define the cost of the project. This process requires both internal and external research. If a company is developing a transportation option, it should compare the cost of transporting their goods themselves to transportation by another company. After it chooses the cheapest method, a company might make another round of calculations to further pare down the cost of implementing whichever option it has chosen.

3. Estimate cash flow or benefit

The next step is to determine how much revenue a new project is able to generate.

The first option is to check the data about similar successful projects. In case the project does not generate the money itself, the company should calculate the amount of money this project might save, and decide if it is worth pursuing.

4. Assess risk

The company needs to estimate the risks associated with the prospective project. The execs must consider the possibility of losing all the money if the project fails, and compare that amount with the potential revenue. The project’s failure should not impact the whole process of the company’s workflow.

5. Implement

If a company decides to invest in a project, a plan must be created. It consists of payment methods, a cost tracing method, and a process for recording the cash flows or benefits generated by the project. A plan should also include the project’s timeline, with a deadline.

Major methods

Payback period

The payback period is the time it takes to pay off the initial investment.

Companies usually use the payback period method when liquidity is a serious problem. If a company has limited funds, it can only deal with one major project at a time. Management will pay great attention to recovering its initial investment for subsequent projects.

There are several limitations to using the PB method

First, the payback period does not take into account the time value of money (TVM).

Another disadvantage is that cash flows that arise at the end of a project’s life cycle, such as residual value, are excluded from payback periods and discounted payback periods methods. Thus, PB is not a direct indicator of profitability.

Internal rate of return

Internal rate of return (IRR) is a method of discounting cash flow that provides the analyst with the project’s rate of return. The internal rate of return is the discount rate at which the sum of the original cash costs and the discounted cash receipts is zero. In other words, it is the discount rate at which the net present value (NPV) is zero.

If different projects have the same costs, a company will select the project with the highest IRR. When an organization needs to choose between several projects with the same value, then these projects will be ranked by the IRR measurement and the most profitable one will be selected. Ideally, a company will select an IRR with a higher cost than the cost of capital.

Net present value

Net present value is calculated as the difference between the present value of cash inflows and the present value of cash outflows over a period of time. Companies usually consider only investments with a positive NPV. In the case of several similar projects, the project with a higher NPV will be selected.

The NPV is greatly affected by the discount rate. Selecting the proper rate is critical to making the right decision. This should reflect the riskiness of the investment, typically measured by the volatility of cash flows, and must take into account the financing mix. A common practice in choosing a discount rate for a project is to apply a WACC that applies to the entire firm, but a higher discount rate may be more appropriate when a project’s risk is higher than the firm’s risk as a whole.

Profitability investment index

The profitability investment index (PI), also known as the return on investment ratio (PIR) and value on investment ratio (VIR), is the ratio of the return to the prospective investment in the proposed project. It quantifies the amount of value created per unit of investment.

Equivalent annuity

The equivalent annuity method expresses the NPV as an annualized cash flow by dividing it by the present value of the annuity factor. It is often used when comparing investment projects of unequal lifespans. For example, if project A has an expected lifetime of seven years, and project B has an expected lifetime of 11 years, it would be improper to simply compare the net present values (NPVs) of the two projects unless the projects could not be repeated.

Summary

Trading forex can be seen as an investment project, where the trader is a big company with a goal of making its inflows greater than its outflows.

Deliberate trading with a well-developed strategy is the key to long-term profit in forex. No matter which method is being used—copy-trading, trading bots, or self-trading—every trader must practice capital risk management.