# Capital Budgeting Decision Using Various Techniques

## Introduction

Project managers should carry out financial analyses on capital investments. This is necessary because capital investments require a large amount of initial capital outlay. Secondly, the benefits from such investments flow in for a long period. Thirdly, capital investment decisions in most cases deal with an organization’s optimal capital structure that is, in terms of sourcing for funds either of debt and equity (Brigham and Ehrhardt 2010). Therefore, analysis of the project should be done before sourcing funds. Therefore, these projects are irreversible. Finally, capital is a limited resource. Organizations and even nations lack adequate resources to invest in all projects. Therefore, it is necessary to appraise all feasible projects. Resources should be dedicated to ventures with high returns.

## Necessary information

Capital budgeting is a multi-dimensional process with distinctive stages. A commonly used model comprises strategic planning, making accept or reject decisions, project implementation and monitoring, and project implementation audit (Dayananda, Irons, Harrison, Herbohn, & Rowland 2002). The essence of this procedure is to ensure that a project manager selects a viable project for investment. This treatise looks at the viability of the proposed venture using various capital budgeting techniques. It also calculates the weighted cost of capital of the company.

## The weighted average cost of capital

Adding up together the various sources of capital estimates the weighted average cost of capital. This requires a decision to be taken on the appropriate amount of debt and capital to be included in the capital structure. This determines the value each adds to the capital structure (Shapiro, 2005).

Table 1.0: Weighted average cost of capital

 Source of fund Percentage of capital Rate of return Computations 1 Stock 60% 14% 0.6*0.14 = 0.084 8.4% 2 Bonds 40% 6% 0.4*0.06*(1-0.34) = 0.01584 1.58% Weighted average cost of capital 9.98%

## Capital Budgeting techniques

### Net present value

Net present value is the “present value of a project’s cash inflow minus the present value of its costs” (From the computations above, the weighted average of capital for the company is 9.98%. The weighted average cost of capital highly depends on the capital structure of the company. The management needs to decide on the favorable mix of various sources of capital these are, debt and equity (Brigham & Ehrhardt, 2010). This approach shows how much a project contributes to the shareholders’ fund. High returns will result in an increase in share prices. An advantage of the net present value is that it is easy to compute.. A drawback of this approach is that it is sensitive to changes in the discount rate. The selection criterion will be the amount of the net present value. A project with a positive net present value will be viable.

Table 1.1 Net present values

 Year Cost Benefits Costs Tax at 0.34 Net cash flow Discount rate at 10% Net present value (\$) (\$) (\$) (\$) (\$) (\$) 0 3,000,000 0 -3,000,000 1 -3,000,000 1 0 2,000,000 800,000 204,000 996,000 0.90909 905,455 2 0 2,000,000 800,000 204,000 996,000 0.82645 823,140 3 0 2,000,000 800,000 204,000 996,000 0.75131 748,310 4 0 2,000,000 800,000 204,000 996,000 0.68301 680,281 5 0 2,000,000 800,000 204,000 996,000 0.62092 618,438 Total 3,000,000 10,000,000 4,000,000 1,020,000 1,980,000 775,623.62

The above table shows the computation of net present value. Depreciation is used to compute the annual tax expense. Secondly, the computations require only the incremental cash flows over the five-year period. From the computations above, the net present value of the proposed venture is \$775, 623.62. Since its positive, it indicates that the project is viable.

### Payback period

Payback period is “the number of years required to recover a project cost” (Brigham & Ehrhardt 2010). This approach has a number of drawbacks. First, “it ignores cash flows beyond the payback period, it does not consider the time value of money and it does not have a precise acceptance rule” (Brigham & Ehrhardt 2010). The decision criterion is to accept a project with a shorter payback period.

### Computation of payback period

Initial investment outlay                        \$3,000,000

Annual cash flow                                       \$204,000

Therefore, the payback period is 3,000,000/996,000 = 3.01years

From the computations above, the project has a payback period of 3.01years. This implies that the project will take 3.01years to recoup the initial investment cost.

## Internal rate of return

Internal rate of return is a unique discount rate which when applied to both cash inflows and cash outflows over the investments economic life provides a zero net present value (Powell and Baker, 2005).

Table 1.2: Internal rate of return

 Years Amount of annual cash flow Present value at 10% discount rate Annual net cash flows 1-5 996,000 3,775,624 Initial capital outlay 0 (3,000,000) (3,000,000) 775,624

Internal rate of return = 10% + 775,624 = 35.85%

3,000,000

## Conclusion

From the above analysis, the net present value of the project is \$775, 623.62 and the payback period is 3.01 years. The project has a high internal rate of return of 35.85%. It is clear that the project is viable and shareholders will get a high return from their investments.

## Appendix

### Appendix 1: Computation of tax expense

 Year Cost Benefits Costs Net income Depreciation Net income after dep Tax at 0.34 (\$) (\$) (\$) (\$) 0 3,000,000 0 1 0 2,000,000 800,000 1,200,000 600,000 600,000 204,000 2 0 2,000,000 800,000 1,200,000 600,000 600,000 204,000 3 0 2,000,000 800,000 1,200,000 600,000 600,000 204,000 4 0 2,000,000 800,000 1,200,000 600,000 600,000 204,000 5 0 2,000,000 800,000 1,200,000 600,000 600,000 204,000 Total 3,000,000 10,000,000 4,000,000 6,000,000 3,000,000 3,000,000 1,020,000

## References

Brigham, F. & Ehrhardt, M. (2010). Financial management theory and practice. United States of America: Joe Sabatino.

Dayananda, D., Irons, R., Harrison, S., Herbohn, J., & Rowland, P. (2002). Capital budgeting: Financial appraisal of investment projects. United Kingdom: The Press Syndicate of the University of Cambridge.

Powell, G. & Baker, H. (2005). Understanding Financial Management: A Practical Guide. Australia: Blackwell Publishing.

Shapiro, C. (2005). Capital budgeting and investment analysis. USA: Pearson/Prentice Hall.

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BusinessEssay. (2022) 'Capital Budgeting Decision Using Various Techniques'. 27 November.

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