The Essay On Capital Budgeting Techniques And Importance.

The most common approaches used in capital budgeting

Capital budgeting is a process which is used for evaluating investment or projects. This method is used for taking decisions about long term investment of capital of company (Kengatharan 2016). Capital budgeting method is considered to be very important as it creates measurability and accountability. With the help of capital budgeting techniques, a project is chosen that adds value to the company. Therefore, capital budgeting is a process which helps the investors in determining the value of investment project (Sarwary 2019).

The most common approaches used in capital budgeting are payback period, accounting rate of return and net present value.

Payback period: This method is used for ascertaining the time period taken by the project to recover the potential investment. It denotes the time taken to reach the break-even point. The payback period of the project is calculated by considering annual cash flows and initial investment (Gorshkov et al. 2018). When the payback period is shorter, then it is suggested to undertake the project as it indicates the hat initial investment will be recovered within a short span of time and when the payback period is longer, then it is recommended to reject the project. This method is used by managers for determining whether to proceed with investment or not (Gorshkov, Murgul and Oliynyk 2016). This method is used for ascertaining investment returns by financial professionals and investors. In this method time value of money is not taken into consideration.

Accounting rate of return: This method is used for ascertaining return from investment and for making capital budgeting decisions. In other words, this method helps in determining annual percentage rate of return of project (Accounting rate of return 2022). The formula for ascertaining ARR is to divide average annual and average investment. When ARR of project is more than cost of capital then it is recommended to accept the project as it indicates that investment is attractive and profit has been generated from project whereas when ARR is negative or lesser than cost of capital it is suggested not to accept the investment as it will not generate any profit.  Hence, ARR is the minimum rate of return that is accepted by an investor for project that compensates for given level of risk (Bragg and Bragg 2022). This method provides clear profitability. In this method time value of money is not taken into consideration and at the same time cash flows are also not taken into consideration.

Net present value method: This method is used for ascertaining present value of future cash flows that are generated by the project. Simply this method helps in determining whether investment in project will generate profit in future or not that is whether the project will be profitable (Gallo 2014). The formula used for ascertaining the net present value of the project is the present value of cash inflows – the present value of cash outflows. When the net present value of the project is positive then it is suggested to undertake the project as it indicates the hat project will generate in the future period of time and when it is negative it is suggested to reject the project. This method is mostly preferred as the time value of money is taken into consideration (Benamraoui et al. 2016).

Payback period

Based on above calculation of payback period it has been seen that payback period of project is 3.756 years which means that time period is shorter. As discussed above shorter payback period indicates attractive investment hence, the project should be accepted as initial investment will be recovered within a time span of 4 years approx. Based on calculation of ARR it has been seen that ARR of project is 3.1% which is lower than cost of capital. Hence, it indicates that project is expected to earn 3 cents out of each pound invested. Based on calculation it has been seen that NPV of project is £29,677.93 which means that it is positive. Hence, as the NPV of project is positive it means that project will generate profit in future and the project should be accepted. This also indicates an attractive investment. Therefore, based on analysis it can be said that the investment in this project is viable and loaded pies should accept the project and proceed with it.

Along with the financial factors, loaded pies should also consider some non-financial factors before going ahead with the project. The non-financial factors that should be taken into consideration are: strategic factors: companies generally prefer the projects that gives focus on strategic viewpoints. When the project is long-term in nature the focus is given on reducing the weakness rather than maximizing the profit whereas when the project is short-term in nature the primary focus is given on earning net income. Technological factors: For remaining in the industry, technological factors are common to every industrial establishment as it results in the reduction of input consumption, enhancement of quality of product, reduction of cost of production, etc. Obsolescence, meeting with unskilled employees, etc results in technological risk (Ainin et al. 2015). Hence, before going ahead with the project it is very important to look at both financial as well as non-financial factors so that investment can be viable and profitable in the future.

Accounting rate of return

The two external sources of finance for the project are:

Equity share capital: For raising finance shares are issued by limited companies and value of shares are disclosed in the balance sheet of the company. For big companies equity shares are considered as common source of finance and it cannot be used by every business as it is governed by many legislations. Share of ownership rights is considered as key feature of equity share and as result rights of current shareholders are diluted to some extent. Financing through equity share capital is considered to be costly as compared to debt financing as the return offered to shareholders in the form of dividends or bonuses is not tax-deductible (Paramasivan and Subramanian 2020). Raising finances through equity share capital is not easy as it requires many legal formalities

Debenture: Companies who prefer debt over equity use another means of finance which is debenture. Financing through debenture is considered to be less costly as compared to equity share capital and it does not share control with investors as payments made to debenture holders are tax-deductible (UDEH 2015). The rest of the process of issue of debenture is the same as the equity issue. It is generally issued to the common public and in this source of finance, necessary obligations need to be complied with. Some cost is involved in issuing debentures and at the same time, they are also collateralized by some assets.

Among both the method of financing, it is generally better to use debenture as compared to equity financing as financing with equity denotes giving awa the equity in the business. Giving of equity means giving all or some control of the company and at the same investors also get involved in the decision making which makes future decision-making complicated. Debt financing is better as taking debt does not provide an ownership stake and also does not lead to the dilution of equity position of owners in business and at the same time it is less expensive source of growth capital when the company is growing at a higher rate. Hence, it is preferred and better to use debenture while financing a project.