Capital budgeting and its importance for investors

General people do not know that management accounting provides a very scientific technique which is very useful to select best investment projects. All people save some money for their rainy days. They are also interested to invest it in different schemes for increasing its principal amount. But due to ignorance of capital budgeting, they invest their money in risky and unprofitable projects and after these they lost all other good opportunity due to shortage of money source. Before clearing the concept of capital budgeting, I take a very simple example.


Mr. Sham is working as Engineer in XYZ Company and Earns Rs. 40000 per month and after some time; he saved Rs. 10, 00,000. Now he wants to invest it.

Saving and investment is two different things. Saving means save the money in your pocket or saving account at 3.5% annual interest but investment means to provide money to big corporate public and private companies for getting shares , debentures, mutual funds, public deposits and purchasing of machines for production . All these projects can give you high profit but also risk of loss of money also involves in these projects. Capital budgeting helps you to choose best investment project out of different choices with high profit at minimum risk. If you do not know the techniques of Capital budgeting, please consult Chartered Accountant or Financial Management (At least MBA finance qualified professionals) before investment of you high savings in any project. Basic Capital budgeting knowledge, you can also get from this article. In simple words, capital budgeting is a technique in which; investor compares profitability with the cost of projects. For this evaluation he can use traditional and time adjusted or discounted cash flow methods. After evaluation of various proposals, final approval for project is given. I also explain both methods of capital budgeting.

Tradition method

Under tradition method, Investor calculates pay back period of investment. Investor accepts that project whose pay back period is less than other project.

For example: - There are two project X and Y . Each project requires and investment or $ 20000. You are required to rank these projects according to the pay back period method from the following information: (pay back means estimated net profit from investment)

Project X
Estimated Net Profit from project X 1st year = $ 1000, 2nd year = $ 2000, 3rd year = $ 4000, 4th year = $ 5000 and 5th year = $ 8000

Project Y
Estimated net profit from project Y 1st year = $ 2000, 2nd year = $ 4000, 3rd year = $ 6000 , 4th year = $ 8000 and 5th year = Nil

Solution:

Project X

First of all we have to calculate annual net profit from project:-
= Total net profit from X project / no. of years = 20000 / 5 = $ 4000
Now The pay back period for project X
= total cost of project / Annual net profit from project
= $ 20000 / $ 4000 = 5 years

Project y

First of all we have to calculate annual net profit from project:-
= Total net profit from X project / no. of years = 20000 / 4 = $ 5000
Now The pay back period for project y
= total cost of project / Annual net profit from project
= $ 20000 / $ 5000 = 4 years
We should give project Y as first rank because , investor gets his cost of project with in 4 years which is less than project X’s pay back period , because that investment proposal is best which gives use recover our invested money in the short period .

Time adjusted or discounted Cash flow method

Net present Value method:

If you operate ms excel or Google docs in your daily life, then you have seen functions/formula of Financial with NPV. Its full name is net present value method. From my personal experience, most of all professional accountants use this method for selecting best investment proposal out of several investment schemes. Net present value technique is based on assumption, that today earned one rupees’ value is more than tomorrow one rupees earning. Under this method, we calculated present value of cash out flow (present value of cost of investment) and deduct it from the present value of cash inflow (present value of all future net profit). After this what we receive will be the net present value of any project. We must select that proposal of investment whose net present value is more than other project. Present value is calculated on the basis of discount rate which is available in market; it may 8% to 20 % on the nature of investment. If you do not use ms excel or Google docs, you have to find the present value from present value tables, it is just like log tables which is available on book shop.
For example from the following information calculate the net present value of the two projects and suggest which of the two projects should be accepted assuming , i discount rate is 10 %

formula of calculating NPV of investment projects

= Present value of Cash inflows - Present value of Cash out flows

or = PV of net profits - PV of total cost of investment

Suppose, there are two projects X an Y
Project X
Initial investment
$ 20000
Estimated life
5 years
Scrap value
$ 1000
The profit before depreciation and after taxes ( cash flows in $ ) as follows :-
1st year 5000 , 2nd year 10000 , 3rd year 10000 , 4th year 3000 and 5th year $ 2000
Project Y
Initial investment
$ 30000
Estimated life
5 years
Scrap value
$ 2000
The profit before depreciation and after taxes ( cash flows in $ ) as follows :-
1st year 20000 , 2nd year 10000 , 3rd year 5000 , 4th year 3000 and 5th year $ 2000

I have solve this problem with using NPV formula in ms excel and upload it in Google docs