Technique of Capital Budgeting - Return on Investment

Capital budgeting as you know related to investment  in fixed assets. Working capital can be another type. You can say assets which fixed written in balance sheet as long term assets. Anther thing you can say is working capital which is net position of current assets also current liabilities on balance sheet.

Why we do investment in capital budgeting & fixed assets is so important?. Simple as that; Machinery, Fixed assets &  machinery either their price will less for sale after some period of they are useless. May be you destroy them or reject them after some time of period. Obsolete material can't be sale in good price. So they needs replacement it must needs price too.

If an organization or any company wants to start project or a new project. What will assess them capital budgeting will be used here and the techniques of capital budgeting help them. Lets suppose any company who wants to launch a new product (a soap), which demands to change manufacturing style or process.

The company must need new machinery which will called fixed assets. So capital budgeting techniques will be used and will help the company to evaluate the value to investment and fixed assets. Also it will assess in working capital requirement and management to check whether it will worked or not.

It's decentralized function. Corporations choose separate teams and departments to fulfill capital budgeting work.They manage and prepare the fixed assets budget for upcoming year or trend. Project managers are also assigned who mange budgets for newly projects; the cost accountants ‘count the cost’ and assess the expenses to be incurred. Research about the market helps the consumer psychology and sales potential. There may be too many departments who can accomplish this work.

Challenges of capital budgeting includes, to find out valuable projects. If any project added in your firm or started in your firm, You must have know how of this project at management level. Which leads you to maximize your shareholders wealth. So you must invest in valuable projects which have net value and which can attract shareholders. e.g construction in some countries.

Developed companies which worked in efficient market environments. After reading financial decisions and concept of risk you will know markets at length. For your idea, In efficient market perfect business ideas taken up immediately and competitions are too much. Which is called efficient marketing strategy.

Example is about video game craze in Pakistan & India so People made Gaming zones. Then margin and profit becomes double. Many people starts business and then value of video gaming zones falls as a results profit decreases. People shutting down their gaming zone for no profits after 2 to 3 years.

Same things happens to bigger firms they start business which look more feasible that time. Then competitors arises then those profit creator business do not remain any more.

Techniques of capital budgeting:

Capital budgeting is a mathematical concept in the sense that we have to use different quantitative investments criteria to evaluate whether an opportunity is worth investing in or not.

Some of these techniques of capital budgeting are as under

1. Pay back period
2. Return on investment (ROI)
3. Net Present Value (NPV)
4. Profitability Index (PI)
5. Internal Rate of Return (IRR)

We will assume that the interest rate, or the discount rate, or the required of return, which we use in
calculating the net present value is given, later on, when we will discuss the concept of risk, we  would see how the discount rate is calculated .

Pay back period:
In this technique, we try to figure out how long it would take to recover the invested capital through positive cash flows of the business.

Take example of cafe where you invest 200,000 and you expect 10,000 per month first year. Then you expect 20,000 per month after a year.

Now according to your estimate you will get 120,000 in the first year. Now you need 80,000 more to full fill your investment. After a year you will get 20,000 so you will get 80,000 in 4 months. You can say you recovered investment in initial 16 months. So you will learn here that the shorter period you get investment back more investors like to invest their money in your project.

Return on Investments:
It is loosely defined, because there are too many number of ratios to analyze it. However, in capital budgeting it implies the annual average cash  flow a business is making as a percentage of investment. or it is percentage earn in any investment per year.
The formula for return on investment is as follows:

ROI= (ΣCF/n)/IO

Dividing the average annual cash flow by the initial investment, we can calculate the return on
investment.
Example:

Taking the example of a cafe, the initial investment of Rs.200,000, Rs 10,000 per month profit in the 1st year in Rs 20,000 per month profit for the second year, we can easily  calculate the ROI.

ROI= ((120,000+240,000)/2)/200,000= 0.90 = 90%

Where, Rs 120,000=cash flow for 1st year at Rs 10,000 per month

Rs 240,000=cash flow for the 2nd year at Rs 20,000 per month.

n=2 years

A high ROI ratio is considered better and 90% is a very good rate of return but before deciding whether or not this project should be taken up, we should compare this project with the alternative opportunities on hand. It is also important to take into consideration the prevailing rate of inflation in the country so that the returns could be adjusted accordingly.