Introduction
Capital budgeting is a technique used in finance for the purpose of evaluating the project’s financial viability. Since a huge amount of capital is involved in the long term investment options, thus, it becomes essential to assess the profitability and financial viability. Capital budget accounting requires thorough understanding of the concept with a background of MBA finance or Accounting degree. Capital budgeting involves discounting of the future cash flows expected to realize from the proposed investment by using opportunity cost of the firm. The application of capital budgeting involves uncertainty as regards accrual of the cash flows and opportunity cost.
Aspects of Capital Budgeting
Figure 1: Capital Budgeting Techniques
Cash Flows:
The cash flow involves both the inflows as well as the outflows of cash relating to an investment option. The outflow of cash occurs in the form of initial investment and annual cash expenditure for maintaining for investment facilities. The Inflow of cash occurs, generally on an annual basis in the form of cash profits earned by the firm from the investments. You would also be required to calculate cash flows, if you are involved into mergers and acquitions for your clients. It forms a crucial decision making criteria to sell, buy or merge your venture.
Maturity Period:
Maturity period is the time frame over which the project, in which investments are to be made, will run. The cash inflows and outflows pertaining to a project occur over the period of maturity.
Discount Rate:
The Discount rate is the rate at which the cash flows of a project are discounted to their present value. The cash flows occur over the period of maturity, thus, for the purpose of comparison, it is necessary to bring the value of those cash flows equal to their present value.
Debt and Equity:
The debt and equity play indirect role in capital budgeting decisions. The debt and equity play role in the computation of discount rate when the firm uses its cost of capital as the discount rate. Since interest on debt is tax deductible, thus, it provides leverage to the firm and lowers the discount rate.
Figure 2: Debt and Equity Portion in Total Capital
Uncertainty in Capital Budgeting
Since the capital budgeting decisions are based on the events that will occur in future, therefore, the element of uncertainty comes into play. The uncertainty designates the risk of happening, something against the developed expectations. In the capital budgeting decisions, the uncertainty is attached with the realization of the expected cash inflows. Thus, it is important to incorporate the element of risk or uncertainty in the evaluation process. This can be achieved by either adjusting the cash flows with the probability so as to make them certain cash flows or by adjusting the discount rate. The discount rate is increased on account of uncertainty or the risk involved in the project.
Figure 3: Risk in Capital Budgeting
However, when the cash flows are adjusted on account of uncertainty, the discount rate is not adjusted, as it will lead to consideration of the risk twice. The process of incorporating the risk in capital budgeting decisions:
Method-1: Adjusting Cash Inflows with Probability
Year-1 Cash Flows Probability Certain cash flows
10000 0.30 3000
12000 0.50 6000
15000 0.20 3000
Total 12000
Method-2: Adjusting Discount Rate
According to established accounting experts, one is not needed to adjust the cash flows with the probability; rather the discount rate is adjusted for risk premium. Say risk premium is 5%, then discount rate would be 15% (10%+5%). Further, in depth understanding on adjustment in the discount rate.
Summary
The aspects governing the capital budgeting decisions and the uncertainty attached with those decisions. The article concentrates discussion on the key elements of the capital budgeting technique such as cash flows, maturity period, discount rate, and debt/ equity portion in total investments. The article also emphasizes the issue of uncertainty and provides the methods of resolving the problems related to uncertainty. The article suggests two methods for incorporating uncertainty issues, namely Adjusting Cash Inflows with Probability and Adjusting Discount Rate.