Capital Budgeting Technique for Agribusiness - Agribusiness Education and Research International

Meaning of Capital Budget

Capital budgeting technique for agribusiness required for financial management perspectives. Capital refers to operational assets used in the development, and the budget leads to a strategy outlining the cash flows expected for a certain period of time. Capital budgeting is, thus, the assessment process for particular investment projects/decisions. A description of the expected investment in operational assets is the capital budget. Thus, the entire process of reviewing projects and choosing which ones to include in the capital budget is capital budgeting.

Capital Budgeting Significance

Capital budgeting decisions last a long time.
Company Planning Decisions.
Timing of required capital assets.
It increases the efficiency of acquisitions of properties.
It requires considerable spending

Capital Budgeting Phase Steps

Step-1: Estimation of project(s) cost(s).

Step-2: Calculation of cash flows expected.

Step-3: Identification of the uncertainty of the cash flows projected

Step-4: Calculation of the cost of capital relative to risk.

Step-5: To their current values, cash flows are transformed.

Step-6: Contrast of PV with expenditure for future cash flows.

Payback Period

It relates to the number of years needed to recover the costs of a project by cumulative cash inflows.

The formula for calculating the payback period is defined as:

Unrecovered cost at the start of yr.

Payback Period = Yr(s). before full recovery + ———————————-

Cash inflow during the yr.

Accept-Reject Decision Rule:

# If payback period < required payback standard—project is accepted

# If payback period > required payback standard—project is rejected

Net Present Value (NPV)

For an investment project, this is the difference between the discounted cash outflows and the discounted cash inflows. The NPV finding formula is given below:

_N _CFt

NPV = (-)CF₀ + ∑———

^{t = 1} ^{(1 + k)t}

Accept-Reject Decision Rule:

# If NPV > 0 = project is accepted

# If NPV < 0 = project is rejected

Average Accounting Rate of Return (AAR)

The average accounting rate of return is the average project earnings after taxes and depreciation, divided by the average book value of the investment during its life. The formula for finding out the AAR is given below:

AAR = Average return (income)/ Average investment

Accept-Reject Decision Rule:

# If the organization has a higher than expected targeted accounting rate of return (actual rate of return), the proposal is denied.

# If the organization had a lower than the expected accounting rate of return (actual rate of return, the project is accepted).

Internal Rate of Return (IRR)

It is a discount rate that equates an investment project’s cash inflows with its cash outflows, the required rate of return or the cost of capital. Below, the IRR finding formula is given:

Accept-Reject Decision Rule:

# If IRR > k = project is accepted

# If IRR < k = project is rejected

Profitability Index (PI)

It is the present value, separated by its initial investment, of the potential cash inflows for a project. So, by using the following formula, the ratio is estimated:

Accept-Reject Decision Rule:

# If PI > 1 = project is accepted

# If PI < 1= project is rejected

NPV and IRR is an important part of the Capital budgeting technique for agribusiness.

Differentiates between NPV and IRR

NPV	Subject	IRR
The discount rate, which is called the cost of capital or opportunity cost, is predetermined in the case of NPV.	i. Predetermined discount	The discount rate in the case of an IRR is not predetermined.
This approach considers the amount of investment in various projects.	ii. Difference in investment	The idea of the disparity between the amount spent on different projects is ignored in the IRR.
The discount rate is easily coordinated by the adjustment in the interest rate in the case of NPV.	iii. Co-ordination of interest rate.	Interest rates are not coordinated under the IRR.
We can get the principle of the asset increased in the business through this technique.	iv. Calculation of asset increase	By this approach, it is not possible to calculate the amount of asset growth, but to get the relative idea of a project fund.
A decision regarding shared project rejection in the NPV is simple to make.	v. Mutual decision of project rejection	The assessment of IRR is difficult because in certain cases, IRR can differ.
When there is only one project, NPV will make independent decisions regarding acceptance-rejection.	vi. Independent method of project evaluation	Only with IRR can the acceptance-rejection decision not be made.
In this approach, cash flow reinvestment is considered at the rate of capital expense.	vii. Stated condition of reinvestment	The measured IRR is used or considered in the IRR system for the reinvestment of cash flow.
This technique is commonly used for easy calculation.	viii. Use	Due to measurement difficulties, its applications are comparatively smaller.
In case of NPV method, if the NPV of any project is positive, it will be accepted.	ix. Acceptance of proposal	The project would be approved if the IRR is greater than the discount rate.
In the case of NPV, the cost of capital is important.	x. Cost of capital	It is not necessary to know the cost of capital.
The project(s) with negative NPV will be rejected under the NPV process.	xi. Proposal cancellation	If the IRR is lower than the project’s discount rate, it will be cancelled.
The NPV approach is simpler than the IRR method in terms of cost and complexity.	xii. Expense and complexity	The IRR approach is more costly and complicated than other strategies.

So, the importance of the Capital budgeting technique for agribusiness can not be ignored by the financial managers.