Introduction to Capital Budgeting

What is a capital budget?

Capital budgeting involves selecting projects that add value to the company. The capital budgeting process can involve almost anything, including the acquisition of land or the purchase of fixed assets such as new trucks or machinery.

Companies are usually required or at least recommended to undertake projects that will increase profitability and thereby increase shareholder wealth.

However, the rate of return that is considered acceptable or unacceptable is affected by other specific factors of the company and the project.

For example, the approval of social or charitable projects is usually not based on the rate of return, but based on the company’s desire to cultivate goodwill and give back to the community.

Key points

  • Capital budgeting is the process by which investors determine the value of potential investment projects.
  • The three most common project selection methods are payback period (PB), internal rate of return (IRR) and net present value (NPV).
  • The payback period determines how long it takes for the company to see sufficient cash flow to recover the original investment.
  • The internal rate of return is the expected return of the project-if the rate of return is higher than the cost of capital, then it is a good project.
  • Net present value shows the profitability of a project relative to alternatives, and may be the most effective of the three methods.

Understand the capital budget

Capital budgeting is important because it creates accountability and measurability. Any company that seeks to invest its resources in a project without understanding the risks and rewards involved will be deemed irresponsible by its owners or shareholders.

In addition, if a company cannot measure the effectiveness of its investment decisions, the company has a small chance of surviving in a highly competitive market.

Enterprises (except non-profit organizations) exist to make profits. The capital budgeting process is a measurable way for companies to determine the long-term economic and financial profitability of any investment project.

Capital budgeting decisions are both financial commitments and investments. By undertaking a project, the company is making financial commitments, but it is also investing in its long-term direction, which may have an impact on future projects the company considers.

Different companies use different valuation methods to accept or reject capital budget items. Although the net present value (NPV) method is the most popular among analysts, in some cases, the internal rate of return (IRR) and payback period (PB) methods are also frequently used. When all three methods indicate that the same course of action is taken, managers have the most confidence in their analysis.

How the capital budget works

When a company receives a capital budgeting decision, one of its first tasks is to determine whether the project will prove to be profitable. Payback period (PB), internal rate of return (IRR), and net present value (NPV) methods are the most commonly used project selection methods.

Although the ideal capital budgeting solution is that all three indicators indicate the same decision, these methods often produce conflicting results. According to management preferences and selection criteria, more emphasis will be placed on one method rather than another. Nevertheless, these widely used valuation methods also have common advantages and disadvantages.

Introduction to Capital Budgeting

Payback period

The payback period calculates the length of time required to recover the original investment. For example, if the capital budget project requires an initial cash outlay of $1 million, PB will show how many years it will take for the cash inflow to equal the outflow of $1 million. A shorter PB period is preferred because it indicates that the project will “pay for itself” in a shorter time frame.

In the following example, the PB period will be three years and one-third of one year, or three years and four months.

When liquidity becomes a major issue, the payback period is usually used. If a company has limited funds, they may only be able to undertake one major project at a time. Therefore, the management will pay great attention to recovering their initial investment for follow-up projects.

Another major advantage of using PB is that once the cash flow forecast is established, it is easy to calculate.

Use the PB indicator to determine the flaws in capital budgeting decisions. First, the payback period does not consider the time value of money (TVM). Simply calculating PB provides an indicator that also emphasizes the payments received in the first and second years.

This error violates one of the basic principles of finance. Fortunately, this problem can be easily solved by implementing a discounted payback period model. Basically, the PB period factor is discounted in TVM and allows people to determine how long it will take to recover the investment based on the discounted cash flow.

Another disadvantage is that both the payback period and the discounted payback period ignore the cash flow at the end of the project life cycle, such as residual value. Therefore, PB is not a direct measure of profitability.

The PB period in the following example is four years, which is worse than the previous example, but for the purpose of this indicator, the huge cash inflow of $15,000,000 in the fifth year is ignored.

The payback method has other disadvantages, including the possible need for cash investment at different stages of the project. In addition, the useful life of the purchased asset should also be considered. If the useful life of the asset does not exceed the payback period, there may not be enough time to generate profits from the project.

Since the payback period does not reflect the added value of capital budgeting decisions, it is generally considered the least relevant valuation method. However, if liquidity is a critical consideration, then the PB period is very important.

Internal Rate of Return

The internal rate of return (or the project’s expected rate of return) is the discount rate that results in a zero net present value. Since the NPV of the project is inversely proportional to the discount rate-if the discount rate increases, the future cash flow becomes more uncertain, and therefore the value will decrease-IRR calculation is based on the actual interest rate used by the company after discounting-tax cash flow .

An IRR above the weighted average cost of capital indicates that the capital account is a profitable endeavor, and vice versa.

The IRR rules are as follows:

IRR> Cost of Capital = Accepted Items

IRR

In the example below, the IRR is 15%. If the actual discount rate used by the company for the discounted cash flow model is less than 15%, the project should be accepted.

The main advantage of using the internal rate of return as a decision-making tool is that it provides a benchmark data for each project, which can be evaluated with reference to the company’s capital structure. IRR usually produces the same types of decisions as the net present value model and allows companies to compare projects based on the return on invested capital.

Although IRR can be easily calculated using financial calculators or software packages, there are still some disadvantages to using this indicator. Similar to the PB method, IRR does not give the true meaning of the value that a project will add to the company-it just provides a benchmark number of which projects should be accepted based on the company’s cost of capital.

The internal rate of return does not allow for proper comparison of mutually exclusive projects; therefore, managers may be able to determine that both Project A and Project B are beneficial to the company, but if they can only accept one, they will not be able to decide which is better.

When the cash flow of the project is unconventional, another error occurs when using IRR analysis, which means that there will be additional cash outflows after the initial investment. Unconventional cash flow is common in capital budgeting because many projects require future maintenance and repair capital expenditures. In this case, the internal rate of return may not exist, or there may be multiple internal rates of return. In the example below, there are two IRRs — 12.7% and 787.3%.

When analyzing individual capital budget items, IRR is a useful valuation indicator, not those mutually exclusive items. It provided a better valuation alternative to the PB method, but failed to meet several key requirements.

Net present value

The net present value method is the most intuitive and accurate valuation method for capital budgeting. Discounting the after-tax cash flow through the weighted average cost of capital allows managers to determine whether the project is profitable. Unlike the IRR method, NPV accurately shows the profitability of the project compared to alternatives.

The NPV rules stipulate that all projects with a positive net present value should be accepted, while those with a negative net present value should be rejected. If funds are limited to start all positive NPV projects, projects with high discounted value should be accepted.

In the following two examples, assuming a discount rate of 10%, the NPV of Project A and Project B are US$137,236 and US$1,317,856, respectively. These results indicate that both of these capital budget projects will increase the company’s value, but if the company currently has only $1 million to invest, project B is better.

Some of the main advantages of the NPV method include its overall practicality, and NPV provides a direct measure of increased profitability. It allows people to compare multiple mutually exclusive items at the same time, even if the discount rate may change, a sensitivity analysis of NPV can usually indicate any overwhelming potential future problems.

Although the NPV method has been fairly criticized for the fact that the value-added figure does not take into account the overall size of the project, the Profitability Index (PI) is an indicator calculated from discounted cash flows that can easily solve this problem.

The profit index is calculated by dividing the present value of future cash flows by the initial investment. PI greater than 1 indicates that the NPV is positive, and PI less than 1 indicates that the NPV is negative. The weighted average cost of capital (WACC) may be difficult to calculate, but it is a reliable way to measure the quality of an investment.

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