Capital Budgeting Managerial Finance

Capital Budgeting is a vital part of any business. Investment decisions, which need time to mature, must be based on the returns that they will make. If investment in a project is unprofitable in the long run, it would be unwise to invest in it. However, if the investment will be profitable, it is important to determine this early in the game.

Because huge sums of money can be lost if an investment or project turns out to be unsuccessful, capital budgeting is an extremely important activity in business. Capital budgeting builds on the concept of the future value of money, which may be spent now. It does this by examining the techniques of net present value, internal rate of return and annuities. The timing of cash flows is important in new investment decisions and the "payback" concept is an important one. (Ross)

When realizing the valuation of corporate securities, the value of an asset, whether financial or real, depends on the discounted value of cash flows over a relevant time horizon. Capital budgeting deals with the valuation of real assets and the total process of generating, evaluating, selecting and following up on capital expenditures.

When working on capital budgeting, valuation is being performed. In valuation, cash flows are identified and discounted down to present value. In capital budgeting, valuation techniques are used to analyze the impact of real assets instead of financial assets. Similarly, in capital budgeting, there is a strong emphasis on cash flow (at acquisition and throughout the project), not profits.

Techniques

Analysts have several capital budgeting techniques that they use. When analyzing a project or investment, it is important to consider all of the project's cash flows and consider the time value of money.

The payback period represents the amount of time that it takes for a capital budgeting project to recover its initial cost. The use of the payback period as a capital budgeting decision rule specifies that all independent projects with a payback period less than a specified number of years should be accepted. When choosing among mutually exclusive projects, the project with the quickest payback is preferred.

The payback period technique is simple to compute and provides some information on the project's risk. However, it provides no concrete decision criteria to indicate whether an investment increases the firm's value; it Ignores cash flows beyond the payback period; and it ignores the risk of future cash flows.

This is why analysts prefer discounted payback methods, which consider the time value of money and consider the risk of the project's cash flows. By using discounted payback methods, which are almost the same as payback, the analyst first discounts the cash flows. This reduces the future payments by the cost of capital, because it is money received in the future, which will be less valuable than money today.

The Net Present Value (NPV) technique involves discounting net cash flows for a project, then subtracting net investment from the discounted net cash flows.

This results in the NPV, which, if positive, would show that taking on the project would add to the company's value. Some companies may choose to adopt all projects that have a positive NPV, even if the value is very small. If a company must be selective, it is common procedure to choose only projects with high NPVs. With this technique, the discount rate used most frequently is the company's cost of capital. (Bodie)

A project's internal rate of return (IRR) shows the rate of return where the cash inflows (net cash flows) is equal to the cash outflows (net investment.) The IRR of a Capital Budgeting project is the discount rate at which the NPV of a project equals zero. The IRR decision rule specifies that all independent projects with an IRR greater than the cost of capital should be accepted. With the IRR technique, the rule of thumb is that, when choosing among mutually exclusive projects, the project with the highest IRR should be selected (as long as the IRR is greater than the cost of capital).

The IRR technique is usually favored by analysts over the NPV technique because it is straightforward, but it uses cash flows and recognizes the time value of money, like the NPV. IRR method is easy and understandable, yet it does not have the drawbacks of the ARR and the payback period, both of which do not take into account the time value of money. Most of the time, the IRR method will provide a correct recommendation and the IRR will be greater than the opportunity cost of capital when the NPV is positive, and vice versa. (Ross)

Problems

Still, the IRR has its own problems. It tends to give unrealistic rates of return. If the cutoff rate is fifteen percent and the IRR is calculated as thirty percent, an analyst should avoid accepting the project because its IRR is thirty percent, because an IRR of thirty percent assumes that a firm has the opportunity to reinvest future cash flows at thirty percent. If past experience and the economy indicate that thirty percent is an unrealistic rate for future reinvestments, the IRR is suspicious. Therefore, unless the calculated IRR is a reasonable rate for reinvestment of future cash flows, it should not be used as a key factor to accept or reject a project. (Brealey)

The IRR technique may also give different rates of return. If two discount rates that make the present value equal to the initial investment are present, this can create additional problems.

If an analyst compares two projects using the NPV and IRR methods, he/she will often get different results. The use of the IRR always leads to the selection of the same project, whereas project selection using the NPV method depends on the discount rate chosen. (Ross)

For instance, Project One and Project Two both call for initial investments of $2,500. Project One will provide annual cash flows of $100 for the next 10 years. Project Two has annual cash flows of $100, $200, $300, $400, $500, $600, $700, $800, $900, and $1,000 in the same period. The analyst finds that the IRR of Project One is 17% and the IRR of Project Two is around 13%.

However, if the NPV method is used, the analyst's decision will change depending on the discount rate used. At a 5% discount rate, Project Two has a higher NPV than Project One does. But at a discount rate of 8%, Project One is preferred because of a higher NPV.

The disadvantages of using the NPV technique are that it requires an estimate of the cost of capital in order to calculate the net present value and it is often expressed in terms of dollars, not as a percentage.