Capital Budgeting the Underlying Principles

Capital Budgeting

The underlying principles of capital budgeting are inherent in any rational business decision. The rational actor - in this case a manager or executive -- must decide whether or not to undertake a project. This decision is based on the expected returns of the project relative to its costs. Capital budgeting is the process by which the manager arrives at the cost and estimated cash flow numbers of a given project.

The most important element of capital budgeting is the process by which the assumptions are arrived. Without sound assumptions, the figures subsequently derived lose their value. In capital budgeting, the initial cost outlay of the proposed project is generally known. The total cost might not be precise, but it should be a relatively precise number. The second element in capital budgeting is the future cash flow projection. This will require a series of assumptions.

Future cash flows can be derived based on a number of criteria. One is internal comparison. The logic behind this is that activities conducted in the future will behave roughly as they have in the past. If the project is similar to other projects undertaken, these assumptions can be considered reasonable. The second method is external benchmarking. If the company has little experience with a particular market or a particular type of project, but a competitor has that experience, the company can use the competitors' experience as a proxy for their own. If neither of these two options is reasonable, the company will need to derive its cash flow estimates through careful estimation. These figures, however, will be subject to greater variability because they are based on weaker information.

One of the unique concepts with respect to capital budgeting is that it is strictly concerned with cash flows. This means that accounting profits are almost irrelevant to the capital budgeting decision process, save for the influence profits have on taxes and other cash flows. All non-cash items should therefore be excluded from the calculations. In addition, flows that do not specifically relate to the project at hand must also be excluded from the calculation. For example, if a project has a portion of overhead allocated to it, but that overhead is a fixed cost that would need to be paid regardless of whether or not the project is undertaken, then the overhead allocation should not be counted.

The next step is to derive an appropriate discount rate. Capital budgeting always factors the time value of money into the calculation. It is inherently understood that because of the devaluing effects of inflation, a dollar earned five years from now will not have the same purchasing power as a dollar earned today. To reflect this, a discount rate must be selected to account for the time value of money. In capital budgeting, the discount rate is typically derived as the firm's cost of capital.

The cost of capital is a typically a weighted average of the cost of equity and the cost of debt. The cost of debt tends to be easy to identify -- most companies have some debt, from which they can extrapolate a cost of debt. If not, they should have a credit rating, from which their cost of debt can be derived by analyzing firms with the same credit rating.

There are several ways in which the cost of equity can be derived. They all have the same underlying principle -- that you can extrapolate past performance to derive future performance. The most simplistic model is the dividend discount model. This (rather optimistically) assumes that the stock price reflects the market's opinion with respect to the value of future cash flows based on the existing dividend rate and dividend growth rate. The most famous method is the capital asset pricing model, which begins with the calculation of the beta. The beta is the firm's covariance with the broad market. This is then used, along with the market rate of return and risk free rate of return to derive a cost of equity. The cost of equity is the risk free rate plus the market rate, factored for the beta, the degree to which the firm's stock prices changes as the market changes.

Related to CAPM is the arbitrage pricing model. Where CAPM relates a firm's stock performance to the overall market performance, the APT weighs the performance against a weighted-average basket of macroeconomic indicators. This is a more complex variant of CAPM but works under the same basic theory. The underlying rational for this theory is that companies move with key drivers in their industry, rather than with the market. For example, FedEx might move with the market in general, but a more robust covariance might be with respect to the cost of jet fuel, since that is the key cost input for the company. The arbitrage pricing theory allows for an unlimited number of variables to be used in the evaluation, but the end user must still assign weightings, which is somewhat arbitrary.

Each of these models assumes a publicly-held corporation, but the capital budgeting process can be applied to any decision in any company. If the firm is private, it obviously will not have a series of stock returns that can be evaluated against the market index or any other variable. In this situation, a proxy is used. The proxy should be a company whose operations are as close to the company being analyzed as possible.

The final step in the capital budgeting process is to synthesize this information. The future cash flows are discounted into present dollars using the cost of capital as a discount rate. These present value cash flows are added together and then to this figure the current value of the initial cash outlay is added. This yields the net present value. The most rudimentary view is that the firm should undertake any project with a positive net present value. However, firms are often faced with a set of mutually exclusive decisions. Therefore, a positive net present value does not automatically mean that a firm should pursue that option.

Before a final decision is arrived at, the firm should subject its NPV calculations to a sensitivity analysis. This means that the firm should change key variables in its calculation to determine two things. The first is whether or not the project will remain profitable given certain changes. The second is to determine the key drivers of success or failure of the project. The elements to which the project's financial estimates are more sensitive can determine the true viability of the project. A variable to which the estimates are not sensitive is no threat, but a variable that is known to be unstable or uncontrollable and to which the project is highly sensitive results in increased risk of project failure.

In addition to NPV, there are several other means by which firms can determine the worthiness of a capital project. Internal rate of return (IRR) is the discount rate at which the project's cash flows equal to zero. An IRR above the firm's cost of capital equates to positive NPV; an IRR below the firm's cost of capital equates to a negative NPV. The payback period is another measure. This method uses the present value of future cash flows to determine the point at which the NPV of the project turns positive. The more quickly a project turns positive, the better.

It should be noted that the notion capital budgeting can be solely used to determine the fate of proposed capital projects is unfounded. Corporations use the NPV, IRR or payback projections and weigh them against many other factors. These include the strategic fit, resource capabilities, the mutual exclusivity of competing project options and other variables. While in theory any project with a positive NPV should be undertaken,